making pay for performance work - willis towers watson€¦ · · 2013-10-03making pay for...

Making pay for performance work

Towers Watson’s Autumn Conference

Short-Term Incentives

Alasdair Wood & Beth Powell 3 October 2013

© 2013 Towers Watson. All rights reserved.

Proprietary and Confidential. For Towers Watson and Towers Watson client use only.

Why do short-term incentives exist?

The number of reasons

and importance of each

reason will vary by

company, and even

employees group, based

on variables such as:

• Company philosophy

and values

• Employee / union

perspectives

• Impact of marginal

increases in

individual effort on

business

performance


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To tie people costs to affordability/profits

To share in business success / foster sense of

inclusion

To focus employees on specific goals and behaviours

To motivate employees to perform better in order to

receive higher pay

To provide fair levels of pay reflecting an employee’s

individual contributions

To attract high-performing individuals to the

organisation

And therefore – to be market competitive in terms of

structure of pay


The premise behind short-term incentives

Short-Term Incentives

Increase in Discretionary

Effort

Increase in Business Results

Expectancy Theory

An increase in effort will lead to attainment of desired performance which

leads to receipt of fair reward that is valued by the recipient


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Question for Group

Do short-term incentives motivate your employees to

perform better?


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Why are short-term incentives still important when long-term

business success is the key objective?

Although most industries operate according to a long-term business

strategy, short-term incentives are still critical because:

It is easier to set annual targets and objectives than multi-year ones

It is easier to measure annual performance than multi-year

performance

Employees rely on receiving regular payments for personal

budgeting purposes

The decisions that most employees make most of the time impact

business performance within a one-year timeframe (exceptions

include executives and planning department)

Employees may not be in same position or even with same

employer over multi-year period


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The latest trends in Short-term Incentives

of performance or a

discretionary

performance

threshold are the two

most common

scenarios

are the same for most

organisation-wide plans but

more differentiated in other

plan types

of companies award

payment in cash and

only 8% defer the

award

represent the

median percentages

of target that a low

and high performer

typically receive

respectively

Profit is the most commonly used

metric used to determine

bonus pay-out levels for tiered

and organisational wide plans,

and individual performance

rating from the Performance

Appraisal system for individual

incentive plans

Individual award payments

A threshold

of 70% –

80% 94%

0% and

150% 1/3

The incentive

pool

is typically determined using

financial and non-financial

methods for tiered plans, pure

financial results for

organisational wide plans and

for individual incentive plans

have a budgeted approach

using a sum of targets

of companies have

introduced new plans and

have the same focus for

the coming 2 to 3 years

of companies only pay

someone a bonus if they

are in employment on the

date the bonus is paid


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Eligibility • Who should be

eligible?

• Segmentation

Performance criteria

Pay-out

Payout schedule

Deferred

Cash/shares

Performance

measurement

Target setting

Absolute/relative

Time period (LTI)

Link and weights

Targets

weighting

Additive/

multiplicative

Quantum

Minimum

Maximum

Target

Calibration

Payout curve

Link to

performance

levels

Funding Budgeted

amounts

Profit share

Funding above

a minimum

return

Design parameters to consider in incentive plans


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Financial

Non-financial

Group, BU,

individual


Potential combinations

Design Decisions Some alternatives

Participation 1. Executives Only

2. Executives & Mid-Managers

3. All Employees

Performance Criteria 1. Group Sales

2. Group Profit

3. Business Unit financials

4. Milestone achievements

5. Individual Behaviours

Performance Measurement 1. Relative to peers

2. Relative to budget

Links & weights 1. Additive

2. Multiplicative

3. Matrix

Quantum 1. Market aligned

2. Based on funding pool

3. Same for all

Calibration 1. Market aligned

2. Based on funding pool

3. Same for all

Funding 1. Sum of targets

2. Based on profit pool

Pay-out 1. Quarterly

2. Annual Cash award

3. Shares

4. Deferred cash

= 6,480 potential

STI designs!

x


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3

5

2

3

3

3

2

4

x

x

x

x

x

x


Eligibility

Manual / Clerical Staff

Professionals

Managers

Executives

Tiered

incentive

plans

most

common Most likely to be

segmented by function,

e.g. sales, critical roles

Most likely to use a Group-

based performance measure

and have a portion deferred

into shares

Most likely to have team

bonuses (but still only

used by c. 15%

companies)

Most likely to use an

Individual-based

performance measure


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Leaders


Question for Group

Has your company made any changes to eligibility

levels in the last five years?


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eligible?

• Segmentation


Pay-out

Payout schedule

Deferred

Cash/shares

Performance

measurement

Target setting

Absolute/relative

Time period (LTI)

Link and weights

Targets

weighting

Additive/

multiplicative

Quantum

Minimum

Maximum

Target

Calibration

Payout curve

Link to

performance

levels

Funding Budgeted

amounts

Profit share

Funding above

a minimum

return



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Financial

Non-financial

Group, BU,

individual


Short-term incentive plan funding can be ‘top down’…

Company performance

Budget / on target

£X

Stretch

£Y

e.g. pool = 3%

of operating

profit


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… or bottom up…

Employee group Number of

employees Average salary Target STI (%) Target STI (£)

A 10 £300,000 60% £1,800,000

B 150 £100,000 40% £6,000,000

C 300 £60,000 25% £4,500,000

D 1,000 £40,000 15% £6,000,000

E 4,000 £25,000 10% £10,000,000

Total incentive

pool £28,300,000


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… or a combination of both approaches

Company performance

Budget / on target

£28.3m

Stretch

>£28.3m


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The degree of flexibility in funding places greater or lesser

emphasis on performance ratings and distribution of awards

1 3 2 4 5

Performance rating

Beyond

budget?

Within budget


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• Forced

ranking

• ‘Rob Peter to

pay Paul’

• Discretionary


Question for Group

How are short-term incentive awards funded

at your company? How do you differentiate higher

performers? Does the process work well?


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eligible?

• Segmentation


Pay-out

Payout schedule

Deferred

Cash/shares

Performance

measurement

Target setting

Absolute/relative

Time period (LTI)

Link and weights

Targets

weighting

Additive/

multiplicative

Quantum

Minimum

Maximum

Target

Calibration

Payout curve

Link to

performance

levels

Funding Budgeted

amounts

Profit share

Funding above

a minimum

return



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Financial

Non-financial

Group, BU,

individual


Incentive performance measures should support achievement

of business objectives

Strategy Key

performance indicators

External messages

Executive performance

measures

Management / employee

performance measures


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Value tree analysis can help identify linkages between

headline measures and levers that employees can pull

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Pre Tax

RONA

Operating

Margin

Capital

Turnover

COGS as %

of revenue

SG&A and

other

Operating

Costs as %

of revenue

Depreciation

as % of

revenue

Net PP&E as

% of revenue

Working

capital as %

of revenue

Long-term

liabilities as

% of revenue

Net other

assets /

goodwill as

% of revenue


The emphasis on individual / business unit measures

generally decreases with employee seniority


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A company’s position on the growth/income curve can be a

good place to start when considering performance measures

Start-up phase Growth phase Mature phase

High growth Medium growth and income High income

Incentive arrangements are

typically awarded annually and

should encourage stewardship

of the business

Incentives focus on high

potential rewards on success.

Typically one-off block

grant/awards

Incentives motivate

management to drive business

forward

Deal-based equity incentive

Market-based salary levels

Market-based equity incentive


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Growth phases have different characteristics, including

implications for performance measures

Start-up phase Growth phase Mature phase

Business profile

Business aim Proof of concept/

breakthrough

Create new market or displace

an industry/region

Top line growth

Build out capability/brand

Build the business/profit

growth

Efficiency/maintain market

share

Own the market/monopoly

Milk and defend the franchise

Executive role Entrepreneurialism/

breakthrough thinking

‘Doer’/’Deliverer’ Custodianship

Manage the franchise

Culture Intellectual

Aspirational

Freewheeling

Pragmatic/hands on/can

do/needs must

Professional/expert

management

Capital volume Low Low but growing fast

Phased financing

High

Core finance Equity lots

Debt light

Debt/equity mix

Role of mezzanine financing

Mainly debt to get equity

leverage impact

KPIs

Categories Milestones ‘Growth in’ measures ‘Return on’ measures

Examples Patents

Market entry

Proof of concept

Growth in turnover

Breakeven profit

Revenue/market share

Gross margin

Operating profit

EBITDA/EBIT

PBT/Earnings

EPS

PBT/Earnings/EPS

Return of Capital

Employed

Return on Equity


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Question for Group

How are short-term incentive performance

measures selected at your company? Are they well

aligned with strategic objectives?


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Implementation & Communications



Regardless of design, successful incentive plans tend to

possess certain common traits around perceptions and

understanding Employees understand their roles and how they can 'win'

Employees believe that they can win

Employees believe that the reward for winning is worthwhile

Fair Perception that goals for all participants have equal stretch and performance has

been fairly assessed

Simple Easily understood by participants

Aligned with

role Employees understand how they can influence outcomes

Champions Managers 'own' the plan and see it as a tool to improve performance

Return On

Investment Management and shareholders feel there is a sufficient return on investment

Support Infrastructure (processes and systems for tracking performance) in place

Business literacy and training used to link employees with key business drivers


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Motivating


Question for Group

What steps has your company taken to

enhance level of understanding and perceived

value of short-term incentives?


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eligible?

• Segmentation

Performance criteria Financial

Non-financial

Group, BU,

individual

Pay-out

Payout schedule

Deferred

Cash/shares

Performance

measurement

Target setting

Absolute/relative

Time period (LTI)

Link and weights

Targets

weighting

Additive/

multiplicative

Quantum

Minimum

Maximum

Target

Calibration

Payout curve

Link to

performance

levels

Funding Budgeted

amounts

Profit share

Funding above

a minimum

return



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Financial performance targets are usually set by reference to a

range of inputs

Budget

Judgement/

climate

Historic

performance

Peer group/

relative

performance

Investor

expectations

Incentive

Plan

Target

Growth

expectations

Board views External

standards

(e.g. cost of

capital)


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It can be helpful to consider threshold, target and maximum

performance in the context of the expected distribution…

Performance ranges may be established based on the probability of

achievement and subsequent motivational impact

100% 0%

Threshold (80% - 90%)

Stretch (10% - 20%)

Target (50% - 60%)

Probability of Achievement

80% 60% 20%

Typical Design

50%

Poor Poor Motivation

10% 90%


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…alongside other key inputs to provide a balanced view

5.0%

6.2%

12.0%

5.0%

12.0%

10.5%

13.0%

10.0%

12.4%

9.3%8.9%

12.5%

10.4%

8.7%

10.7%

11.7%

12.8%

0%

5%

10%

15%

HistoricalSep06-Sep09




ForecastSep10-Sep13

ForecastSep11-Sep14

ForecastSep12-Sep15

ForecastSep13-Sep16

A B C D E Median PSPtarget

range (4)

Historicaltargets

3 yr historical EPS andresulting vesting under plan

Internal EPSprojections (2)

Analyst ForecastSep13-Sep16 (3)

FTSE 100(excl Co

ABC)

An

nu

al

EP

S G

row

th

0% vesting

99.12% vesting 83.8%

vesting

100% forecastvesting

72% forecastvesting

64% forecastvesting

100% vesting

83% forecastvesting


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The degree of performance/payout leverage is also a key

factor – should you offer a broad performance range…

Target

Performance

Threshold Target

Maximum

Pa

yo

ut


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Performance

Threshold Target

Maximum

Pa

yo

ut

…or a narrower range with higher leverage (perhaps

appropriate when targets can be set with more certainty)

Target


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Question for Group

How does your company determine

short-term incentive performance targets? Do all

stakeholders support targets every year?


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making pay for performance work - willis towers watson€¦ · · 2013-10-03making pay for...

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