TWELVE WAYS TO STRENGTHEN YOUR INCENTIVE PLAN

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<ul><li><p> Journal of Applied Corporate Finance S U M M E R 1 9 9 9 V O L U M E 1 2 . 2</p><p>Twelve Ways to Strengthen Your Incentive Plan by David Glassman, Stern Stewart &amp; Co. </p></li><li><p>TWELVE WAYS TOSTRENGTHEN YOURINCENTIVE PLAN</p><p>by David Glassman,Stern Stewart &amp; Co.</p><p>107BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE</p><p>ew areas of corporate governance generate as much divisivenessand distrust as incentive compensation. From determining the keymeasures, to setting the targets, to establishing the payout range,companies seem continuously to undermine their own plans,</p><p>processes, and credibility.With great fanfare new incentive schemes are rolled out that few under-</p><p>stand. Worse, new plans from the outset are viewed as the flavor of the month,likely to be changed again next year. Lack of credibility diminishes the buy-inof managers and, along with it, the enthusiasm, motivation, and drive the plansare intended to generate. For investors, this makes the incentive plan a low rate-of-return initiative.</p><p>Our experience at Stern Stewart suggests that the problems besettingincentive plans are surprisingly similar across companies and even acrossapparently dissimilar industries. Most plans are ineffective because of:</p><p>Too many performance measures;Measures that motivate the wrong behavior;Too much complexity;Arbitrary targets that are subject to intense lobbying by executives;Too much managerial discretion;Performance measured at a level too high to be meaningful, or too low to</p><p>encourage teamwork;Caps and floors that narrow the payout range and stifle incentives;A failure to integrate the incentive plan into the overall compensation</p><p>philosophy; andIneffective or non-existent communication.</p><p>Obviously, companies do not set out to develop convoluted programs. Sowhy does it happen? Why are incentive plans so poorly constructed when CEOsrecognize their importance for corporate governance? And why are plans socomplicated when simplicity is so clearly a priority?</p><p>This paper identifies why incentive plans are unproductive, and offers 12suggestions for implementing plans that support managements aspirations to createvalue for shareholders. The remedies described below are not difficult to executeand, judging from the evidence, are remarkably effective. But they require the strongcommitment and attention of senior management. Left solely to the human re-sources staff, capable as they may be, institutional resistance will be overwhelming.</p><p>F</p></li><li><p>108VOLUME 12 NUMBER 2 SUMMER 1999</p><p>1. IMPROVE FOCUS AND GET THE MEASURERIGHT</p><p>Most companies ask too much of their incentiveplans. Obviously, they aim to motivate improve-ments in financial performance, but how is thisdefined? Growth is a key goal, so a target for Salesgains plays a role. Profit (or EPS), of course, ishighlighted in the incentive plan. And Finance oftenproposes a balance sheet measure, such as inventoryturns or Return on Investment. With these threemeasures, the Compensation Committee believesthat all financial bases are covered. In fact, theproblems are just beginning.</p><p>One problem is that any particular initiative islikely to push different financial measures in conflict-ing directions. Sales may rise but the gain may be toocostly, leaving profits unchanged, or even belowwhere they started. Or an SKU reduction initiativemay reduce sales and profit but increase inventoryturns and ROI. Instead of guiding decisions, themeasures create confusion. And, to add to theconfusion, management also inserts non-financialconsiderations into the incentive plan. These mayinclude customer and employee satisfaction, safetyand environmental compliance, investment for thelong term, leadership, and so forth.</p><p>Also, the many measures influencing bonusesdiffuse, rather than concentrate, the focus of execu-tives. Worse, they can even encourage counterpro-ductive behavior. At one company that used Salesand Profit measures for its incentive plan, a particu-larly candid manager admitted that in a recent yearhis business was unlikely to achieve the Profitcomponent. When asked how this influenced deci-sion-making, he said, We made sure we hit the Salestarget. How? By discounting product in the fourthquarter. Margins suffered, profits were down, but atleast part of the bonus was salvaged.</p><p>Management can improve the focus of incen-tive systems by using just one financial measure,Economic Value Added (EVA). EVA, measured asthe profit after deducting a charge for all capital,internalizes the tradeoff between income statementreductions and improvements in capital productiv-ity. As Peter Drucker said recently in Fortune:</p><p>there is no profit unless you earn the cost ofcapital. Alfred Marshall said that in 1896, PeterDrucker said that in 1954 and in 1973, and nowEVA (economic value added) has systematized thisidea, thank God.1</p><p>EVA contains in one measure the benefits ofSales and Margin gains offset by increases in Capitalthat may be required. An internal study performedby Stern Stewart, and summarized in the sameFortune article, indicates that companies adoptingEVA for incentive compensation outperform peercompanies in the stock market. The 67-companysample of EVA firms provided an average annualreturn of 21.8% vs. 13.0% for industry peers.</p><p>Some companies add EVA to the menu ofcompensation measures, but without eliminatingmeasures like sales and EPS growth. This both addsto the confusion and double counts gains or lossesin sales and earnings. Sales, obviously, is a key driverof EVA, but it can be improved without necessarilybenefiting EVA. The same is true of EPS. SternStewart performed a study of the largest 1,000companies in the U.S. to determine the extent towhich EPS and EVA move together. The resultsindicate that, when EVA increases, EPS increases in82% of the cases. But when EVA decreases, EPS stillgrows 57% of the time.2 In other words, set yoursights on EVA growth and favorable EPS results willfollow. But the reverse is uncertain.</p><p>EVA focuses incentive plans on the right moti-vationsgrowing the business profitably while tak-ing into account all costs of doing business. But thisfocus is undermined when EVA is forced to share thestage with other financial measures. Eliminate them.</p><p>2. ABANDON ATTEMPTS TO MEASURE WHATEXECUTIVES CONTROL</p><p>Conversations about development of incentiveplans almost always begin with instructions to Keepit Simple. At the same time, however, CEOs andhuman resource directors want to pay managersonly for what they control. This is a combination sureto cause frustration. Unanticipated events during theyear convert up-front simplicity into back-end com-plexity. Complexity results from the failure to con-</p><p>2. Annual data from the Stern Stewart 1,000, 1988-97. The reason why EPSdoes not increase in even more cases can be attributed to accounting restructuringcharges, and increases in R&amp;D. While they diminish EPS, these items are capitalizedfor EVA purposes.</p><p>1. September 28, 1998, Q&amp;A with Peter Drucker.</p></li><li><p>109JOURNAL OF APPLIED CORPORATE FINANCE</p><p>sider, and incorporate into bonus programs, thetendency for events to overtake plans.</p><p>Despite evidence to the contrary, managersenter the year believing they can estimate within arelatively tight range the performance that can beexpected. Yet, time and again, surprises early in theyear make a mockery of expectations. Surprisesresult from changing trends in economic and indus-try growth, interest rate and commodity price vola-tility (either for inputs or outputs), regulatory changes,competitor initiatives, unusual weather patterns,legal actions, and the like. Because these are viewedas out of the control of managers an after-the-factadjustment to the bonus plan is proposed.</p><p>This is where it gets complicated. While out ofmanagements control, arent investors exposed tosuch events? How is a change to be explained tothe Board? And what will be the harm tomanagements political capital with Directors? Ofgreatest importance, shouldnt managers be re-quired to respond swiftly to changes in their mar-kets? While outside of managements control theyare the reality. And managers must internalize anurgency to anticipate such possibilities, build con-tingency plans, and execute them swiftly to limitlosses and capitalize on the opportunities offeredby change. Insulating executives from the impactof market fluctuations denies reality and gets in theway of the necessary responses.</p><p>It is easier and simpler to forbid incentive planadjustments during the year. In place of such ad-justments, establish realistic multi-year EVA im-provement targets (discussed in a later section)driven by shareholders requirements for earningan adequate return on investment. Missing thetarget in the current year, for whatever reason, ispenalized with a reduction from the target bonus.But, if the shortfall is judged by top management tohave been caused by factors beyond managementscontrol, the improvement target could then belowered, using as a new base the current (disap-pointing) level of profitability. By making such anadjustment, executives are given the opportunity toearn an attractive award in the following year byrecovering lost ground.</p><p>The principle underlying this plan is that man-agers should share with investors the value theycreate. And, using EVA as the key performancemeasure ensures that each dollar of improvementdrives additional value for shareholders as well asmore bonus compensation for participants. Accord-</p><p>ingly, the bonus plan motivates managers to think,and act, like owners.</p><p>But owners also face risk. They can lose someor all of their money. Accordingly, an EVA BonusPlan sets aside a portion of outstanding awards in aBonus Reserve (or Bonus Bank). The set-aside ispaid to executives if performance is sustained; but ifEVA subsequently declines below a defined thresh-old, the deferred amount can be lost. In other words,a negative bonus is a key feature of the EVA Plan.This ensures that, among other things, decision-makers are properly focused on the long-termconsequences of todays actions.</p><p>What executives control is difficult to deter-mine, and in the end does not much matter. Resultsmatter. And results are more likely to be achieved ifexecutives face the downside risk associated withunanticipated events. Economists call this moralhazard. If managers know they will be given relieffor what they cannot control, their incentive to planfor such events is reduced, making the conse-quences more severe.</p><p>3. USE INVESTORS, NOT MANAGEMENTS,EXPECTATIONS TO SET TARGETS</p><p>Typically, companies rely on the budget pro-cess to determine incentive targets. This is a mis-take, one that corrupts both planning and incen-tives. And, because each is a critical element ofcorporate governance, they should be separated.The reason is that managers tend to water downtheir plan for next year in the hope of achieving asoft performance target.</p><p>Knowing that managers have the incentive tohide opportunities, headquarters stretches the per-formance targets. The result is a cycle of managerssubmitting plans, headquarters rejecting them, man-agers recycling them, and so on. For almost allcompanies, negotiating budgets is a time-consumingprocess that makes adversaries of line and staff.Instead, they should be collaborating to find solu-tions to the problems they face and to identifyopportunities to grow.</p><p>To make the planning process more effective,bonus targets should be set in advance for a multi-year period without referencing the budget or busi-ness plan. Breaking the link enables managers tocraft a Budget that beats the target, instead ofdeveloping a Budget to negotiate a target. And,because the target is known in advance, manage-</p><p>In a study of the largest 1,000 companies in the U.S., Stern Stewart found that whenEVA increases, EPS increases in 82% of the cases. But when EVA decreases, EPS still</p><p>grows 57% of the time.</p></li><li><p>110VOLUME 12 NUMBER 2 SUMMER 1999</p><p>ment can plan for an EVA improvement that will earnthem and their team a satisfactory award.</p><p>But this still leaves the original question: Howmuch EVA improvement is necessary to pay a targetbonus award? Managers should be awarded a targetbonus when they provide investors with a competi-tive stock market return. This takes into consider-ation the demands of investors now owning orbuying the stock, and recognizes that performancemust improve to deliver a competitive return. Thisrequired return is the companys cost of capital.</p><p>When shareholders each day determine theprice at which they are willing to buy or sell thecompanys stock, they signal their perception of thecompanys management, its strategies, prospects,and risks. Investors today are making a statement: astock price and market value that represents apremium over and above the capital currently usedin the business is a vote of confidence in managementsability to produce positive EVA in the future. In fact,the amount of the premium provides an indicationof the amount of EVA growth expected by investors.</p><p>Thus, we can use the current stock price andmarket value premium (a measure we call theMarket Value Added, or MVA) to back into thenecessary growth in EVA to justify todays price andearn competitive returns for our current sharehold-ers. Further, we can establish the growth targets fora multi-year period. This eliminates the counter-productive and frustrating annual negotiation, andfrees managers to craft a budget to beat the alreadydefined targets.</p><p>Outperforming the growth targets will thendrive outstanding returns to investors and superiorbonuses for executives. Similarly, failing to achievethe targets will disappoint shareholders and gener-ate a less than target bonus for managers.</p><p>An important feature of the EVA plan is that itestablishes at the outset the growth track that willdrive a target award. To illustrate, lets suppose thatthe result of the analysis indicates that the companymust improve EVA by, say, $10 million per year foreach of the next three years. If EVA then improvesby $20 million in the first year, a substantial bonuswould be awarded. (Not all of the award would bepaid; a portion would be set aside in the BonusReserve.) But in the next year, an improvement ofanother $10 million would be required to earn a</p><p>target award. The Plan is demanding; it pays forgrowing value but always asks for more improve-ment in the next year.</p><p>Eli Lilly implemented such an EVA plan in 1995.Randall Tobias, then the companys CEO, says:</p><p>We saw as a shortcoming of our incentive systemthat executive pay was linked to sales and net in-come. There just wasnt a very good correlation at allwith shareholder value... Basically, Lillys bonusplan now requires managers to achieve continuousyear-to-year improvements in EVA. Each year wehave to beat that targetand each year the bar israised. Its a small percentage increase, but it keepspounding at you. Whatever you did yesterday, youneed to do better tomorrow to keep raising share-holder value.3</p><p>Of course, it is always possible that EVA im-provement will be below the target. Lets s...</p></li></ul>