The Advisors' Blog

– Liz Dunshee

We talk a decent amount around here about performance targets for incentive awards – here’s a blog about how they tend to compare to earnings guidance. And it’s easy for shareholders & the media to run with that shorthand. But when you’re doing the detailed work to help compensation committees develop performance plans – and maybe also, when you’re communicating to shareholders, that’s not exactly the best thing to emphasize. As articulated in this Semler Brossy memo, it’s the performance range around target that actually drives payouts.

How can compensation committees reduce the risk of ending up below threshold or above maximum? The memo suggests changing threshold & maximum performance levels annually to keep likelihood of achieving those levels at a set percentage – e.g. threshold performance expected to be exceeded 90% of the time & maximum performance expected to be achieved 10% of time. Here’s some recommendations on how to come up with those numbers:

– Review historical results for the company and its peers to assess probabilities

– Assess the current drivers of performance and the sensitivity of the various drivers on performance to supplement historical data & get a forward-looking perspective on an expected range of outcomes

– Understand how the incentive goals stack up against other Wall Street inputs – e.g. whether achieving target payout means that consensus earnings were achieved

– Test “sharing ratios” – how much of the company’s incremental earnings are being paid out in incremental bonuses – to confirm you’re within industry norms

– Establish guidelines for incentive adjustments at the beginning of the year – and ensure the adjustments are fair & adequately disclosed