Annual incentive programs are one of a bank’s most important tools for executing a meaningful pay-for-performance philosophy. The degree to which they drive strategic priorities and shareholder value depends on three important design dimensions:
- The selection of performance measures
- The degree of difficulty built into performance goals
- How payout levels are calibrated with different levels of performance
The Banking Edition of Pearl Meyer & Partners’ On Point Survey: Annual Incentive Plans for Top Corporate Officers provides insight to the most common practices as reported by 31 banking institutions (representing 22% of the total survey group), the majority of which are publicly-traded. Among the findings:
Banks typically build their annual incentive around three to five key financial measures. The most common performance measure, used by 58 percent of bank survey participants, is net income (including earnings per share or EPS). Operating income is the second most common measure, used by 46 percent of respondents, and top line revenue or sales is used by 31 percent. In addition to financial measures, most banks use individual performance to either modify the calculated bonus amount (45 percent) or independently generate a portion of the annual incentive amount (23 percent).
Performance goal-setting is arguably the most difficult and also one of the compensation committee’s most important responsibilities. Fifty-five percent of banking participants base annual performance goals on the board-approved budget. Among those banks that do not reference the budget, 26 percent reported using long-term internal standards (e.g., 1 percent return on assets, or 10 percent earnings growth) and 10 percent each used either long-term strategic plan objectives or other forecasts.
In addition to a target goal, 71 percent of respondents establish a threshold/minimum goal and a superior/maximum goal as a consistent percentage (e.g., 80 percent and 120 percent) of the target performance goal each year. While defining a consistent range around target is a reasonable approach, institutions should take care to evaluate the degree of difficulty of goals each year—120 percent of budget may be a reasonable goal in one year, but extremely aggressive in another year. Also, 120 percent of budget will be a more or less aggressive level of performance depending on which financial measure is used.
Only 7 percent of banking participants consider other factors in setting goals, such as degree of difficulty relative to peers/industry expectations and/or the level of performance expected by shareholders. In addition to evaluating approved goals externally relative to peers and industry performance, as well as shareholder expectations, every compensation committee should also understand the difficulty of achieving goals relative to the bank’s internal historical performance and planned investments and expenditures during the year.
Almost all annual incentive plans are designed to pay out 100 percent of the target award opportunity for achievement of the target performance goal. However, survey respondents reported much more variety in maximum payouts for achievement of superior goals—ranging from 19 percent of respondents with a maximum payout of 100 percent of target (i.e., no upside leverage above target performance), to another 19 percent of respondents with a maximum of 150 percent or 200 percent of target. Payout levels for threshold and superior performance should be adjusted to appropriately reflect the degree of difficulty for achieving each goal. For example, a plan design in which threshold performance to achieve any award at all is 90 percent of target goal should have a higher payout (perhaps 60 percent of target) than if the minimum threshold to achieve any award is 70 percent of the target goal. (In this case, perhaps a 20 percent payout would be appropriate.)
An effective annual incentive plan links and appropriately calibrates performance goals and payout opportunities, taking into account the degree of difficulty involved in meeting goals. Moreover, as part of good plan design, compensation committees should understand how the goals relate internally to the bank’s historical performance results and anticipated future investments, and externally relative to peer performance and shareholder expectations. By taking such steps, companies can improve the strength of their performance-pay relationships.