Finance’s Critical Role in Incentive Design

Why companies need to tap the function’s analytical tools and quant mind-set in pulling together incentive compensation plans.

The role of the finance function has changed dramatically over the past couple of decades, and it continues to evolve. Traditionally, the primary responsibilities of finance included financial reporting, cash flow management, and activities around securing corporate funding. Increasingly, though, finance leaders are being asked to play a more strategic leadership role in their organization.

One area in which leaders of the finance function can be particularly instrumental in reinforcing corporate strategy is in the design of companywide incentive compensation. Finance can help with the selection of performance measures, the evaluation of possible performance targets, and an assessment of the cost and affordability of alternative compensation-program designs. Getting an analytical finance manager’s perspective is especially important for companies evaluating long-term incentive plans, with which the range of alternative designs is virtually limitless—and the selection is high-risk.

Although the annual incentive plan tends to receive the most attention from the management team, developing an effective long-term plan is ultimately more critical for shareholders. In most industries, major capital allocation decisions or strategic reorientations can be effectively measured only over a multiyear time frame. As a result, long-term incentive programs have become the primary focus for most CEOs and board compensation committees, and have become the main driver in overall executive compensation.

Several characteristics contribute to the effectiveness of a particular performance measure within an incentive plan, regardless of the time period:

Most businesses start by doing a bottom-up assessment of performance levels that are considered to be achievable within different areas of the business. Finance may then stress-test the bottom-up view by reconciling it with external (market) expectations, as well as an assessment of the rigor of the performance goals relative to the company’s past performance and the performance of comparable organizations. By reviewing analysts’ expectations for future performance, the company can assess whether performance that achieves its own internal goals will meet or fall short of market expectations. Incorporating such a perspective into the budgeting process helps to avoid a situation where the company meets its internal targets but disappoints shareholders and underperforms relative to the competition.

Finance can also provide sensitivity analysis around target performance levels to understand how external factors or market conditions are likely to impact the company’s ability to achieve its goals. Incentive plans are generally structured on a sliding scale, defining three key performance levels for each metric: the target, at which the executive receives 100 percent of her incentive payout; a threshold for minimum acceptable performance, below which the executive receives no incentive compensation; and a level of “outperformance” at which the executive receives the maximum possible payout. As a rule of thumb, finance should shoot for the following probabilities of achievement for each of these performance levels:

Enter finance. The fair value of an award will depend on specific design parameters, such as the performance level required to earn the threshold, target, and maximum watermarks and the number of shares earned at each level of performance relative to the target number of shares. In addition, fair value will depend on technical factors like the volatility of the company’s stock price and the cross-volatility of the company’s stock price with comparable companies. Finance should be involved early, first to help provide a baseline estimate of cost and then to collaborate with other members of management and the board’s compensation committee to assess the accounting impact of different design alternatives.

Beyond market conditions, which affect TSR-based plans, numerous other design factors can have complicated accounting impacts, including:

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