Setting Incentives Without a Budget

Setting Incentives Without a BudgetZoom inDownload PDF

This is the season when many boards evaluate operating budgets and set targets for incentive compensation plans for executives. The two processes are so commonly blended together, they have essentially become one. And that can be a problem.

The intent of setting operating budgets is to forecast, as accurately as possible, what the company can achieve in the coming year and what resources will be required to perform at that level. However, a frequent concern of compensation committees is that goals may have been “sandbagged” with lower targets than are actually expected or achievable to help managers look good at year-end and ensure larger bonuses. In other words, the process of managing compensation compromises the forecasting process. Indeed, CEOs sometimes fret that linking incentives to annual business plans turns the whole planning process into a negotiation, rather than a realistic assessment of the business and opportunities.

Even without such negotiation, in the current market environment, accurate forecasting is already challenging enough, and can often lead to unintended consequences for incentive plans. This is true in the short-term as companies seek to set annual operating plans, and it is even more of a problem over the long-term, as multiyear business forecasts are notoriously difficult to “get right” in all but a handful of businesses.

For example, the outlook this year may look so shaky your board is ready to agree to relatively low targets for executive incentives. But suppose there is a breakthrough in the euro crisis and the U.S. Congress unexpectedly reaches an historic compromise on taxation and spending (wishful thinking, but for the sake of argument I ask for your indulgence). The landscape would then quite suddenly look very different than when the budgets were set and we would be paying near maximum incentives with little effort on behalf of management.

With such powerful and uncontrollable variables at play, even the shrewdest forecasters are likely to be wrong as often as they are right. Yet under today’s regulations, your board and compensation committee may have little flexibility to change performance goals mid-year to make them more reasonable in light of unanticipated conditions, be they positive or negative.

The alternative? Disconnect incentive compensation from the annual budget or long-term forecasting process. Key incentives instead to a fixed standard — for example, a specified level of revenue growth, profit growth, or some combination of the two — that equals strong value creation for shareholders over several years, regardless of what the near-term budgets might say. This approach focuses the company on what needs to be done on a sustained basis, rather on “guesstimates” of what will happen in a given year, thus linking executive incentives to the ongoing strategic health of business. We see maybe 20 percent of companies using a fixed standard rather than budgets to set performance goals for the annual and/or long-term incentive plans.

One high-tech company we work with, for example, saw that analysts were forecasting a decrease in the rate of revenue growth, offset by expectations for higher earnings growth, for the company as well as its peers. We worked with the company to thoughtfully define a multiyear performance standard that was above the analyst consensus and would beat the Street’s ongoing expectations — clear and constant keys to sustaining strong market valuation. Thus, executive compensation for that company is now more closely aligned with optimizing shareholder returns, and less with beating annual (and to varying degrees, arbitrary) forecasts. No doubt, most shareholders value the former more than the latter.

The risk to keying performance goals to a set multiyear standard is increased volatility in pay results. When you no longer move targets up or down each year, based on favorable or unfavorable short-term outlook, you tend to experience wider swings above and below target. The board must be prepared to pay the maximum incentive if things go well, or nothing at all if they do not, perhaps for several years in a row, and even if the results are driven more by macroeconomic factors than by management decision-making. And to many boards, that feels risky, even though a standard-based approach more closely aligns management’s experience with that of shareholders.

Nevertheless, when a long-term performance standard is set, and when the system has credibility for the management team, such absolute standards of success can become engrained in the management culture of the company. The question becomes not “what do we think we can do this year?” but rather “how can we achieve our goal despite this year’s headwinds?” When linked to pay and used consistently, performance standards can be a powerful motivator and retention tool.

Advantages

Disadvantages

Using business plans for goal setting works fine for many companies — after all, sometimes we will get the forecasts right! — but especially in these uncertain times, all companies should at least consider the alternative of keying incentives to fixed performance standards to effectively remove negotiation and gaming from annual forecasting, and to focus management on driving sustained strategic success, each and every year.

This article by John Borneman originally appeared in NACD Directorship.