How To Fix “Busted” Incentive Plans

Chief Executive Officer

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CEOs and senior leadership teams have been doing the heavy lifting of keeping employees safe and healthy, safeguarding liquidity and building future business plans. All the while, 52% of companies have seen revenues erode 15% to 50% or more, according to a recent Korn Ferry Pulse survey. One of the downstream casualties of the current crisis is corporate short-term incentive plans that have moved from “achievable” to “highly unlikely” payouts due to the crisis.

So, what can or should a company do—particularly when front line employees and institutional shareholders are watching carefully? According to our survey, only 10% to 15% of companies have taken immediate actions to revise short-term incentives. The vast majority of companies are taking a wait-and-see approach.

Instead of being passive, we think CEOs should help their Compensation Committees think through a model for evaluating incentive plan performance. Any appropriate adjustments that result should be clear and understandable to the Committee, the participants and other key stakeholders. We believe that this requires carefully thinking through the applications of a series of levers to produce the best outcomes.

Incentive Support Model

We have built an Incentive Support Model to provide a roadmap. While management and the Compensation Committee have a point of view and approach on each key area, they may not need to exercise all these levers:

1. Financial Adjustment: The first lever to consider using is adjusting the financial targets used in the incentive plan. This pandemic’s financial impact was not one of the scenarios that was anticipated when companies were setting their goals. The Committee needs to evaluate the rationale and impact of adjusting out the effects of the crisis on global, regional, business unit or local results (to the best of the company’s ability to generate these numbers). This will allow the Committee to reason through the appropriateness of adjusting performance metrics. To the extent this lever is “activated” by a Committee when calculating final results and payouts, the adjustments would need to be explained in detail in any public filing (CD&A). This lever is best used in situations where the performance miss is more modest, and the impact of the crisis is easier to ascertain.

2. Overriding Discretion: This lever must be used carefully, as the institutional shareholders get concerned when it is applied. However, given the magnitude of the crisis’ impact on some companies, it is likely that even these usual critics will have to understand the situation at hand. In this case, the Committee needs to reason through when it is appropriate to apply discretion, in what situations and with which executive/management populations. This lever is best used in situations where actual performance is significantly off plan and/or the impact is harder to disaggregate from other factors (such as commodity prices, regulatory changes, etc.).

3. Incentive Plan Restart: This lever would suspend the annual plan that was implemented at the beginning of the year, and re-set goals (and possibly change metrics) for the last six months of the year in a “new” six-month plan. Payout potential is correspondingly cut in half as well. Committees need to reason through how critical goal alignment, and/or a new direction are for the back half of the year. This lever is best used when in situations where the impact of the crisis on business has rendered current incentive goals meaningless, and/or management alignment on a new set of priorities is critical to re-invigorating your business.

4. Incentive Caps: This final lever would come into play if performance results produce a windfall payout, primarily due to exogenous factors. Caps can be set depending on the circumstances anywhere between target and 125% of target goals. This lever is best used in situations where business results will be positively impacted by Covid-19.  Even in situations where financial performance is poor, great care should be taken when considering maximum payouts for any non-financial goals.

Caveats

In addition to the shareholder concerns raised earlier, cash management is a primary goal of the executive team in this crisis. Cash considerations should provide an overlay to any potential decisions that are made, as activating any of these levers (except the cap) would be a net negative to cashflow.

Conclusions

Short-term incentive plans are a core management tool for retaining, motivating, and aligning executives. Companies caught with a non-functioning plan and no game plan are at risk for an under-motivated management team, turnover and poor performance.

The world of executive pay was changing even before the Covid19 crisis hit—and that change has since accelerated. More than ever, the design and quantum of executive pay will send messages about a company’s role in broader economic and social recovery. It presents a genuine opportunity to put money where mouths are and to convey the right signals to a world that is hungry for signs of leadership—employees, shareholders and individuals alike.

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