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Financial Incentives Perspectives and Implementation Guidance0CONTENTSPerspectives on financial incentivesImplementation guidelinesExhibits1PerspectiveDetailIncentive programs should beprominent,especially in support ofgrowth and significantimprovements in performance Financial incentives have a signaling function and managers in anyorganization very quickly work out what is important and how performancelinks to rewards,and their behavior will,in time,clearly reflect thoselinkagesReward programs should be linkedto how value is created and thelevel of risk and be uncapped If a company expects its managers to take a lot of risks,then it shouldconsider highly leverage incentives and insure proper managementcontracts are in place as a counterbalance If a company expects its managers to take some,but not to much risk,themmore conventional types of performance pay are likely to be moreappropriate“Sharing the prize”by uncapping reward programs should be underpinnedby rigorous analysis to ensure that nobody“gives away the store”Meaningful differentiation is a criticalaspect of any reward program At companies in the top quintile of performance,the total compensation oftop performers is 30%or more higher than that paid to average performers At growth companies,annual financial incentives are over 200%of targetlevels,while companies with lower growth generally cap their payouts at150%Executives consider differentiated pay slightly more important than total pay.High performers,not surprisingly,felt that this was particularly importantTop companies pay more acrossthe board In each of the compensation categories(salary,cash bonus,long-termincentives),top quintile companies were more likely than mid-quintilecompanies to pay above the benchmark average for their industry(Exhibits 1-5)EMERGING PERSPECTIVES ON FINANCIAL INCENTIVES2PerspectiveDetailHigh-performing companies activelyseek out ways to make key employeesthink like shareholders Not only is total compensation higher,but many companies are tying a portion of theirrewards to longer-term company success.However,they take great care to ensurethat options do not come to be seen as a“perk”rather than an incentive,and thenlose their motivational value Stock options,performance shares,and time-vested stock are often pushedfurther into the organization(Exhibit 6)At one company,for example,to get managers to focus on stimulating growth,annual cash incentives were recently reduced to fund a 3-year incentive planlinked to growing EVAtm.Companies that experienced dramatic improvements in performance worked toincrease the equity holdings of their top teams.Our research has shown a verystrong link between executive stock and stock option holdings and performance.Discretion or forgiveness aroundrewards linked to explicit growth orperformance targets should be minimal Having established clear agreed minimum parameters for incentives(the“gate”)andstretch targets,leaders of high performing companies rarely,if ever,deviate from thereward hurdles that are linked to these points.If they do,they have found that thisvisibly reduces the management effectiveness of the reward system itself.This doesnot imply that there is no room for discretion where exceptional performance isachieved,or that a discretionary penalty should not be applied if behavior is belowexpectationIndexing can be a valuable tool wherecompanies have significant exposure tomacroeconomic conditions This indexing is applied either in determining the options exercise process or in thetotal value of payout linked to group resultsBroad salary bands improvemanagements ability to use salary andopportunities more flexibly to rewardhigh performers In our research we found that top quintile companies are much more likely to usebroadbanding for setting salaries(Exhibit 7)Pay for performance but only for a fewperformance measures The more measures in the appraisals of performance,the more difficult it is tocombine them into an overall appraisal of performanceEMERGING PERSPECTIVES ON FINANCIAL INCENTIVES(CONTINUED)3KEY ISSUES TO ADDRESS WHEN DESIGNING AN INCENTIVE SYSTEMWhat drives basic salary and salary increases?What key indicators make up the“gate”to annual or long-term incentives?How do you determine realistic stretch targets within management control,but without going into detailed annual negotiation?How steeply does the reward increase as managers approach their agreed stretch?How do appropriate or inappropriate behaviors impact the reward level?How is performance beyond stretch rewarded?What combination of short-and long-term incentives is appropriate?What is the right mix of focus on individual and group/peer group results?Exhibits 8-11 provide more detail and case examples as the underlying mental model for incentive designs4Step1.Translate overall strategy into specific targets2.Establish guiding principles 3.Conduct competitive benchmarking4.Design high-level compensation framework5.Develop compensation program by category of senior management6.Stress-test the compensation program7.Determine legal and tax implications8.Implement individual plans9.Design implementation approach10.Create ongoing management processesBrief descriptionClarifying growth aspiration in terms of clear value drivers(typically 3-5,e.g.,AUM,earnings,EVAtm,etc.).Developing set of guiding principles,e.g,level of conformance to companys compensation policies,use of variable compensation,level of deferred compensation,etc.Benchmarking competitive compensation levels and structures,upper/lower quartiles for each level,etc.For each category of senior management,establish competitive compensation levelsDefining overall compensation framework in terms of three factors:Composition and variability,i.e.,salary vs.incentives Timing,i.e.,current vs.deferred,vesting period Instruments,e.g.,cash,company stock/options,XYZ phantom stockLinking value drivers and the compensation program Develop robust performance metrics tailored to each category of senior management Design incentives to optimize performance metrics,using compensation frameworkTesting robustness of compensation system by modeling the pay-out under a variety of scenarios,e.g.,difference performance levels and market conditions,and modeling aggregate impact of pay-out on XYZ overall financial resultsIdentifying potential adverse incentives and loopholes created by the systemClarifying legal and tax implications of new compensation plans and identifying potential issues overallDefining unambiguous termination conditions,administration responsibilities,limits on awards,redemption processes,non-competition conditions,tax withholding policies,etc.Developing individual plans consistent with category compensation program,keeping in mind the guiding principles and competitive benchmarkingNeeds to be in the context of current compensation levels and of competitive benchmarksCreating clear documentation and communication materialsConducting a series of meeting with key individuals to plan roll-outDeveloping the goal-setting,performance review,and compensation cycleCreating contingency plans for changes in environment,e.g.,fall in phantom stock priceSTEPS IN DESIGNING NEW COMPENSATION SYSTEM5Revise based on financial impact,perverse incentives,etc.Conduct in parallel while building compensation programRevise based on legal/tax issuesOverall success and speed of process depends on Quality of existing compensation system Degree of change imposed by new system Compensation framework Performance metrics Individual compensation Ability to track and confidence in new performance metrics Management process infrastructure,e.g.,performance reviews,etc.PROCESS FOR DESIGNING NEW COMPENSATION SYSTEM1.Translate overall strategy into specific targets3.Conduct competitive benchmarking4.Design high-level compensation framework5.Develop compensation program by category of senior management6.Stress-test compensation program7.Determine legal and tax implications8.Implement individual plans9.Design implementation approach10.Create ongoing management processes2.Establish guiding principles 6Exhibits-Appendix 17Executive team payMedian,$Thousand1,4209505705501,9901,500Executive team pay breakdownMedian,percent of total payBase payAt-risk pay*Valued with Black-Scholes;indexed to 1997 dollars Source:Dr.Rakesh Khurana(MIT);Dr.Brian Hall(HBS);Evergreen company database“Sharpbenders”executives get paid with larger portion“at risk”.Equity and options/market capitalizationsMedian,percent(1992-96)Equity and optionsMedian,$Thousand*(1992-96).and hold much larger equity stakesWinnersLosersWINNERS PAY MORE AND USE LONG-TERM INCENTIVES72632837100100WinnersLosersCEO onlyTop 5 executivesWinnersLosers58.16.720.43.6WinnersLosers1.50.5CEO onlyTop 5 executivesWinnersLosers1.50.51.20.8WinnersLosers2.71.3831323330Top 20 executivesMore than 15%above benchmark averageUp to 15%above benchmark averageAt benchmark averageUp to 15%below averageMore than 15%below averageTop 300 executivesTOTAL COMPENSATIONAverage percent of companies respondingSource:TTs War for Talent Executive Survey-final results based on 72 companies48211430837463018433630333415304349300TotalTop-quintile companiesMid-quintile companiesTotalTop-quintile companiesMid-quintile companies99185733Top 20 executivesMore than 15%above benchmark averageUp to 15%above benchmark averageAt benchmark averageUp to 15%below averageMore than 15%below averageTop 300 executivesSALARYAverage percent of companies respondingSource:TTs War for Talent Executive Survey-final results based on 72 companies16114111302259122515711016175090875923TotalTop-quintile companiesMid-quintile companiesTotalTop-quintile companiesMid-quintile companies1019403732Top 20 executivesMore than 15%above benchmark averageUp to 15%above benchmark averageAt benchmark averageUp to 15%below averageMore than 15%below averageTop 300 executivesANNUAL CASHAverage percent of companies respondingSource:TTs War for Talent Executive Survey-final results based on 72 companies29371303432525011424242164617033058803TotalTop-quintile companiesMid-quintile companiesTotalTop-quintile companiesMid-quintile companies1138302624Top 20 executivesMore than 15%above benchmark averageUp to 15%above benchmark averageAt benchmark averageUp to 15%below averageMore than 15%below averageTop 300 executivesLONG-TERM INCENTIVESAverage percent of companies respondingSource:TTs War for Talent Executive Survey-final results based on 72 companies48181104203535332535298333291532343712311TotalTop-quintile companiesMid-quintile companiesTotalTop-quintile companiesMid-quintile companies12TotalTop-quintile companiesMid-quintile companiesCOMPENSATION STRUCTURE AND MIXAverage percent of base salary*Future value for 100%target attainment*Value at grantSource:TT War for Talent HR executive survey-final results based on 72 companies614620213187361565397Annual bonusValue of long-term incentivesPerformance units or shares*Performance vested restricted stock*Time vested restricted stock*Unrestricted stock grantsStock options*68421617418541176851135549252618932116133Top 20Top 30013TotalNarrow grades or ranges(5%to 20%different between mid-points)Broadbands(more than 20%difference between mid-points)4640Top-quintile companiesMid-quintile companies61395928WIDTH OF SALARY GRADES/BANDSAverage percent of companies respondingSource:TT War for Talent HR executive survey-final results based on 72 companies14RewardExtent of achievementFinancialBehavioralOther milestonesSalaryTargetAgreed stretchBeyondHow can stretch beyond expectation be appropriately rewarded?What is the shape of the sliding scale?How does less appropriate behavior impact the multiplier?What constitutes realistic stretch?What drives salary increase?What should differentiation be for achieving agreed stretch?What combination of long-and short-term incentives are appropriate?What is the maximum?What key indicators make up the“gate”?SELECTING AN INCENTIVES APPROACH15RewardExtent of achievementFinancialBehavioralOther milestonesTargetAgreed stretchBeyondOne-off bonus shares awarded for excellent performance,Redeemable after 5 years.Average of 3,000 shares approx.$60/shareReward for behavior not systematic but“360 output when done is taken very seriously”.Poor behavior will result in reduced opportunity or dismissal,not necessarily in reduced cash bonusEmerson renowned for tough stretch.Example of$100m business to become$500 m in 5 yearsSalary just above median for the industrySalary increase driven by affordability,personal performance and potential?Difference between OK and good 20-30%Share options awarded by CEO for good performance and behaviour(every 3 years)Cash bonus maximum on average c.60%EBIT is the main driver of the“gate”INCENTIVES APPROACH-EMERSON ELECTRIC16RewardExtent of achievementFinancialBehavioralOther milestonesTargetAgreed stretchBeyondDriven primarily by amount of share options and targeting for rapid promotionDeductions made from maximum bonus,if non-financial goals are not metRigorous annual planning process where targets are set.Dont talk about“stretch”in the same waySalary at or above median for the industrySalary increase in hands of P+L management but still relatively formulaicDifference between OK and good has been 15-30%.Share options awarded based on agreed formulaCash bonus maximum of the order of 50%“Gate”is primarily financials,but not always mechanical.Tends to be at senior management discretionINCENTIVES APPROACH-JOHNSON AND JOHNSON17IMPACT OF BEHAVIOR AND PERFORMANCE ON COMPENSATION%of base salary?%cash/shares?%LT incentives?%salary riseProbable departure Below TargetAbove target below stretchAbove stretchFinancial Performance e.g.,some combination of:ProfitRevenue.RONA or ROCEUnacceptableOKExcellentBehaviour?%cash/shares?%LT incentivesInflation+%salary riseClear milestones?%cash/sharesLT incentives at CEO discretion(probably low)Low%Base pay riseDefine and track actions for improved behavior?%cash/shares?%LT incentives?%salary riseDefine and track key financial targets closely,dont wait whole year?%cash/shares?%LT incentivesLow%salary riseDefine and track key financial targets closely,dont wait whole yearCash bonus up to?%LT incentives at CEO discretionRadical%salary riseTarget for rapid promotion and find additional roles?%cash/shares?%LT incentivesLow%Base salary riseDefine and track actions for improved behavior?%cash/shares?%LT incentivesInflation+Salary riseDevelop rapidly?%cash/shares?%LT incentivesInflation+%salary riseDevelop rapidlyILLUSTRATIVE