Page 384 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

370 The Complete Guide to Executive Compensation

that net income could be as low as $1,000,000 and still pay out $100,000. Upon review, the
chief financial officer might indicate that there should be no payout at $1,000,000 of net
income but could agree with $200,000 at $2,000,000 net income, thus suggesting the thresh-
old level be set at 20 percent of normal award (e.g., $200,000 $1,000,000 normal award).
The same approach can be used to set the maximum payout. If the threshold payment was
set at 80 percent probability, one might set the maximum performance level at 20 percent
probability and a payment double the normal award. This would suggest a payout of
$2,000,000 (e.g., $1,000,000 normal award 2) or a net income of at least $20,000,000
(e.g., $2,000,000 10% of $20,000,000).
A more definitive basis, and one consistent with the bottoms-up approach, is to multiply
the bonus maximum for each job grade by the number of individuals in that grade and
sum the results. This would be the maximum total amount needed. If target awards are one-
half the maximum award, halving the total maximum fund would be adequate for the target
fund. The threshold fund could be established in a similar manner. For example, if threshold
or marginal performance were one-third of target, the threshold fund would be one-third
of the target fund (or one-sixth of the maximum). Thus, if the maximum total fund were $2
million, the target for normal awards would be $1 million and the threshold allowable would
be $333,333. Dividing the target pool by the targeted performance would provide the bonus
formula. For example, if a net income of $10 million is the performance target, 10 percent
would be the formula value. It would generate $1 million at target, $333,333 at $3.3 million,
and $2 million at $20 million net income.
Target vs. No-Target Funded Plans. Fund formulas can be structured around a target, but
they do not have to be. If a target is established, it normally equates to budgeted financial
performance. This type of plan is sometimes called a target plan. It may also be referred to as
a performance-sharing or goal-sharing plan. (This should not be confused with gain sharing,
where payment is based on sharing a reduction in expenses with employees. Gain-sharing
plans are typically unique to a particular location and include all employees, although execu-
tives at the site may be excluded.) A target plan may or may not stipulate a maximum payout
(typically 150 percent or 200 percent of target) and a minimum or threshold below which
there will be no payment. Target plans are structured a number of different ways: looking
at past performance, looking forward to expected performance, and looking around to see
what peer companies are doing. When one includes whether or not the formula will use a
threshold, or deductible, there are four possible combinations, as shown in Table 7-20.

No Target Target
No deductible A B

Deductible C D
Table 7-20. Target and deductible combination plan

1. No deductible/No target (A). This type of plan typically uses a formula to set aside a
portion of earnings. It is a nonqualified version of a profit-sharing plan.
2. No deductible/Target plan (B). This is a simple refinement of the no deductible/no tar-
get plan. Based on history and/or future expectations, a targeted or expected level of pay-
out is determined. This is helpful in communicating the value of the plan to participants.