Simplifying Performance Target Setting For Executive Compensation

In today’s economic environment, boards, remuneration committees and activist shareholders must reassess the traditional approach to defining and assessing executive performance — even more so with the recent amendments adopted by the Securities Exchange Commission (SEC) for companies to disclose executive pay and financial performance measures for the past five fiscal years.

Conventional wisdom on performance target setting dictates that companies must set “stretch, but realistic” targets. In essence, companies are trying to find a sweet spot between what can be fair pay for performance but also fair to the management. However, not many companies have been able to translate this philosophy into practice.

This article shares obstacles faced by companies when setting performance targets for their executives and how an effective framework can help them navigate the road ahead.

What Ails Conventional Target-Setting Systems?

In our experience, most leading companies can articulate their performance metrics in a way that reasonably captures the company’s strategy and key drivers of value creation. While performance metrics are indicative of a company’s strategy, the approach to setting performance targets and appraising them using these metrics is much less robust. Many companies do not have the facts they need to make fully informed decisions about target setting. Instead, they make do with a mix of data (that is not broadly shared across the senior team or the board) and legacy opinions that have acquired the status of facts simply because no one has ever challenged them. As a result, assumptions are not tested, and often, the board and management resort to their comfort zone of extrapolating last year’s actual performance to set next year’s target performance.

These issues should be examined more closely because they illustrate the three underlying components of the target-setting process - politics, emotions and analysis.

Emotions, Politics and Analysis Issues in Target Setting

1. The Emotional Component

The target-setting process is often an intensely personal experience for the CEO and board − amplified by the fact that millions of dollars of management compensation is linked to achieving these targets. This can result in the board and management potentially using this process to score points against each other.

Debating targets can be fraught with ego battles. Some CEOs feel that asking their management team to participate in target-setting discussions with the board will undermine their own leadership status and credibility. Board members, too, may feel that challenging management targets can be misinterpreted as a loss of confidence by the board.

Then there’s the risk of distortion. For most boards, strategy and target-setting discussions require interpretation of facts, and ultimately using the interpretations to decide if the recommendations are correct. Unsurprisingly, this multistage process can often be distorted by individual judgment. Individuals may be unaware of their own biases. Further, in the absence of factual information, they may not even be equipped to detect or neutralize any such biases.¹

2. The Political Component

The target setting process inherently carries tensions arising from the different interests of each stakeholder – the management, the board and shareholders. Even more critical are the dynamics between the board and the management. Most large companies have a dedicated strategy team that develops a rolling long-term plan every year. In theory, companies expect a functional leader, such as a Chief Financial Officer, to challenge the strategy. But an insider, whose primary job is to critique management, can quickly lose political capital.

3. The Analytical Component

A significant issue impacting target setting is the depth and breadth of the analysis that supports the dialogue. In addition to the business plan, information on analyst consensus estimates, peer performance and future guidance, and the growth expectations implied in current market multiples, can yield valuable insights. Yet, these are often not considered and dismissed as irrelevant, with statements such as “We are overvalued by the stock market.”

Scenario and sensitivity testing of key value drivers is far easier to incorporate into the analysis. Such tools can be used to improve the quality of the strategy through a deeper exploration of the risks involved. Moreover, they can also help the board understand the range of performance outcomes, set realistic levels of stretch in targets, design appropriate pay performance schedules, and develop a formal, proactive mechanism to recalibrate targets if long-tail risk events occur.

¹ Refer to “The Big Idea: Before You Make That Big Decision” by Daniel Kahneman, Dan Lovallo, and Olivier Sibony, Harvard Business Review, June 2011, for a more detailed and insightful exposé on cognitive bias in decision making.

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.

Next Steps

Clearly, there is no silver bullet solution to target setting for executive compensation. Nonetheless, boards and compensation committees can institutionalize a reasonably comprehensive target-setting framework to set the bar for the value that management needs to create for its shareholders and can assess whether their actual performance has met expectations in a transparent and objective way.

To learn more about performance target setting for executives, please reach out to humancapital@aon.com.

A version of this article was published on aon.com/india.