Management teams and compensation committees have long pondered how to establish credible financial targets for incentive structures that not only align with stakeholder interests but, importantly, also serve as a powerful behavioral tool to drive performance.
The need to establish performance targets that underpin incentive compensation structures is a natural extension of performance frameworks, which are the strategic foundation for executive compensation success. WTW’s Mike Oclaray addressed this topic in his article on how to Set your executive compensation program for success. Once that solid foundation is built, most public companies undergo some form of financial incentive goal-setting discussion that often starts in the fourth quarter.
Years ago, those goal-setting conversations focused narrowly on using the budget almost exclusively for setting incentive compensation goals. However, as compensation committees, data quality, investor expectations and the governance community have become more sophisticated in the past 15 to 20 years, the budget reliance theory has been tested — and challenged — with perceived rigor serving as a point of debate.
When setting financial incentive targets, there are at least five inputs that compensation committees should consider (assuming that budget will always be a primary consideration) when reviewing financial performance goals (see Figure 1).
In part, these views are supported by WTW’s Executive Compensation Guiding Principles, which reflect a well-reasoned perspective on executive pay (and goal setting) through the prism of purpose, alignment, accountability and engagement.
Many large public companies have multiyear strategies to develop a path toward long-term shareholder and stakeholder value. Companies often take great care in cultivating these strategies and refine them over time as competitors, macroeconomic factors, consumer preferences and markets often converge to test management’s mettle in the face of adversity.
Generally, having both metric selection and performance targets cascade from the multiyear strategy is a best practice. This is especially true for three-year performance stock unit plans with forward-looking goals. This is not to suggest that a linear progression to the Year 4 or Year 5 goal is required; however, ensuring that performance goals contain a reasonable glide path toward the end state is important.
Enduring standards — or performance levels that, if sustained over time, would likely be deemed favorable to shareholders — often are overlooked in goal setting. An example is an implied return on invested capital that is several percentage points above the organization’s weighted average cost of capital (WACC). The logic behind this could be that shareholders are unlikely to be supportive of paying management for performance below a company’s WACC.
Another example is consistently setting threshold EBITDA performance at a fixed percentage above prior years’ actual performance (e.g., 2% to help reinforce a growth mentality). It’s important to periodically test those enduring standards to ensure they make sense in the current environment.
Most large public companies provide earnings guidance to investors and the broader market when performance goals for the upcoming fiscal year are also being established. Typically, performance targets for metrics such as EPS, revenue or EBITDA are set at or very near the mid-point of the guided range. The slope of the incentive curve that is layered on top of these data is based on the extent to which guidance is viewed as conservative or more aggressive. Understanding key analyst expectations relative to the guidance also should be considered.
Throughout the year, most public companies use a compensation peer group to benchmark pay levels and incentive design topics. Gathering relevant information from some or all these peers as part of the goal-setting process serves as a proxy for industry trends and can be insightful.
This exercise also can be challenging, as certain non-GAAP adjustments from one company to the next can vary meaningfully, so it’s important to proceed carefully with this work to get some measure of comparability.
Showing recent (e.g., five-plus years) incentive payout history versus target can also serve as a useful reminder on pay outcomes. Consecutive years of payouts that are skewed in one direction often can raise questions about the underlying goals themselves. There are many who often cite that, on average, incentive should pay out near target levels over the course of time. While broad statements like this should not be relied upon in a vacuum, the spirit of the point is fair: Incentive targets should be challenging but reasonably attainable.
There’s no one way to set financial performance goals for incentive structures. Multiple frames of reference that balance both internal (e.g., budgets/forecasts, long-term strategies) with external data points (e.g., peer performance, analyst/market expectations) will allow for a well-rounded process. Having consistency from a principle and philosophy perspective will go a long way toward having a more credible year-over-year framework.
A version of this article appeared in Workspan on February 15, 2024. All rights reserved, reprinted with permission.
