Short-term incentive plans have a performance period of one year or less. The most common performance periods are annually and quarterly. For 2019 calendar year plans, the last quarterly or annual payment was made by March 15 of this year in order to be compliant with section 409a.
Sometime in March all states issued a stay at home order and business as we know it changed. Looking ahead to December 31, it is unknown what the financial impact will be on business results expected at the start of the calendar year. Here are actions organizations can consider for their short-term incentive plans going forward.
FOUR CONSIDERATIONS – Short-term Incentives
1. Participants Share in Company Success
The first perspective is a business and cultural one. If the company is doing extremely well or has been harmed by this “interim normal”, should incentive plan participants share in how the business has been impacted? This approach would pay out the incentive plan based on the performance measures and plan design at the start of the performance period. This would not be adjusted even though results have been impacted by something outside of a company’s control.
A second perspective is that because the external issues caused the impact and were not within the company’s control, the plan should be modified. This approach would include options discussed below relative to performance measures, performance periods and incentive mechanisms.
A third perspective, whether dealing with a windfall (because the company’s financial success is accelerating in this environment) or shortfall, is to cancel the current plan and award incentive plan payments to participants on a discretionary basis. This approach allows for the most generous and reasonable payouts possible given a company’s individual financial circumstance.
2. Performance Measure Type, Weight and Goals
There are several short-term incentive plan design features that connect to a plan’s performance measures that should be considered. These include the allocation or weight of measures by job level, the company’s circuit breaker, and the types of incentive criteria that measure performance as described here.
In many cases, there will be multiple incentive criteria that measure performance at the company, business unit/department and the individual/team level. Each of these criteria will likely have different weights relative to each job’s line of sight to the company. For example, a senior leader will have a company profit measure that is weighted 70% of their payout opportunity, whereas an analyst will have that same measure, but it will be weighted 20%. Therefore, those with the most line of sight to the company, will receive limited or no payout if the company is being impacted negatively, or the highest payout if the company is experiencing a windfall.
If your plan requires that there is a minimum profit required to make any payments (circuit breaker) and the company is significantly behind by year end, will those who have achieved their individual results be unduly penalized for the company’s financial results? The company may want to make an exception by ignoring the circuit breaker and paying for individual achievement. This will benefit those with a higher percentage of their total payout opportunity tied to their individual performance.
Another consideration would be to try to reduce or eliminate the external forces impacting payouts under the plan. This could include reducing the weight of the company financial measure(s), changing how the current financial measure is calculated or replacing the financial measure with another. This applies in both shortfall and windfall situations.
WorldatWork’s “COVID-19 Quick Poll” in April found that 43% of employers surveyed are undecided about whether they will adjust their performance measures, 17% of employers said they considered adjusting but decided to revisit the option later, 15% said they are still in the process of setting performance measures and 14% said they considered the option but do not plan any adjustments. Based on their broad reference to performance measures, we believe this could include the types of measures, the weight of each measure and the goals/performance levels assigned to each measure.
3. Plan Mechanics: Formulas and Calculations
There is an opportunity to apply discretion in how the short-term incentive plan calculates payouts for each participant to adjust for shortfalls or windfalls. In cases of an anticipated or actual company shortfall this could include:
- Paying out the threshold or first performance/payout level for company financial measures, regardless of the actual results, and then pay participants for their individual results.
- Guaranteeing an overall threshold payout on all measures now and challenge participants to do what they can through innovation and extra effort to reach beyond a threshold payout. And if external forces on the company’s financials improve, then the plan can reward as originally intended.
- After reviewing payout calculations, the company can provide a discretionary adjustment based on the ability to pay and related issues. This could involve applying a consistent multiplier to participant overall results to reach a higher but affordable total company payout. For example, multiplying what each participant has already earned by 110%.
- Rather than applying the same multiplier to each participant, ask managers to nominate participants who went above and beyond during this time and add discretionary payments to the total calculated payout. It is important to make sure that all job levels are represented in the discretion.
- In the case of an anticipated windfall, ensure that there are maximums or caps that are included in plan design or a contingency clause that the management may adjust maximums to in these cases.
4. Performance Periods
If your plan has an annual performance period and you have made significant adjustments in your revenue streams now and later in the year, you may want to consider moving to a quarterly plan. Pay employees now for first quarter results on conditions before the “interim normal” and then reconstruct your measures, goals and weights to align with your new business strategy and plan for the remainder of the year, paying for quarterly results.
The four considerations above of how to adjust short-term incentive plans provide a variety of ways to modify this fiscal year’s incentive plans. First, you have to consider your culture and philosophy about the degree to which incentive plan participants win or lose with the company due to this health and financial crisis. The second and most common adjustments are made to performance measures; the type, weight and goals or performance levels established for each measure. Third is an adjustment to the plan mechanics, including performance measure formulas, guarantees and discretionary payments. Lastly is to move from an annual plan to a quarterly plan if your organization has made significant changes in revenue stream and business strategy and operations.