Below is an excerpt from ISS-Corporate’s recently released paper “Individual Performance Metrics: Discretionary Adjustments or Pay Flexibility?” The full paper is available for download from the ISS-Corporate online library.
Key Takeaways
- Incorporating discretionary components within a company’s Annual Incentive Program has become increasingly common, particularly in the Real Estate and Financial sectors.
- Companies that have individual performance metrics in their Annual Incentive Programs tend to deliver higher payouts and executives are more likely to achieve target than companies that do not.
- Discretionary components in a compensation program generally shift pay more towards the Annual Incentive Program for companies in the Russell 3000, while having the opposite effect for the S&P 500.
- Individual performance metrics may be used as a substitute for discretionary bonuses for S&P 500 companies, but the opposite is true for Russell 3000 companies, where companies with discretionary metrics also award larger discretionary bonuses on average.
Metric selection in an Annual Incentive Program (AIP) gives company directors the opportunity to tailor compensation plans to the specific circumstances of the company’s named executive officers (NEOs). Often this decision revolves around competing goals as the compensation plan is expected to compensate NEOs for the opportunity cost of their time, reward exceptional performance, retain talented individuals, and incentivize high effort and productivity. While a well-designed Annual Incentive Plan considers all of these factors, shareholders generally prefer AIPs that display a clear relationship between shareholder value creation and executive pay.
Traditionally, metric selection for an AIP has focused on preset, quantifiable metrics so that clear goals can be established at the beginning of a performance period. However, firms have also included individual performance metrics (IPMs) that reflect non-financial objectives such as individual performance, strategic and personal goals, and other more qualitative and subjective measures.
These qualitative metrics allow compensation committees a greater degree of flexibility in rewarding executives. While preset, quantitative metrics may be assessed more easily by shareholders, a weak metric may lead to opportunistic behavior on the part of executives in pursuit of a singular goal at the expense of shareholder value. Complementing traditional metrics with IPMs may mitigate the noise of other performance measures by allowing directors to reward executives more holistically.
A more cynical view is that these IPMs are used as a substitute for discretionary adjustments and to ratchet up pay. A compensation committee always has the discretion to alter payouts, but ex-post adjustments usually generate significant shareholder pushback. This is especially true if an executive performs below his or her target within several financial metrics, and the compensation committee uses its discretion to restore final payouts back to near-target level. Having some percentage of executive compensation tied to factors that are difficult to adjudicate may be a way for compensation committees to retain the power of discretion without losing the support of shareholders.
This paper focuses on how IPMs allow compensation committees to set discretionary performance targets. The analysis looks at IPMs within Annual Incentive Programs across 2,124 companies in the S&P 500 and Russell 3000 to determine how often they are used, and what their impact is on executive pay. Given the lack of transparent disclosure for many instances of these metrics, it was nearly impossible to evaluate goals and payouts at a metric level. Instead, this paper divides companies into those that do and do not use IPMs and compares compensation patterns within the two groups. The goal of this analysis is to determine whether there are any noticeable differences among companies that utilize IPMs, and whether IPMs led to higher incentive program payouts. It should be noted that the analysis here implies correlation rather than causation.
By:
Craig Benedict, Senior Associate, ISS-Corporate, Compensation and Governance Advisory
Daniel King, Associate, ISS-Corporate, Compensation and Governance Advisory
