Overcoming the Barriers to Sound Target Setting
To help with the challenges mentioned above, here are a few best practices and practical steps that can improve both the process and the outcome of target setting.
1. In-depth information and analysis to support the target-setting conversation.
Boards and remuneration committees must insist on greater depth and breadth of the information underpinning the target-setting conversation. Four main sources of information should be required to defend their targets:
Information and Analyses to Facilitate Target Setting
2. Co-opt shareholders in the target-setting process.
Boards can prepare themselves by having a dialogue with key institutional shareholders. Understanding and managing shareholder expectations is a critical responsibility of the board for both target setting and incentives. Many institutional shareholders consult pay-for-performance tests from proxy advisors to scrutinize targets and incentive plans. However, boards would be well served to have direct interactions with a few key shareholders well before the disclosure event. If conversations are conducted early in the process, it is likely to be more open ended and conducive to a candid sharing of information. Delaying the conversation until after the fact can lead to more defensive discussions.
3. Establish top-down direction.
In one scenario, the CEO of a large engineering group required his business unit heads to identify three of the top five percent of the company’s maintenance assets for potential disposal every year. The divisions were allowed to retain assets in this category only if they could demonstrate a certain minimum increase in return on investment. In essence, the burden of proof of performance improvement fell to the business heads rather than the other way around. The additional effect was the launch of an underperforming asset reduction initiative by all business units that led to return on capital employed (ROCE) improvements beyond the minimum threshold.
Other potential positive results of a top-down method are enhanced focus on non-financial drivers of the business and more comprehensive coverage of peer-group performance in business planning and target-setting discussions.
4. Frame the conversation around a range of outcomes, instead of a point estimate.
Scenario modeling elevates the notion of “stretch” target setting beyond a mere catchphrase. It helps quantify “stretch” based on the likelihood of achievement. Also, by understanding the range of performance outcomes, remuneration committees can define the performance upside/ downside and finetune the pay-performance curve.
No doubt, the rigor of scenario planning influences the quality of target setting and incentive design. However, in our experience, the issue is less analytical and more about the organizational mindset. Most leaders feel uncomfortable with the very notion of acknowledging the existence of significant risks, let alone discussing them with the board.
5. Define the conditions under which the targets will be adjusted or revisited.
Establishing targets is a good starting point, but companies also need a sound governance mechanism to revisit them over time. Progressive companies define boundary conditions that will trigger a re-examination of the plan. These could include large, non-recurring events such as mergers, divestitures and large investment projects. Certain other companies also define thresholds around variables, such as oil and commodity prices or freight rates, for which the targets will apply. The targets would be retroactively adjusted upon movements beyond the threshold to ensure that management is not unduly rewarded or penalized.
Many progressive companies not only articulate boundary conditions up front, but also define the methodology for recalibrating targets. For example, quite a few asset-intensive companies have successfully deployed a capital deferral policy to incentivize managers to undertake strategic value-creating investments that have long gestation periods. This involves creating a suspense account, wherein the planned negative earnings are “parked” for a pre-approved gestation period. However, management is held accountable for any overrun or additional deviation from planned earnings during the gestation period.
Projected Economic Profit
These adjustments not only eliminate the disincentive to invest in growth that creates long-term value, but they also hold management accountable for the additional capital they invest.