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MEMORANDUM
February 2, 2007
To: Mr. Smith
ABC Company, Inc.
From:
John K. Gayley
James F. Reda & Associates, LLC
Managing Director
You asked us what proportion of the earnings
above target typically is shared with management or employees, versus
shareholders. Your specific question focused on long-term performance plans,
but you also indicated that information on annual plans would be helpful as
well. Below, we’ve outlined some preliminary reactions.
We gathered information from a number of
sources on your peer companies. This information included publicly available
documents and published survey data. We also talked with a select number of
compensation contacts among your peers. Additionally, we did a few “sanity
checks” against a broader cross-industry universe.
·
Quick upshot:
past design experiences and the data gathered thus far suggest a logical
“sweet spot” would be in the neighborhood of 20% - 40% of incremental
earnings above target as the relative proportion shared with management.
This is based on how such plans typically are structured, and discussions
with practitioners at peer companies.
A few general comments, based on experiences
with other clients, our research this week, and conversations with peer
companies are as follows:
·
Not surprisingly, specific
practices vary widely, depending on numbers of participants, the types of
performance goals and the relative prominence of variable pay plans in the
total compensation mix.
·
At the senior-most executive
and management level, most annual and long-term performance plans have
broadly similar performance/reward relationships above target. These
relationships help define, the sharing rate of incremental earnings:
o
Maximum individual awards
typically are 150% or 200% of target
o
The performance “corridor”
around target for earnings-based plans typically falls in the +/- 10% - 20%
range; for EPS the range is tighter, typically 5% - 10% at the outside.
·
The character of goal-setting
also plays a part. To the extent performance goals are set aggressively
(i.e., sustained earnings growth well above peers, far in excess of capital
costs and market expectations, etc) the acceptable sharing ratio will be
different than for companies with more conservative goals.
·
There is not one universal
standard. There are some industries (e.g., some parts of financial services)
in which the sharing ratios are more common and accepted. This does not
appear to be true in your industry.
Initial Findings
As you can imagine there is a fair amount of
informed extrapolation involved, as these ratios aren’t explicitly “baked
into” most plans. Based on the research we’ve done thus far, however, the
plans at your peers appear to conform broadly to the “sweet spot” we
identified above, and which Jim and I described when we talked with you
earlier this week.
Annual Incentive Plans
·
For annual incentive plans,
the marginal sharing rate of incremental pretax profit above target may be
double, or at times even triple, the sharing rate at target;
·
Given how the
performance/reward “slopes” in most plans are constructed, the sharing
above target may be graduated, such that the ratio at maximum is materially
higher than (say) somewhere in between target and maximum
·
In absolute terms, this means
that the typical sharing ratio of 10 – 20% of pretax profit at target
increases to 20% - 30% of incremental profit at maximum.
·
As you know, the typical award
leverage above target often is quite modest for incentive-eligible employees
below the executive and management levels. As such, the marginal sharing of
incremental pretax net looks to be more in the 20% - 25% range for many
companies of your type. Other companies with a more typical leverage profile
for all eligible employees would be at the higher end of this range.
·
A number of companies we’ve
spoken to recently are more accustomed to assessing the aggregate
sharing ratio on (all) pretax net income, regardless of where the target is
set. With significant ramp-ups in sharing above target, the aggregate
sharing ratios for typical annual incentive plans fall in the 15% - 20%
range.
Long-term Performance Plans
·
These plans consistently have
performance/reward “slopes” that kink up significantly beyond target,
providing a 200% award payout for a relatively narrow band of net income or
EPS performance.
·
At many companies, multi-year
performance plans still cover a relatively select group of executives. As
such the absolute sharing percentage against incremental net income may be
smaller than under annual incentive plans which cover a broad group of
salaried employees.
·
On the other hand, companies
that (like yours) provide a significant portion of their LTI opportunities
through performance plans will inevitably provide more of the incremental
profits to management.
·
Our initial calculations from
such companies suggest that the sharing rate of net income beyond target for
long-term plans would be three to five times the rate at target
·
In absolute terms, this might
translate into a marginal rate of 4% to 5% (for more selective executive
groups) to as high as 10% to 15% for plans covering broader groups.
We’d be happy to discuss the preliminary
findings. Please call me if you have questions.
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