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The Executive Incentive Plan Design: Who Creates, Who Critiques?

By Chris Crawford and Ian Keas, Longnecker & Associates  |  June 2013

In any company, the relationship among the management team, compensation committee and outside advisers can be complex. This dynamic interplay of parties often comes to a crescendo in the executive incentive plan design process.

When a company implements an executive incentive plan design, best practices often involve four categories of involved parties: senior management (which usually includes a number of different people on the design team), the compensation committee, an audit committee representative (the €œaudit committee €) and the compensation consultant (the €œconsultant €). In the executive incentive plan design process, the question often becomes €œWho creates and who critiques? € The following is a brief road map for navigating this often difficult path.

Step 1: Incentive Payout Targets, Threshold and Maximum

Create: Consultant
Critique: Senior management and compensation committee

The first step in designing an executive incentive plan is to establish payout levels. The initial recommendations, which are based on market information, are often developed by the consultant. In some organizations, management teams take on this responsibility. However, while they may have a solid understanding of what is market competitive, such an undertaking can present conflicts of interest in dealing with senior management pay.

The consultant’s recommendations (excluding those for the CEO’s incentive) are then revised by senior management based upon internal equity. Senior management has the best understanding of a company’s internal culture and operations and is therefore in a prime position to refine the consultant-proposed recommendations.

The last items in this step are to obtain compensation committee approval of targeted payout levels and set targeted payouts for the CEO. Since this first step only establishes payout levels, the audit committee may not have any responsibility or oversight at this time.

Step 2: Metric Selection

Create: Senior management
Critique: Compensation committee, audit committee and consultant

As the entity most in tune with the business, senior management should retain the responsibility of identifying metrics and the corresponding goals and weightings to be used to calculate annual incentive payouts. Senior management should establish the metrics, goals and weightings based upon the goals, objectives and budget of the company. In public companies, senior management should establish these figures independent of public guidance numbers provided to the market.

Once developed, the metrics and associated goals and weightings should be vetted by the other parties involved in the executive incentive design process. The compensation consultant should review senior management’s proposal and provide recommendations based on market best practices. Guidelines, but not prescriptions, for such practices typically include three to five financial and operational metrics in addition to threshold, target and maximum metric goals based on 80%, 60% and 20% achievement probability, respectively.

The audit committee’s representative should review senior management’s recommendations based on submitted budgets and provide guidance on the recommendations if applicable. The compensation committee then has the final say on senior management’s recommendations, scrutinizing and approving metrics, goals and weightings for the CEO and all other executives in the plan.

Step 3: Measuring Performance

Create: Senior management
Critique: Compensation committee, audit committee and consultant

Once the framework of the executive incentive plan is in place, senior management may provide periodic updates to the compensation committee, audit committee and employees on the company’s performance. It is important that the compensation committee, audit committee and compensation consultant review the company’s performance in relation to the established metrics prior to final payouts.

Step 4a: Senior Management Payouts

Create: CEO
Critique: Compensation committee, audit committee and consultant

When the performance period ends, senior management is responsible for gathering company performance data from the applicable period so that the CEO can make recommendations on calculated payouts for those employees included in the executive incentive plan based on the established metrics, goals and weightings. The audit committee representative is responsible for reviewing these recommendations and calculations to ensure accuracy. The compensation consultant, after also reviewing for accuracy, may then take the recommended payouts and compare them against the company’s attributed market, identifying the executive incentive awards’ competitiveness.

As such, the compensation committee, in its review of performance payouts, may take into account the consultant’s review and assessment of the competitiveness of the awards. The compensation committee may make changes to the executive incentive plan to adjust for external market conditions over which the company and CEO have no control or influence. Moreover, in an effort to motivate and retain key talent, the committee may have the ability to apply discretion to formulaic awards or award discretionary bonuses at the end of a performance period.

Step 4b: CEO Payouts

Create: Compensation committee and consultant
Critique: Audit committee and full board of directors

While somewhat similar to the process used to calculate and recommend senior management incentive payouts, the CEO payout process uses different parties in order to preserve process independence.  When the performance period ends, the compensation committee and consultant are responsible for taking company performance in the applicable period and making recommendations on the payout for the CEO based on the established metrics, goals and weightings. The full board of directors is responsible for reviewing these recommendations to ensure accuracy. The compensation consultant, after reviewing for accuracy, may then take the recommended payouts and compare them against the company’s attributed market, identifying the CEO’s incentive award competitiveness.

As such, the compensation committee, in its review of performance payouts, may take into account the consultant’s review and assessment of the competitiveness of the awards. The compensation committee may make changes to the executive incentive plan to adjust for external market conditions over which the company and CEO have no control or influence. Moreover, in an effort to motivate and retain key talent, the committee may have the ability to apply discretion to formulaic awards or award discretionary bonuses at the end of a performance period.  

Summary

The design, implementation and execution of executive incentive plans are conducted in a dynamic environment of various parties, personalities and relationships. Using the “Who creates, who critiques?” approach to address the four steps essential to the executive incentive design process, the four sets of decision makers are able to streamline the various processes and responsibilities involved at each step of the incentive design. The result is an executive incentive plan design with fewer hiccups; greater transparency, understanding and participation; and a more successful implementation.

About the Authors

Chris Crawford is COO and executive director of Longnecker & Associates in Houston. He can be reached at crawfordc@longnecker.com.

Ian Keas is a consultant at Longnecker & Associates in Houston. He can be reached at keasi@longnecker.com.


Read the June edition of Compensation Focus.

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