Setting Executive Performance Goals in a Rapidly Changing Environment
The most common performance award term is three years, but that doesn’t mean it’s right for all companies. For example, a highly acquisitive company with a cash flow metric might face serious challenges in forecasting three years into the future (or be forced to make so many non-GAAP adjustments that the metric becomes somewhat arbitrary). Similarly, a company in a highly cyclical or unpredictable industry might not feel confident about where revenues will be even 12 months out, let alone 36.
Some companies have responded to the difficulty of multi-year goal setting by selecting one- or two-year metrics. By incorporating shorter-term goals into the long-term incentive program, it becomes possible to reset goal expectations more often than three-year goals allow. We’ve seen some companies transition from three-year goals to two-year goals, and we’ve seen some transition from three-year goals to a series of one-year goals.
Despite their advantages, shorter performance horizons do come with tradeoffs. First, the accounting grant date doesn’t occur until goals are set, which can cause cost surprises in the proxy. Next, investors and proxy advisory firms are exerting more pressure against goals that span anything less than three years, arguing that these designs are really short-term incentive programs masquerading as long-term ones.
One solution is to layer in a three-year total shareholder return (TSR) modifier, or pick some three-year goals to operate alongside the one-year goals. In almost all cases, it’s appropriate to add a time-vesting tail such that even awards earned based on first-year performance do not pay out until all three years have passed.
Another, more elegant solution is to recast a metric that’s difficult to forecast into a related metric that’s easier to forecast, such as a ratio. Earnings might be impossible to forecast three years out, but profit margin, return on invested capital (ROIC), and return on equity (ROE) are going to be much more stable.
Ultimately, plan for mounting pressure to transition to a three-year metric. For this reason, building a repertoire of analytical tools to help you pick threshold, target, and stretch goals is important. It goes a long way toward managing pay-for-performance relationships while delivering believable and realistic incentives to executives.
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