Talking Points - Sins of Performance Measurement and Board Oversight

Diane Doubleday is a Partner of Mercer Consulting and Don Delves is President of The Delves Group

Poor Incentive Design #1: It is only about the long-term plan; the annual plan is fine

Adding a long-term performance based plan affects the annual incentive plan.  Companies can find themselves paying twice for the same performance or paying handsomely for annual performance year after year without ever achieving the long-term goals.

The Cure:   The Compensation Committee should take a holistic approach to incentive plan design so that all goals are aligned.

Poor Incentive Design #2: Keep it simple – use just one measure

Don’t make the mistake of making your plan easy to manipulate.  Don’t blindly follow what other companies are doing in order to make your process simple. This usually results in goals that don’t motivate the team, motivate the team to do the wrong thing, or are too easy and result in overpaying for performance. 

The Cure:  The selected measures should reflect your company’s business strategy, culture, and HR philosophy.  The measures should be controllable and they should communicate how the company intends to achieve its strategy.    If you aren’t discussing a balance of growth, return and strategic measures, ask why. 

Poor Incentive Design #3: Setting goals is too hard

Cyclical companies and those in the midst of change may use this as an excuse for not implementing long-term performance-based plans.

The Cure:  Consider a blend of relative and absolute performance.  Establish ranges around goals to avoid cliffs -- on/off switches encourage manipulation. Decide what the  payout curve between threshold and outstanding performance should be – straight line not required.  Figure out what it takes to beat the competition, what it takes to produce economic profit and design your plan accordingly.

Poor Incentive Design #4: Looks good, sounds good, must be good

The process doesn’t end with the decision about metrics and targets. Unless you thoroughly test a plan design under multiple scenarios, you don’t know whether it will work. There should be no surprises about payouts, about the performance that produced the payouts or about how much the plan cost. 

The Cure:  Thoroughly test the plan.  Back test against your company’s performance and against your competitors’ historical performance.  Forward test to avoid surprises later. Analyze the cost sharing: for every dollar of improved performance, how much goes to the incentive plan participants. 

Board Oversight Sin #1: Stick to traditional competitive pay analysis - annual compensation data only, on a position-by-position basis, using consulting firm surveys only.

The Cure:

• Calculate and evaluate the Total Cost of Management (TCM)
• Use proxy data from peer companies to check survey data. Peer group should be chosen by the Compensation Committee.
• Performance data is as important as pay data.
• Test competitive pay levels relative to competitive performance levels. 75th percentile pay should require 75th percentile performance.
• Calculate Return on Management (ROM). ROM is TCM relative to various performance measures.

Board Oversight Sin # 2: When an unplanned event occurs, make it up as you go along. Determine adjustments to incentive targets and payouts on a purely subjective, ad hoc basis.

The Cure:

• Establish "rules of the road" or guidelines for how most events (acquisitions, divestitures, currency swings, natural disasters, etc.) will be treated.
• Establish underlying principles that will guide the committee if an item is not covered by the guidelines or is unclear. Principles include materiality, responsibility, accountability, consistency etc.
• Make adjustments on a consistent basis. Refer to how similar (or opposite) events were treated in the recent past.

Board Oversight Sin # 3: Ask management to pick your compensation consultant, and make sure to pick one that has lots of other business with management.

The Cure:

• Compensation committee selects and retains the compensation consultant.
• Consultant meets with management as needed at the direction of the committee.
• Consultant only engages in additional projects with management at the direction of the committee
• Committee has control over the consultant's fees and payments.