More companies are using judgment as well as set performance targets to incentivize top managers during uncertain times, a recent survey finds.
In a survey last June of 230 major US corporations, consultancy Mercer found that 26 percent either said they would increase judgment related to short-term incentives last year or that they planned to do so this year. Nineteen percent either said the same thing in connection with long-term performance plans.
The trend in part reflects the recent downturn in the economy, and so could reverse course if the economy improves, some observers contend. And others think it will be of little significance so long as the make-up of compensation committees themselves isn't revisited.
What chiefly characterizes the trend is a move away from bonuses tied to fixed targets for performance in favor of ranges. In addition, some committees now reserve the right to pay a bonus, though often at a reduced level, to reward managers who beat their competitors but fall short of budget or bring in earnings that are lower than the prior year's.
More committees are also paying bonuses based on operational goals such as the execution of a marketing campaign, cost-cutting initiative, or debt refinancing.
Some consultants say the trend is evidence that formulas aren't always reliable. "Many formulas do work, but much more thought and testing of metrics is necessary," Don Sagolla, a Mercer partner who recently wrote about the survey results, told CFOzone.
Then there are new SEC disclosure requirements. While the rules put more pressure on companies to articulate any remuneration-related judgments, they evidently believe it's worth the trouble in order to avoid competitive harm. How so? Relying on judgment allows them to make their compensation practices less cut and dried, and thus protects them from one-upmanship by competitors who might try to lure executives away through firm but easier targets.
"Any formula for executive compensation runs into the problem of possibly creating competitive harm to the company through its public disclosure," said Frederick Lipman, a partner with the law firm of Blank, Rome. Lipman noted that the SEC has taken a tough position on omitting disclosure of targets on that ground.
Even so, the emphasis on less formulaic approaches may disappear if the economy continues to improve, according to Margaret Engel, a partner with consulting firm, Compensation Advisory Partners. When the recession hit, Engel explained, more companies wanted the ability to reward and thus retain executives despite poor performance. So they moved away from hard and fast targets.
"When the economy and stock prices were tanking, compensation committee members and management teams were uncomfortable," said Engel. "There was a lack of clarity around how the consumer would behave and the risk of underperforming budget was high."
On the flip side, she said, companies were reluctant to set low budgets that would be overshot. But with the economy recently showing signs of improvement, she said this mindset is becoming "less prevalent."
One reason is that formulas have some clear advantages. "They are easy to communicate. It boils down to, do x, get y. Everyone understands the underlying dynamic," Engel said, though she cautioned that "it can sap morale when the management team feels like there is little chance of success right out of the box."
Formulas can also protect the compensation committee from criticism. "If compensation is awarded on a black and white formula determined in advance, the thinking is that no one can really criticize the outcome," she said.
In addition, formulas provide a certain level of assurance to the compensation committee. "Applying a formula to peer company data or industry surveys to determine compensation levels provides some empirical support for the reasonableness and competitiveness of compensation," said Amy Seidel, co-chair of the public companies group with the law firm of Faegre & Benson
Finally, formulas may help committees take risk into account, which has become a much bigger concern following the financial crisis, especially at banks. "A credible risk assessment usually involves quantification and is to some degree formulaic, so that will have to be incorporated somehow," said Daniel Borge, author of The Book of Risk.
Some observers contend that the degree to which formulas and judgment are used is irrelevant if compensation committees don't understand what makes top executives tick, or care about aligning their incentives with the interests of shareholders.
"Worry about getting the right people on your compensation committee, not about telling them how to do their job," said Curtis Alva, corporate governance litigation group leader at the law firm of Gunster.