Approaches for Using Informed Discretion in Executive Annual Incentive Plans

It is understandable that investors and proxy advisory firms continue to favor formulaic incentive plans driven by preset, quantitative goals for executives. These plans are transparent, have targets that typically align with budgets approved by the board, and the process allows for a straightforward evaluation of results. However, goal setting for incentive plans has become ever more challenging due to the increasing influence of macroeconomic, geopolitical and public policy factors that are outside of the control of management teams. The economy and markets are not static, and extraneous events can change the trajectory of performance at any point within the cycle. Because of that, adopting a dynamic incentive plan that incorporates informed discretion can help ensure that outcomes are aligned with overall performance.

There is a view that when discretion is used in incentive plans it is done so arbitrarily — that it is only loosely based on performance and not subject to detailed review and evaluation. In practice, most compensation committees administer a rigorous process whereby a mix of quantitative and qualitative metrics, strategic scorecards and comparisons of performance to budgets, prior year performance and peer performance are all considered when determining the appropriate informed discretion apply within incentive plans. Unlike fixed formulaic goals set at the beginning of the year, informed discretion provides a mechanism for the committee to consider macroeconomic headwinds and tailwinds, management’s response to unforeseen events and achievements or missteps not contemplated in the budgeting process, such as M&A. For banks, risk behaviors and compliance matters can also be incorporated by using informed discretion to adjust balanced scorecard outcomes, bolstering the bank’s risk management.

There are several ways that banks incorporate informed discretion within incentive plans. The impact of discretion can range from a plan based fully on informed discretion to a discretionary risk management modifier that is only used to reduce payouts when risk management concerns arise. 

Five Ways Banks Incorporate Informed Discretion in Executive Incentive Plans

1. Create a plan based solely on informed discretion or a completely, non-formulaic approach where the committee conducts a holistic review of qualitative and quantitative factors and determines the appropriate pool funding or individual awards. While payouts are non-formulaic and specific targets are not set in advance, there are typically predefined areas or a scorecard that the committee will consider when evaluating performance. Achievement is evaluated using broad categories (e.g., meets, exceeds etc.) and performance is determined with reference to a scorecard of factors. The following are examples of factors committees consider when using informed discretion:

2. Weighted component based on discretion. The majority of the plan is formulaic and based on preset metrics while the remaining is determined using informed discretion (e.g., 80/20). This approach is often preferred by proxy advisers and many institutional investors given the emphasis on pre-established goals but still gives the committee the ability to align pay decisions with business and risk factors that may not be represented in preset incentive scorecard goals.

3. Discretionary performance modifier. This approach formalizes a range for the committee to adjust the corporate performance result based on a discretionary assessment of company performance (+/- 20%). The initial corporate performance factor is calculated based on preset incentive scorecard goals. Then, the committee applies a modifier within the given range to reflect the committee’s discretionary assessment of company performance to arrive at a final corporate factor for the year:

Corporate Factor   X   Discretionary Performance Modifier (0.8X to 1.2X)   =   Payout

4. Weighted component based on strategic business objectives (SBOs). This approach places a majority weighting on formulaic results with the remaining portion based on SBOs. SBOs are goals or metrics that generally support key business priorities, can be measured and objectively evaluated, are specific in nature, often mix quantitative and qualitative goals and typically differ from the core financial metrics. 

5. Discretionary risk management modifier. This approach integrates a bank’s risk management scorecard when confirming incentive pool funding or finalizing individual awards. The committee, using its discretionary authority, can reduce the entire pool or choose not to fund it depending on the degree of concern. Alternatively, the discretion could be applied on an individual basis to adjust specific executive’s awards. For example, significant liquidity risk could call for zero funding while other material items, not matters of solvency, could result in lesser reductions.

As external factors and market volatility increasingly influence bank performance, having a mechanism for using informed discretion within incentive plans can serve as a strategic tool for committees. Informed discretion provides flexibility, reinforces pay-for-performance alignment and considers risk management when determining appropriate incentive awards for their executive teams.