In today's business and governance environment, aligning executive compensation with company performance is essential. Shareholders, proxy advisors, and boards expect increased transparency and a clear connection between pay and long-term value creation. Effective incentive design ensures that companies not only attract and retain top talent but also drive behaviors that deliver sustainable results.
Designing performance-driven compensation programs requires a careful balance among many factors. In this article, we share best practices for creating effective incentive plans.
1. Start with Clear Business and Strategic Objectives
The foundation of any well-designed incentive plan begins with a clear understanding of the company’s business strategy and priorities. Organizations should identify the specific short-term and long-term goals that drive shareholder value and align incentives to these objectives.
Companies will typically include both a short-term incentive program (STIP) that focuses on the company’s short-term performance (e.g., 1-year performance) and a long-term incentive program (LTIP) that focuses on the company’s long-term performance (e.g., multi-year period).
2. Select the Right Performance Metrics
Selecting performance metrics is a critical aspect of incentive design. Metrics should be measurable and align with shareholder and company expectations of success. Common metrics include:
- Financial Metrics: Revenue, earnings, free cash flow
- Market-Based Metrics: Relative or absolute total shareholder return (TSR)
- Strategic Non-Financial Metrics: Customer growth, achieving project milestones
Many companies have a mix of metrics in incentive plans to ensure executives are not overly focused on a single outcome at the expense of long-term value.
3. Ensure Appropriate Goal Setting
The effectiveness of any incentive plan hinges on setting challenging yet realistic and achievable goals. Goals that are too easy may not drive performance, while goals that are overly ambitious risk discouraging executives or prompting excessive risk-taking.
To strike the right balance, companies should:
- Use threshold, target, and maximum performance levels to reward varying degrees of success
- Test whether payouts align with expected performance outcomes
- Assess company performance against industry peers and market trends
- Regularly revisit and recalibrate goals to ensure they stay relevant in changing business conditions
Aligning Pay with Performance:
Best Practices for Effective Incentive Design
4. incorporate Vehicles that Align with Long-Term Strategy
LTIP vehicles provide a link to long-term performance (typically three to five years) and are key to driving sustained value creation and discouraging short-term decision-making. Each equity vehicle achieves different objectives:
- PSUs: Ties executives to achievement of critical long-term metrics (e.g., relative TSR, earnings)
- RSUs: Provides retention value while aligning executives’ interests with shareholders
- Stock Options: Encourages stock price appreciation, directly linking pay to shareholder value
5. Address Pay-for-Performance Alignment through Rigorous Governance
Boards and compensation committees must establish a strong governance framework to ensure ongoing alignment between pay and performance. This includes:
- Regularly reviewing pay-for-performance outcomes to ensure alignment with shareholder returns
- Conducting pay equity and risk assessments to avoid unintended consequences, such as over-leveraging incentives
- Adopting clawback policies to recoup compensation in cases of misconduct or financial restatements
- Engaging independent consultants to provide unbiased insights and support sound decision-making
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6. Consider Stakeholder Expectation and External Perceptions
Companies today operate under increasing scrutiny from shareholders, proxy advisory firms, and the public. A strong pay-for-performance narrative is critical for obtaining shareholder approval during proxy season and maintaining investor confidence. Best practices include:
- Providing clear and concise disclosure of performance metrics, goal-setting rationales, and outcomes in proxy statements
- Conducting proactive shareholder outreach
- Continuously reviewing compensation programs in light of evolving market conditions, industry standards, and investor expectations
Transparency and stakeholder engagement are essential to building trust and aligning interests.
By setting clear objectives, selecting the right metrics, incorporating appropriate long-term compensation vehicles, and maintaining rigorous governance, companies can create incentive programs that motivate executives, drive sustainable performance, and align with shareholder interests.
