An Incentive to Control Incentive Pay

CFOs should play a central role in setting incentive-compensation practices.
David McCannApril 15, 2013

When it comes to establishing incentive-compensation targets and weighting the measures used to calculate payouts, CFOs who are not heavily involved in the process – especially where non-executives are eligible for bonuses – are making a mistake.

At least, so says Juan Pablo Gonzalez, a partner at management-consulting firm Axiom Consulting Partners, whose specialties include talent acquisition, development and rewards.

Investors have grown increasingly more attuned to compensation matters since the Securities and Exchange Commission, under the Dodd-Frank Act, required public companies to give shareholders a nonbinding advisory vote on executive-pay programs as detailed in proxy statements, starting in 2011.

The so-called “Say on Pay” votes apply only to the compensation packages of a company’s chief executive, CFO, and three other most highly paid officers. But, says Gonzalez, Say on Pay for senior executives has opened the door to greater investor scrutiny about a whole range of incentive-compensation issues. This year, with salaries relatively flat and bonuses and short-term incentives comprising a larger share of employee compensation, CFOs certainly will be answering more questions about the details of their payout policies and how those policies serve the interests of shareholders.

“CFOs don’t often get involved with human-resources issues, but when it comes to incentive compensation, they should,” says Gonzalez. “At a minimum, the CFO’s team should be involved in running payout calculations and performance curves against various assumptions about the company’s performance. But the greater value is in having the CFO look behind the numbers to assess whether bonuses are really driving the behavior that supports company strategy.”

Some are doing so, Gonzalez notes. For those who haven’t been involved, now is a good time to start. Since many companies release bonus payments in March, it’s common for management to follow up with a review of incentive-compensation policies and practices in April or May to see how they can create better alignment between compensation and performance in the following year. “The CFO should step in sooner than later,” he says.

Make Sure Bucks Are in the Equation
Among the more enlightened is Dan Gallagher, CFO at Town Sports International, a $500 million publicly held company that operates 160 health clubs in the United States. Town Sports offers incentive compensation for its executives and club managers. The HR and operations department offer suggestions about how to structure the incentives, “and I usually counter with something else,” Gallagher says.

For example, five years ago the company was making such extensive use of secret shoppers at its clubs that the idea arose to base half of the club managers’ incentive pay on the secret shoppers’ scores. “I nuked that right away,” the CFO says. A club could “buy its way” to higher scores by hiring more housekeepers and “extra-friendly staff,” meanwhile burying themselves in a financial hole. “There always has to be financial metrics in the dialogue, and if the CFO is not involved those metrics can be underplayed.”

What Town Sports ended up doing instead was set a minimum threshold for secret-shopper scores below which club managers were not eligible for a bonus. For those who qualified on that count, half of the bonus was based on membership gain and half on a club’s “controllable profit,” an EBITDA-like measurement that excludes rent and a few other items not under the manager’s control. “It means they shouldn’t be overspending on payroll and shouldn’t be leaving the lights on and things like that,” says Gallagher.

The same criteria remain in effect today for club managers and also for regional business and operations directors. For upper-level executives, bonuses are based 60% on EBITDA, 20% on revenue, and 20% on return on assets.

The performance measurements Town Sports use adhere strictly to one of Gonzalez’s key tenets: the plan has to be simple. “If you give people 17 different things to focus on, you’re not going to change their behavior,” the consultant says. “You’re just going to confuse them. Then they’ll throw their arms in the air, keep doing their jobs the way they always did, and hope they get paid.”

Going back about eight years, Town Sports’ plan was far too complicated, says Gallagher. “If you went into the field on any given day and polled 50 club managers, half of them didn’t understand how the calculation worked.” Keep it simple so employees always know whether they are tracking to the plan, and new ones will more quickly understand the company’s goals.

Tailor the Program to Industry Norms
The incentive-compensation program is even simpler at Aptiv Solutions, which performs research on a contract basis, in the sense that not only is every bonus-eligible employee subject to the same measurements, but with few exceptions everyone gets the same percentage payout. “Our overarching philosophy when it comes to incentive pay is that there are no winners on a losing team,” says Matt Bond, the company’s finance chief.

The payout is based on revenue, EBITDA, and the amount of new contract work Aptiv lands. Leaders of the company’s 15 business units have their own individual targets but achieving them has no influence on the payout. “They are mindful of it, with the idea that if they get their units’ business up, it will help them get their bonus,” Bond says. About 35 percent to 40 percent of Aptiv’s work force is in the bonus program.

Aptiv finds that the nature of the company’s business makes the homogenous payout sensible. “If you dissect us down to our skeleton, we’re a professional services firm,” he says. “Billable hours is one of the key drivers. If individual business units aren’t linked at the top, people may hoard customers, activities and resources to maximize their business unit at a cost to the organization as a whole.”

The company does get its business-unit leaders to each year submit target levels for the three metrics the company uses to calculate incentive payouts. Often the submissions are “obscenely low,” an example of what Gonzalez calls the “sandbagging approach.” In addition to under-promising results, people may slow down near year-end after targets are achieved, if the program is not structured properly.

In Aptiv’s case, performance levels higher than target numbers trigger payout multipliers. As for the initial low-balled targets, they don’t actually have any effect, Bond says. “We go out to the organization for input on what each business unit can commit to, but it’s not communism where we let them rule the roost. We have a set of numbers in mind. I have to take our overall targets to our three private-equity owners, who want to see upward-focused graphs.” 

Make It Complex – If You Have To
Sandbagging is more of a concern at the American Bankers Association (ABA), which has traditional nonprofit activities but also for-profit ones that generate about $100 million of revenue per year.

During the budgeting process for 2013, the ABA had to do substantial negotiating with the organization’s sales team to “get the number to where we realistically thought it ought to be, given the economy and where the banking industry stood,” says CFO Robert Eady.

But while the ABA worked with Axiom Consulting for two years to overhaul its incentive-pay program, it didn’t end up with the degree of simplicity that Gonzalez espouses.

“For us it’s kind of complicated,” says Eady. At one end of the sales spectrum is cold calling regarding products and services the organization offers to its members. Eady calls that “pure sales, a one-on-one, close the deal kind of thing.” At the other end of the spectrum is membership sales, which is very important to the organization because it collects $34 million in member dues annually. That’s hardly ever a one-on-one sale; Eady may get involved, as might the ABA’s government-relations experts, for example, depending on what interests the potential new member. Ultimately there could be up to six people involved in the sales process.

That’s part of what makes structuring an incentive program difficult for the ABA. The other part is that the spectrum of sales activities is broad, and what kinds of payout criteria and weightings make sense varies greatly across that spectrum. There are also four different revenue-generating groups, each with an individually designed plan. Some are individual commission-based plans. Some are plans where a group that reaches its targets triggers the creation of a bonus pool, to be doled out by the executive vice president over that group based on team members’ individual contributions.

Overall, suggests Gonzalez, “A CFO is not necessarily in a position to assess how well everyone eligible for incentives does their jobs, but he’s in a great position to evaluate how the combination of all those efforts contributes to different levels of organizational performance.”

In that regard, one final note of caution: be careful about how many people you make eligible for incentive pay. If you go too far down in the ranks, you may bog down the organization. “You may end up spending an awful lot of time trying to come up with something for the clerical person to do against which to pay the incentive, and trying to come up with ways to measure that person’s performance, to pay out an award that may not be all that substantial,” Gonzalez says.