High inflation, global warming, and international conflicts continue to disrupt supply chains in the wake of a multiyear pandemic. Although the personal and business hardships of COVID-19 now lie mostly in the past, discussions of possible recession still dominate the media, and many US executives are receiving significantly reduced bonus payout and performance awards (if they get any at all). These turbulent economic conditions highlight significant issues with incentive design, and the business world should explore multiple possible options until more predictable forecasting conditions return.
Goal-Based Performance
Most executives probably have a goal-based performance incentive plan, a “best practice” shared by most established and respected US companies. Goal-based variable-incentive plans use financial and accounting measures and preestablished incentive formulas that convert corporate, business unit, and individual performance (all tabulated at the end of the performance period) into bonus payout dollars or shares of stock. Incentives are usually paid within two to three months after the end of the calendar year, timing that qualifies many corporations for an accelerated tax benefit for these payments.
Plans that incorporate goal-based performance targets for the current incentive plan year were established back in the days when overall US corporate financial performance exhibited few early warning signs in limited industrial sectors. As this current incentive plan year progresses, however, many US organizations may find that they are unable to meet preestablished budget-based incentive targets or thresholds. The collective US corporate experience has tempered many of the budget and incentive target expectations for the incentive plan year. The incentive thresholds and targets for future years have generally diminished or increased at a slower rate in light of the poor performance results, reflecting a newly shared reality within the industrialized world. One consolation is that executives who may not have earned a bonus or performance award this year could make up for this loss with larger incentive cash and performance equity opportunities for lowered overall corporate performance expectations.
The larger and more immediate problem with goal-based incentive plans in 2023 is that no one really knows how inflation and supply-chain interruptions will affect the bottom line. In the worst case, the United States and other industrialized countries may experience frequent supply-chain interruptions that could further diminish global commerce and significantly reduce corporate growth and earnings. In the best case, new markets could be opened, and companies would globally rebound to unprecedented levels of prosperity. Accordingly, preestablished budget-based incentive bonuses for 2023 could either tank for a second straight year or could reach capped payout maximums. Some argue that, in this time of uncertainty, companies are more likely to perform either well above or well below already diminished 2022 performance ranges. The crystal balls of corporate forecasting are currently foggy at best.
Profit Sharing
One of the incentive practices that went out of vogue with the spread of goal-based incentives was the use of old-fashioned profit sharing for the executive team. Profit-sharing bonus pools are linked by a formula to how much the company earned each year above a long-established threshold. Some profit-sharing plans have payout caps, whereas others do not. Profit-sharing plans directly link incentive bonus payouts to corporate earnings. In good years, participating executives receive more; in not-so-great years, they receive less. In all cases, awards are based on how much the company earned, not on the ability (or inability) of management to budget or set goals beyond a threshold minimum. In a time when it is difficult to know with certainty what the business environment will be like over the next several months or years, a simple approach based entirely on earnings and not targets could be an attractive alternative to goal-based structures.
Peer Comparisons
The peer-comparison approach to annual-incentive and long-term performance awards mitigates the impact of external political and economic factors by using formulas that link payout levels to how well the company performs relative to statistical reference points of peer-group performance. Budgets and historical peer-group relationships are generally used to calibrate peer-based incentive formulas from year to year. The peer-based approach shifts the focus of annual incentives away from absolute budget-based targets to how the company’s financial performance compares with the peer group. Consequently, peer comparisons often involve calculation lags of several weeks or months as the company waits for financial performance data to become available for companies within their peer groups.
Measuring a company’s performance relative to other competitors in the industry may initially appear feasible but is frequently difficult in practice. The complexity of this approach often becomes apparent in the peer-group selection process. A large peer group is necessary to lessen the impact any one company could have on the group’s executive bonuses and to monitor the industry’s performance for incentive comparison purposes. Yet many companies run into problems identifying a sufficient number of companies that are comparable in size, market, product, and relative financial health. Some “ideal” candidates might be incorporated in other countries that have different currencies, economies, and accounting conventions, and others could be subsidiaries of firms that serve vastly different industries or are privately held (and therefore do not have public performance-reporting requirements). A related problem is that, during trying times, many companies may enter—or exit—the list of “ideal” peer groups in any given year.
Something Completely Different
For the brave, an alternative to goal-based incentives during uncertain times involves equity awards over a mid-term (i.e., one to two years) period. In this approach, equity values are not set by corporate goal-setting; rather, the market for shares of stock is global, and investors do peer comparisons on a minute-to-minute basis. Temporarily replacing goal-based incentives with equity-appreciation–based incentive awards would directly link payouts to shareholder returns at a time when economic uncertainty makes other approaches difficult and unpredictable. This strategy also preserves cash at a time when it is most needed and could be set up to yield frequent periodic grants to avoid having awards that are unexpectedly based on market peaks or troughs.
These four approaches offer four viable options for creating and managing incentive plans during uncertain times. Not all approaches are suitable for every organization, though. It’s up to each company to find the incentive plan that is most appropriate to its circumstances and best meets its needs.