CEO Bonus Plans: Getting a New Purpose?

When it comes to bonus time for CEOs and others at the top, the bottom-line may soon no longer be, well, the bottom line.

In yet another sign of sweeping shifts in corporate priorities, a host of boards are rewriting top-level incentive plans for this year, with an emphasis away from the purely financial metrics that used to make or break a CEO’s year. The new focus: rewarding the C-suite in part for improving everything from employee engagement to digital transformation, or for decreasing their organization’s carbon footprint.

“CEOs want to drive behavior, and boards want to be able to reward them for it,” says Irv Becker, Korn Ferry’s vice chairman of executive pay and governance. “It’s more long-term thinking,” he says.

To be sure, only about 30% of the revised bonus plans—which are technically known as annual incentives in this case—are tied to strategic priorities. Even that, however, can create complications and headaches for compensation committees. But in a variety of ways, companies are under pressure to shift their focus this way, going beyond only the bottom line. Just last summer, nearly 200 CEOs signed an agreement establishing that shareholder value was no longer the sole goal and purpose of corporations.

Historically, incentive plans focused on a few financial metrics that involved little or no discretion in determining the year-end awards. The idea was to reduce complexity and guard against shareholder claims of enriching management—the numbers were set; management fell short, met, or exceeded the targets; and incentives were paid out accordingly.

Interestingly, one factor that’s forcing bonus changes is the 2018 tax law, which eliminated the deduction eligibility for compensation in excess of $1 million. Prior to that, any pay over that amount had to be based on performance to get a deduction, which caused boards to shy away from subjective measures. “Losing the deduction opened the door for compensation committees to tie more incentives to nonfinancial strategic measures,” says Becker. 

A bigger factor, however, is that consumers and investors are pressuring organizations to incorporate so-called purpose-related issues into their operations. Companies that ignore this can lose business, which in turn can reduce bonuses. Conversely, Becker points out, adding purpose and strategic priorities into incentive plans may increase shareholder value in the long term, which will drive stock price growth and incentives.

Including strategic priorities also gives compensation committees more points of diversification to award incentives when financial goals aren’t met. There are, after all, factors outside of management’s control—such as an unforeseen macroeconomic shift or a trade war—that could impact financial performance and incentive awards. “It’s advantageous for management because it allows for a more predictable outcome,” says Becker of making strategic priorities a part of incentive plans.

Wayne Guay, a Wharton School accounting professor who specializes in executive compensation and incentives, says the more factors that go into awarding bonuses reduces the risk that any one factor gets undue attention. Indeed, while basing bonuses solely on financial metrics is supposed to reduce subjectivity, it’s possible for management to use accounting maneuvers to legally manipulate revenue or earnings per share to achieve certain goals.

The problem for compensation committees, Guay says, is in developing ways to measure strategic priorities. While the aim of including strategic priorities is to allow boards some discretion when awarding incentives, not having metrics around them and leaving it totally open-ended renders them little more than a gesture to appease shareholder concerns, says Guay.

“Once you put it into a bonus plan, you have to be able to measure it in a transparent way that shareholders can understand,” he says.

The important thing, says Becker, is that compensation committees need to have a framework to understand how to evaluate achievement of goals at the end of the year. “Committees are both trying to incorporate these strategic priorities into the mix and are looking for a hedge against pure financial performance outcomes, but they also want to avoid having to use too much discretion,” says Becker.