What boards don’t understand can hurt the goal-setting process
By Todd Sirras and Greg Arnold
One of the toughest challenges for a board’s compensation committee is the approval of incentive plan goals. And the biggest hurdle is a gap of information.
The management team proposes the goals but is closer to the day-to-day operations of business and has a better sense of the difficulty of the objectives. Meanwhile, a compensation committee must balance goal-setting that is fair and properly motivates management with payouts that are appropriate for the results delivered to shareholders.
It is also one of the primary causes of many activist investors’ success. At a recent conference, a portfolio manager from a large pension fund and the founder of an activist investment firm discussed the role activist investors play in bridging this gap. One of the investor’s key activities is conducting rigorous analysis using their expansive resources.
Regular board members do not have the same time or resources and, as a result, are often less equipped to assess management’s proposals with as much rigor.
Directors will never understand how hard goals are to reach to the same level that management does, or even some activists. Given that reality, what do compensation committees do?
We outline four strategies to help close the information gap.
Pressure test the company’s planning and budgeting process. Many companies set annual incentive targets equal to the budget for the year. This simple approach makes sense and aligns incentive payouts with other indicators of financial performance regularly communicated throughout the year.
Moreover, most companies dedicate significant resources to the budgeting process so that it has gone through rounds of review and stress testing by the time it gets to the Board for approval. However, tying incentive pay to the budget puts additional pressure on ensuring the budget is set appropriately.
The best approach we’ve seen is for board members to make sure they understand the process and ask detailed questions about both the numbers and the process to establish the goals. Areas to test include: sensitivity to specific assumptions (e.g., market growth, cost-cutting measures), potential impact of large customer or supplier contracts, sensitivity to when the results occur during the year, and alignment with Wall Street expectations.
Inform goal-setting process with supplemental data and analysis. Committee members can get more comfortable when the goals are put in context, particularly the ranges used for threshold or maximum. Backward-looking analysis like probability of achievement, in which financial results are analyzed for a group of comparator companies, can provide a baseline of what may or may not be achievable based on historical results.
Forward-looking scenario analysis can also provide a helpful perspective into the difficulty of goals based on the company’s current financial situation. For instance, one company we work with provides a set of analyses each year to the committee to help them understand how the maximum and threshold goals could be achieved based on various key drivers of performance, like same store sales and operating margin.
Ask pointed questions about external influences. The deeper the committee’s understanding of the range of business outcomes, the better a committee can determine the right goals for incentive plans. Human nature often causes people to overly discount the likelihood of extreme outcomes, both positive and negative. This discounting can lead to incentive goals and ranges that are too tight and cause the incentive plan to be more of a lottery than a mechanism to align management performance with compensation.
Institute good governance process. Many of the committees we work with find it helpful to use a two-step process to approve goals. The first step is a review meeting in which the initial proposal is presented and committee members can review the data, ask questions, and contemplate the proposal. The second meeting is used for approval. Management and the outside advisors can use the time between meetings to prepare information and responses to the committee’s questions. It also gives the committee members time to consider the proposal. Another helpful process is regularly updating the committee on progress towards incentive goals throughout the year. We’ve found this to be particularly helpful when goals are non-formulaic and require a degree of discretionary judgement.
Boards and compensation committees always will need to manage the information gap reality when approving incentive goals. However, committees can be well-positioned to assess and approve incentive plan goals by asking tough questions, informing the discussion with analysis, and using a process that allows for deliberation and consideration.