April 09, 2015
Annual incentive plans typically represent 20–25% of total direct compensation for chief executive officers (CEOs). Companies can leverage these plans to promote greater alignment between executive pay and company performance. In the previous fiscal year, the compensation committee sets performance goals. If the goals are achieved, the annual incentive plan will consist of cash bonuses that are paid early in the fiscal year. The annual incentive opportunity is often expressed as a target percentage of base salary with corresponding threshold, target, and maximum levels of performance. The actual level of performance will then result in a corresponding threshold, target, or maximum level of payout.
In designing annual incentive plans, companies are careful to establish plan features with specific performance criteria that will provide optimal incentives to executives. It also allows companies to ensure that executive pay and company performance are aligned.
While these plans traditionally contain an assortment of weighted financial (i.e., cash flow, EBITDA) and non-financial (i.e., safety, customer satisfaction) metrics that will vary among companies due to the nature of the business and external market conditions, a number of companies also incorporate an individual performance element into the plan. To illustrate how companies design plans to account for individual performance, Equilar analyzed the annual incentive plans of CEOs at S&P 500 companies with fiscal years ending between July 1, 2013 and July 1, 2014.
Measuring Individual Performance
Within the S&P 500, 46.4% of companies factor individual performance into the CEO’s annual bonus plan payout. The remaining 54.6% of companies have one of three possibilities: an annual plan based on achievement of weighted financial performance, non-financial metrics with no individual performance component, or do not have an annual non-equity incentive plan for the CEO.
Companies factor individual performance into annual incentive plans in three ways: weightings, multipliers, or discretion. Weightings indicate what percentage of the annual bonus plan payout is dependent on individual performance, and are used at 16.6% of companies. Multipliers, which specify that the individual performance score be multiplied by the corporate performance score, are used by 13.6% of companies. Discretion indicates that an executive’s individual performance is a consideration but ultimately, has no formal weighting or multiplier effect on the payout. In 16.2% of companies, the board has the discretionary authority to increase or decrease payouts based on individual performance.
Individual Performance Weightings
Assigning a weighting is the most common way for companies to incorporate individual performance into an annual incentive plan. While individual performance weightings among companies ranged from a low of 2% to a high of 75%, nearly a third of companies used a weighting of 20%. Plans that assign a larger weight to individual performance will have a more significant total payout.
In addition, the majority of companies (54.9%) that used an individual performance weighting disclosed payouts above target at a median payout of 118%. Payouts at and below target for individual performance are not nearly as prevalent (17.1% and 15.9%, respectively). When weighting is disclosed, 12.2% of companies do not disclose payout versus target for the individual performance component.
Individual vs. Corporate Performance Scores
An interesting point of comparison exists between the individual performance payout versus target and the corporate performance payout versus target. There were 72 companies that provided a payout versus target figure for both a weighted individual performance score and a corporate performance score. At exactly half of these companies, the individual performance score exceeded the corporate performance score.
Individual Performance Multipliers
Multipliers are not as prevalent as weightings, but are useful for companies to integrate an executive’s individual performance with some level of discretion. A multiplier consists of both threshold and maximum levels for the individual performance component. Using these two parameters, the board will determine the actual adjustment to apply to an executive’s corporate performance score in an effort to increase or decrease any payout.
Companies may choose to account for individual performance within an annual incentive plan by offering the board some form of discretion to increase or decrease an executive’s payout. The vast majority of companies employing discretion in annual incentive plans do so with both downward and upward discretion. However, there are companies that will grant discretion in only one direction.
Of the 81 companies with discretionary individual performance components, 32 companies exercise discretion in making an actual adjustment to the individual performance component. Of these companies, only 6 made a downward adjustment to the payout.
Please contact Dan Marcec at email@example.com for more information. Dan Marcec is the Director of Content & Marketing Communications at Equilar. The contributing authors of this paper are Andrew Gordon, Senior Project Manager, and Chris McGoldrick, Content Manager.