Incentive Plan Design for Compensation Committees

By Paul McConnell and Matt Ward of Board Advisory.

Board members bring a wealth of talent and experience to the companies they serve, but often have no practical exposure to the basic building blocks of effective compensation design. Before new compensation committee members jump into aligning incentives with company strategy, discussing “best practices” or considering accounting and tax implications, it can be very beneficial to review the concepts typically used by compensation professionals in incentive design. In our experience at Board Advisory over the past 30 years, we have seen countless successes and failures of incentive arrangements. As our experiences accumulated, we found a distinct pattern for successful incentive plans which we have distilled to the four “pillars” shared below.

In general, the most successful Board member incentive plans strike a balance between four pillars that support the entire incentive design structure; the plans work when Board participants:

  1. Know what is expected of them.

If the performance metrics are not a “household word”, do not tie pay to them. Companies and boards often get excited about new concepts and measurements that drive organization value, but if those measures are not part of the 24/7 fabric of the participant’s work life, the plan likely won’t work. Thus transitioning to new concepts requires training and retraining, until the concepts sink in, before tying pay to the measure. As we develop and select new measures to better reflect execution of company strategy, the trick becomes ensuring that the measure is also understood and embraced, much like the strategy.

  1. Believe it is achievable.

Oftentimes, companies place unrealistic targets in front of participants (e.g., $4.00 EPS when $2.50 is the rolled–up budget). There has to be a degree of buy-in to the goals, Board Advisory or the plan will be ignored or at the very least be ineffective. Many firms have moved away from such top-down goal setting, but several still use this approach and their incentives do not incent. If you want to reward for a 16% ROIC and the enterprise is currently only generating 12%, a roadmap showing how the goal can be achieved is mandatory.

  1. Track progress during the performance measurement cycle.

Participants need to see the goal line regularly. During the performance measurement period (say, monthly for an annual goal) tracking performance is crucial to plan effectiveness. Modern enterprise data solutions make this issue fairly moot in many cases, but newer goal concepts at many firms have resulted in performance tracking lag times that render the plans ineffective. For example, not seeing the results versus goal for Q1 until the end of Q2 is not highly motivational for annual plan participants. If the metric is important enough to be rewarded, it is important enough to be a part of timely, transparent communication.

  1. Earn a meaningful amount for achieving the goal.

In most executive pay plans, this is also a moot issue so long as we regularly set competitive target bonus opportunities, but many firms don’t. Also, in certain industries, the bonus plans often roll down to lower levels in the firms. Experience has taught us that at least one-month of pay (e.g., 8% of base salary), is the minimum target opportunity for the lowest level. At executive levels, we seldom see targets below 30% of annual salary. Participants are incented by pay amounts that can make a difference in their lives. Working hard to achieve meaningful goals that earn merely enough to take one’s spouse to dinner after a long year, is probably not really a meaningful amount.

The Take Away

Compensation committees are responsible for bringing the company’s strategy into focus through the use of executive and employee incentives. In addition to all the other critical elements in addressing compensation matters, members are advised to keep in mind these four simple pillars to ensure the resulting incentive design for Board members is effective.

Paul McConnell is Managing Director and co-founder of Board Advisory. Matt Ward is a Managing Director at Board Advisory, LLC. The original version of this blog post can be found here.