Incentive compensation is a critical hot topic for CEOs, boards and compensation committees. Significant time is spent each year analyzing whether existing incentive plans achieved and/or are achieving their stated objectives. The most important of which are the incentives for high performance and long-term retention.
The process of crafting a great incentive plan requires that executive management and board compensation committees maintain some discretionary control while still working together to set clear, measurable, results-driven expectations. Typically, objectives for the incentive plan include:
- Should it be one or multiple?
- Should it be cash, stock, or both?
- Should it include a vesting period, and if so, how long?
- Who should participate in the plan?
- Should the incentive be based on performance, retention, or both?
Identifying an incentive plan that hits every goal can be virtually impossible. By identifying the strengths and weaknesses of each variable, decision makers can implement a blended plan or plans that fit the specific needs and challenges of the institution.
Any incentive plan must keep in mind the immediate and long term implications of the incentive, the people involved, the economy and the impact of the performance metric.
With that in mind, this first in a series of blogs on incentive compensation is focused on the five considerations for developing a successful Cash Incentive Plan for key employees.
1. Consider the best performance metric to use in calculating annual contributions to the incentive pool.
Ultimately, the calculation must show that the performance has enhanced the bottom line to more than compensate for the related incentive.
This consideration can fluctuate widely depending on the unique needs and goals of the institution. Organizations that define this metric well consider its performance against a comparable peer group. While the specifics of the performance metric can be discrete or all inclusive for each key employee, the structure is realistic and clearly articulated to all stakeholders.
2. Consider whether you should distribute 100% of the annual contribution each year or over a period of time?
In the banking industry it can take multiple years to fully appreciate the true impact of annual performance decisions. Holding back some of the cash incentive is not only smart, but it also encourages retention and consistent performance.
Many plans distribute 100% of the annual incentive each year. The best practice, however, is to allocate the distribution over multiple years. Assessing true annual performance, particularly in banking, can be near impossible. Every loan is a great decision on the day it is initiated, but knowing whether it will continue to perform well over the long term takes time. Incorporating a provision that allows for reductions in the incentive pool during years of underperformance places more incentive on wiser long term decisions.
3. Consider who should participate?
Identify the true leaders in the organization who are contributing significantly to its success.
Again, the answer to this question varies widely from one institution to another. Often key employees are determined based on title alone without a full consideration of the related performance. Best practice is to define the performance standards, understand how the identified key employees contribute to these standards, and clearly communicate the expectations.
4. Consider the existence and length of the vesting period?
A good vesting plan can ensure a new participant isn’t “riding the wave” of the bank’s current performance, rather they are being compensated for making a difference.
An initial vesting period for new participants enhances the bank’s retention benefit, while building the size of their respective inventive pool. The multiple year distributions, as discussed in the second consideration, then provides the additional retention incentive once the participant is fully vested in the plan.
5. Consider how the plan handles employee terminations, retirement, disability and change in control?
Incentives are simplest and most effective when there is a risk of forfeiture, particularly in situations where employment is terminated. But in cases of retirement, disability and change in control, it is rewarding to know that earned incentives will be paid in full.
Accounting for forfeiture provisions can be tricky. A best practice is to ensure that employee forfeitures remain in the overall incentive pool. If forfeitures are returned to the bank, it can be challenging to determine when the incentive is actually earned and should be expensed. The key is aligning the plan so that expenses are matched to the related revenues. If the annual incentive contributions remain in the overall incentive pool regardless of a participant’s forfeiture, then the incentives are earned and expensed in the year of the related performance and contribution.
A secondary benefit of keeping forfeitures in the plan is the opportunity for enhancing incentive rewards of other participants that have achieved extraordinary performance and/or providing an upfront incentive pool with recruiting new key employees.
In addition to the five considerations above, stakeholders are also wise to consider the related tax implications. The taxation of cash bonuses, deferred compensation plans, and equity award plans can vary widely. Timing of inclusion of income and deductions also can vary from plan to plan. Structured correctly, incentive plans can be very rewarding to both the employer and employee.
Have you considered every facet of your incentive compensation plans and whether they are achieving their stated objectives? Stay tuned for future blogs covering other types of incentive compensation plans.