4 Tips for Creating Great Incentive Plans in Uncertain Times

Inflation is higher than usual, and global warming combined with international conflicts are disrupting supply chains in the wake of a multi-year pandemic. The personal and business hardships of COVID-19 are now mostly in the past. Many citizens in the United States and other nations have braved unimaginable and well-publicized personal loss since 2020. Discussions of possible recession jam the media. In the next few days and months and over the coming year, executives in the United States will experience what it is like to have a significantly reduced, bonus payout and performance awards – if they are among the few to even receive bonus and performance award payouts at all. Turbulent economic conditions raise significant incentive design issues and may merit exploration of possible alternatives until more predictable forecasting conditions return.  

Goal-Based Performance Incentives 

Most readers, probably have a budget or goal-based performance incentive plan. It is a “best practice.” shared by most established and respected U.S. companies. Goal-based variable incentive plans use financial and/or accounting measures and pre-established incentive formulas. These incentive formulas convert corporate, business unit, and/or individual performance, tabulated at the end of the performance period, into bonus payout dollars or shares of stock. Incentives usually are paid within two to three months after the end of the calendar year. This timing qualifies many corporations for an accelerated tax benefit for these payments.  

Goal-based performance incentive targets for the current incentive plan year were established back in the days when overall U.S. corporate financial performance exhibited few early warning signs in limited industrial sectors. As the year progresses, however, many U.S. organizations may find that they are unable to meet pre-established budget-based incentive targets or thresholds. The collective U.S. 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 impact 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, pre-established 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 the 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 while 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 were 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 design alternative to goal-based structures. 

Peer Comparisons 

Peer comparisons mitigate the incentive impact of external political and economic factors. The peer comparisons annual incentive and long-term performance award design approaches uses 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 the peer-group. 

Measuring a company’s performance relative to other competitors in the industry may initially appear feasible but often is difficult in practice. The peer-group selection process is often where the complexity of peer groups become apparent. A large peer-group is necessary to lessen the impact any one company would have on the bonuses of its executives and to monitor how the industry is performing for incentive comparison purposes. Yet many companies run into problems trying to identify a sufficient number of companies for this peer-group that compare in terms of size, market, product, and relative financial health. “Ideal” candidates may be incorporated in other countries with unique currencies, economies, and accounting conventions. Other candidates could be subsidiaries of firms that serve vastly different industries or they are privately held and do not have public performance reporting requirements. A related problem is that many companies may enter or exit the “ideal” peer-group list on any given year during trying times.   

Something Completely Different 

For the brave, an alternative to goal-based incentives during uncertain times would involve equity awards over a mid-term (one to two years) horizon. Equity values are not set by corporate goal-setting. The market for shares of stock is global and peer comparisons are done on a minute-to-minute basis by investors. Temporarily replacing goal-based incentives with equity appreciation-based incentive awards would directly link payouts to shareholder returns at a time when alternative structures are made difficult and unpredictable by economic uncertainty. This would also preserve 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 upon market peaks or troughs. This concept will be explored in more depth in a follow-up article. 

This is a unique time of economic uncertainty. Are your incentive plans up to the task? If not, give FutureSense a call – we have several ideas that could make a difference.

About FutureSense 

FutureSense is a management consulting firm that provides integrated solutions to build and sustain human capital capacity. The firm can work with you by offering support and guidance to manage your workforce. To learn more about FutureSense, please visit FutureSense.com.