Making pay for performance work

Making pay for performance work Towers Watson’s Autumn Conference Short-Term Incentives Alasdair Wood & Beth Powell 3 October 2013 © 2013 Towers Wats...
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Making pay for performance work Towers Watson’s Autumn Conference

Short-Term Incentives Alasdair Wood & Beth Powell 3 October 2013 © 2013 Towers Watson. All rights reserved.

Why do short-term incentives exist?

      

To tie people costs to affordability/profits To share in business success / foster sense of inclusion To focus employees on specific goals and behaviours To motivate employees to perform better in order to receive higher pay To provide fair levels of pay reflecting an employee’s individual contributions To attract high-performing individuals to the organisation And therefore – to be market competitive in terms of structure of pay

The number of reasons and importance of each reason will vary by company, and even employees group, based on variables such as: • • •

Company philosophy and values Employee / union perspectives Impact of marginal increases in individual effort on business performance

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The premise behind short-term incentives

Short-Term Incentives

Increase in Discretionary Effort

Increase in Business Results

Expectancy Theory An increase in effort will lead to attainment of desired performance which leads to receipt of fair reward that is valued by the recipient

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Question for Group

Do short-term incentives motivate your employees to perform better?

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Why are short-term incentives still important when long-term business success is the key objective? 

Although most industries operate according to a long-term business strategy, short-term incentives are still critical because:  It is easier to set annual targets and objectives than multi-year ones  It is easier to measure annual performance than multi-year performance  Employees rely on receiving regular payments for personal budgeting purposes  The decisions that most employees make most of the time impact business performance within a one-year timeframe (exceptions include executives and planning department)  Employees may not be in same position or even with same employer over multi-year period

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The latest trends in Short-term Incentives

The incentive pool

Profit

is typically determined using financial and non-financial methods for tiered plans, pure financial results for organisational wide plans and for individual incentive plans have a budgeted approach using a sum of targets

A threshold of 70% – 80%

0% and 150%

is the most commonly used metric used to determine bonus pay-out levels for tiered and organisational wide plans, and individual performance rating from the Performance Appraisal system for individual incentive plans

of performance or a discretionary performance threshold are the two most common scenarios

represent the median percentages of target that a low and high performer typically receive respectively

Individual award payments are the same for most organisation-wide plans but more differentiated in other plan types

%

94 1/3

of companies award payment in cash and only 8% defer the award

of companies only pay someone a bonus if they are in employment on the date the bonus is paid of companies have introduced new plans and have the same focus for the coming 2 to 3 years 6

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Design parameters to consider in incentive plans Eligibility

Pay-out Payout schedule Deferred Cash/shares

  

Funding



 

• Who should be eligible? • Segmentation

Budgeted amounts Profit share Funding above a minimum return

  

  

Payout curve Link to performance levels

 

Target setting Absolute/relative Time period (LTI)

Calibration    

Minimum Maximum Target



Financial Non-financial Group, BU, individual

Performance criteria

Performance measurement

Targets weighting Additive/ multiplicative

Quantum Link and weights 7 © 2013 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. towerswatson.com

Potential combinations Design Decisions

Some alternatives

Participation

1. 2. 3.

Performance Criteria

1. 2. 3. 4. 5.

Performance Measurement

1. 2.

Links & weights

1. 2. 3.

Quantum

1. 2. 3.

Calibration

1. 2. 3.

Funding

1. 2.

Pay-out

1. 2. 3. 4.

Executives Only Executives & Mid-Managers All Employees

3 x

Group Sales Group Profit Business Unit financials Milestone achievements Individual Behaviours

5

Relative to peers Relative to budget

2

x

x

Additive Multiplicative Matrix

3 x

Market aligned Based on funding pool Same for all

3

Market aligned Based on funding pool Same for all

3

Sum of targets Based on profit pool Quarterly Annual Cash award Shares Deferred cash

= 6,480 potential STI designs!

x x 2 x 4 8

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Eligibility

Most likely to use a Groupbased performance measure and have a portion deferred into shares Executives

Tiered incentive plans most common

Leaders

Managers

Most likely to use an Individual-based performance measure Most likely to be segmented by function, e.g. sales, critical roles

Professionals

Manual / Clerical Staff

Most likely to have team bonuses (but still only used by c. 15% companies) 9

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Question for Group

Has your company made any changes to eligibility levels in the last five years?

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Design parameters to consider in incentive plans Eligibility

Pay-out Payout schedule Deferred Cash/shares

  

Funding



 

• Who should be eligible? • Segmentation

Budgeted amounts Profit share Funding above a minimum return

  

  

Payout curve Link to performance levels

 

Target setting Absolute/relative Time period (LTI)

Calibration    

Minimum Maximum Target



Financial Non-financial Group, BU, individual

Performance criteria

Performance measurement

Targets weighting Additive/ multiplicative

Quantum Link and weights 11 © 2013 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. towerswatson.com

Short-term incentive plan funding can be ‘top down’…

£Y

e.g. pool = 3% of operating profit

£X

Budget / on target

Stretch

Company performance 12 © 2013 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. towerswatson.com

… or bottom up… Employee group

Number of employees

Average salary

Target STI (%)

Target STI (£)

A

10

£300,000

60%

£1,800,000

B

150

£100,000

40%

£6,000,000

C

300

£60,000

25%

£4,500,000

D

1,000

£40,000

15%

£6,000,000

E

4,000

£25,000

10%

£10,000,000

Total incentive pool

£28,300,000

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… or a combination of both approaches

>£28.3m

£28.3m

Budget / on target

Stretch

Company performance 14 © 2013 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. towerswatson.com

The degree of flexibility in funding places greater or lesser emphasis on performance ratings and distribution of awards Within budget Beyond budget?

• Forced ranking • ‘Rob Peter to pay Paul’ • Discretionary 1

2

3

4

5

Performance rating 15 © 2013 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. towerswatson.com

Question for Group

How are short-term incentive awards funded at your company? How do you differentiate higher performers? Does the process work well?

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Design parameters to consider in incentive plans Eligibility

Pay-out Payout schedule Deferred Cash/shares

  

Funding



 

• Who should be eligible? • Segmentation

Budgeted amounts Profit share Funding above a minimum return

  

  

Payout curve Link to performance levels

 

Target setting Absolute/relative Time period (LTI)

Calibration    

Minimum Maximum Target



Financial Non-financial Group, BU, individual

Performance criteria

Performance measurement

Targets weighting Additive/ multiplicative

Quantum Link and weights 17 © 2013 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. towerswatson.com

Incentive performance measures should support achievement of business objectives

Strategy

Key performance indicators

External messages

Executive performance measures

Management / employee performance measures

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Value tree analysis can help identify linkages between headline measures and levers that employees can pull

COGS as % of revenue

SG&A and other Operating Costs as % of revenue

Depreciation as % of revenue

Net PP&E as % of revenue

Operating Margin

Working capital as % of revenue

Net other assets / goodwill as % of revenue

Long-term liabilities as % of revenue

Capital Turnover

Pre Tax RONA

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The emphasis on individual / business unit measures generally decreases with employee seniority

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A company’s position on the growth/income curve can be a good place to start when considering performance measures Start-up phase

Growth phase

Mature phase

High growth

Medium growth and income

High income

Incentive arrangements are typically awarded annually and should encourage stewardship of the business

Incentives focus on high potential rewards on success. Typically one-off block grant/awards Incentives motivate management to drive business forward

Deal-based equity incentive Market-based salary levels Market-based equity incentive 21 © 2013 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. towerswatson.com

Growth phases have different characteristics, including implications for performance measures Start-up phase

Growth phase

Mature phase

Business profile Business aim

Proof of concept/ breakthrough Create new market or displace an industry/region



Entrepreneurialism/ breakthrough thinking





Pragmatic/hands on/can do/needs must



Professional/expert management



Intellectual Aspirational Freewheeling



Low



Low but growing fast Phased financing



High



Mainly debt to get equity leverage impact





Executive role Culture



 

Capital volume

 

Top line growth Build out capability/brand Build the business/profit growth ‘Doer’/’Deliverer’

Equity lots Debt light







Debt/equity mix Role of mezzanine financing

Categories



Milestones



‘Growth in’ measures

Examples



Patents Market entry Proof of concept Growth in turnover Breakeven profit





   



Core finance



Efficiency/maintain market share Own the market/monopoly Milk and defend the franchise Custodianship Manage the franchise

KPIs

   

    

Revenue/market share Gross margin Operating profit EBITDA/EBIT PBT/Earnings EPS

  



‘Return on’ measures PBT/Earnings/EPS Return of Capital Employed Return on Equity

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Question for Group

How are short-term incentive performance measures selected at your company? Are they well aligned with strategic objectives?

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Implementation & Communications

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Regardless of design, successful incentive plans tend to possess certain common traits around perceptions and understanding 

Employees understand their roles and how they can 'win'



Employees believe that they can win



Employees believe that the reward for winning is worthwhile



Perception that goals for all participants have equal stretch and performance has been fairly assessed

Simple



Easily understood by participants

Aligned with role



Employees understand how they can influence outcomes

Champions



Managers 'own' the plan and see it as a tool to improve performance

Return On Investment



Management and shareholders feel there is a sufficient return on investment



Infrastructure (processes and systems for tracking performance) in place



Business literacy and training used to link employees with key business drivers

Motivating

Fair

Support

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Question for Group

What steps has your company taken to enhance level of understanding and perceived value of short-term incentives?

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© 2013 Towers Watson. All rights reserved.

Design parameters to consider in incentive plans Eligibility

Pay-out Payout schedule Deferred Cash/shares

  

Funding



 

• Who should be eligible? • Segmentation

Budgeted amounts Profit share Funding above a minimum return

  

  

Payout curve Link to performance levels

 

Target setting Absolute/relative Time period (LTI)

Calibration    

Minimum Maximum Target



Financial Non-financial Group, BU, individual

Performance criteria

Performance measurement

Targets weighting Additive/ multiplicative

Quantum Link and weights 28 © 2013 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. towerswatson.com

Financial performance targets are usually set by reference to a range of inputs Budget Judgement/ climate

Growth expectations

Investor expectations Incentive Plan Target

Board views Historic performance

Peer group/ relative performance

External standards (e.g. cost of capital)

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It can be helpful to consider threshold, target and maximum performance in the context of the expected distribution… Performance ranges may be established based on the probability of achievement and subsequent motivational impact

Typical Design Threshold (80% - 90%) Target (50% - 60%) Stretch (10% - 20%)

90%

100% Poor

80%

60% 50%

20%

10%

Probability of Achievement

0%

Motivation

Poor 30

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…alongside other key inputs to provide a balanced view 15%

13.0% 12.0%

12.0%

11.7%

100% vesting 10.5%

99.12% vesting

Annual EPS Growth

10%

10.0% 83.8% vesting

12.8%

12.5%

12.4% 100% forecast vesting

9.3% 8.9%

83% forecast vesting

10.7%

10.4%

72% forecast vesting

8.7%

64% forecast vesting

5.0%

6.2%

5%

5.0% 0% vesting

0% Historical Sep06Sep09

Historical Sep07Sep10

Historical Sep08Sep11

Historical Sep09Sep12

Forecast Sep10Sep13

Forecast Sep11Sep14

Forecast Sep12Sep15

Forecast Sep13Sep16

A

B

C

D

E

Median PSP target range (4)

Historical targets 3 yr historical EPS and resulting vesting under plan

Internal EPS projections (2)

Analyst Forecast Sep13-Sep16 (3)

FTSE 100 (excl Co ABC)

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Payout

The degree of performance/payout leverage is also a key factor – should you offer a broad performance range…

Target

Threshold

Target

Maximum

Performance

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Payout

…or a narrower range with higher leverage (perhaps appropriate when targets can be set with more certainty)

Target

Threshold

Target

Maximum

Performance

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Question for Group

How does your company determine short-term incentive performance targets? Do all stakeholders support targets every year?

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