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
© 2013 Towers Watson. All rights reserved.
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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