Page 365 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 7. Short-Term Incentives 351

Target Awards
In addition to determining the appropriate risk/reward relationship, planners need to deter-
mine the probability level, in other words, the probability of hitting the targeted performance
level. The performance target is also called the standard or expected performance. Some plans
set the target performance level at 50-50; that is, there is an equal chance of either achieving
or failing to meet the target. Other plans set a stretch target with perhaps a 40 percent
probability of attaining the target and a 60 percent chance of failing.
Once the target has been set for the year, it is not expected to change. While executives
would be most unhappy should the target be increased during the year, even though justifi-
able because of windfall conditions (e.g., a major competitor going out of business), they are
not adverse to pleading for a reduction in the target because of various difficulties.
Companies should avoid making such changes because doing so destroys future credibility.
Nor should the company try to make up lost bonus money by looking to pay for effort or
other qualitative factors.

Threshold and Maximum Awards
Some plans set the two outer limits (threshold and maximum) by determining the probability
of achieving the award level. For example, some might set the threshold at a point where
the probability of achievement is 90 percent, and conversely, the probability of attaining the
maximum performance level is 10 percent. Some plans strive for this symmetry or reciprocal
relationship as shown in Table 7-3. Others find it too difficult or subjective to determine the
probability and simply set the award size as a percentage of a normal award, stipulating they
will not pay less than 10 percent of the normal award nor more than double.

Maximum Probability of achieving 10–20%
Payment as percentage of normal award 150–200%
Threshold Probability of achieving 80–90%
Payment as percentage of normal award 10–20%

Table 7-3. Probability and payments at threshold and maximum levels

Performance/Payment Relationship

Following the progressivity principle described in Chapter 5 (“Salary”), one would expect
the highest short-term incentive both in absolute and relative (to salary) terms to be at
the highest job level (typically the Chair/CEO). At that level, the normal award may be
100 percent of salary with a threshold of 20 percent and a maximum at 200 percent.
The performance-award relationship can be expressed in a chart such as shown in
Figure 7-3. In this example, the payment line is linear. It could be curvilinear with either
an increasing or decreasing rate of growth from threshold to target and/or target to
maximum (some plans have no maximum limit). In addition, the threshold and maximum
could be higher or lower in relation to the target awards. No payment is made below
threshold performance unless there is either a carry forward of unused amounts from
previous years or an allowance for discretionary payments (see shaded area). Discretionary