In an environment of weak economic growth, geopolitical uncertainty and the resulting volatility in results as well as financial bottlenecks, the incentive systems for managers are in difficult waters. What approaches are there to ensure that incentive systems continue to be effective as a control instrument and are also as crisis-proof and flexible as possible?
Incentive systems for managers usually reflect the central control variables and value drivers in companies. The prerequisite for this is a reliable database, such as valid planned values or meaningful historical trends. This is the only way to calibrate ambitious but realistic target achievement and payout curves.
But in view of increasingly volatile conditions, the question arises: Is this basis still in place? Are companies able to create reliable medium-term planning? In addition, communicatively difficult constellations arise when, in a year of crisis, payouts from long-term incentive plans that still reflect the performance of good years are due, and when, on top of that, not the entire workforce participates in these programs. Are there then ways to adjust the incentive systems so that they continue to be justified?
There is no patent recipe. However, depending on the respective situation, adjusting screws can be turned. It should be noted that due to external requirements, the scope for action at board level is limited. When making possible adjustments, it is important to weigh up breaks in the design of the systems, between the board of directors and subsequent management levels, and a consistent, uniform design.
Adjusting screw 1: Financial KPIs
Depending on the intensity of the crisis, it may be necessary to anchor new control variables in the system (e.g. costs, liquidity, profitability). If the KPIs (Key Performance Indicators) are fundamentally correct but can hardly be planned, the following considerations can help:
- When the entire industry or direct competitors are equally under pressure, it can help to consider relative performance measurement. The key is to do better than the competition. However, the KPIs should always be able to be reported or derived in a standardized manner, and the comparison group should be reliable.
- Particularly in long-term variable compensation, a combination of internal and price-related goals is usually used. Here the focus can be on the price or the total shareholder return, if necessary in combination with the relative performance measurement mentioned.
- An alternative to fixed target values are growth-oriented KPIs: the benchmark is the annual improvement compared to the initial level; Planning is included, but is not decisive.
Adjusting screw 2: Target achievement curves
If there is little planning, there is a risk of high volatility of the payout. This can be remedied by adjusting the level of tension in the target achievement curve. This means that the corridors between the minimum hurdle, 100 percent target and maximum are widened: the more volatile the environment, the wider the ranges are. When making adjustments to executive board compensation systems, it is important to argue this in a way that is fair to investors.
Adjusting screw 3: Success or performance
Especially in times of crisis, the tension between company success and individual performance becomes more acute. While the board is primarily measured by the overall result and strategic responsibility, the individual contribution becomes more important at lower management levels. The challenge is to find the right balance between the two dimensions in order to ensure incentives and fairness.
Adjusting screw 4: more flexibility
A dynamic environment requires adjustments in control; Completely fixed compensation systems do not work in this case. However, frequent adjustments are not practical in the management board remuneration of listed companies, as system changes must be presented to the general meeting. At downstream levels, however, long-term incentive systems in particular should be stringent, because too many changes increase the communication effort, reduce traceability and weaken the control effect. In addition, it applies across all levels that too many options for intervention quickly appear arbitrary and can be counterproductive in terms of motivation. Flexibility can have the following characteristics:
- Anchoring opening clauses to supplement, replace or give different weightings to KPIs in the event of significant strategic changes.
- Determination of ranges for the weighting of the KPIs instead of fixed specifications.
- Possibility of introducing a transformation incentive that is linked to clear goals or milestones and, if possible, paid based on share prices.
In all of these measures, a clear justification logic, guard rails, transparency and robust governance are essential prerequisites in order to exclude arbitrariness and thus ensure external as well as internal acceptance.
Adjusting screw 5: additional instruments
Especially in large international companies, there is already a conscious break between the board systems and those for lower management levels: the use of conditional share transfers, which only provide for time restrictions but no further success goals. At the board level, these are not very well received by investors and have therefore largely disappeared; at the downstream levels they are more common.
The advantages: direct reference to the share price and there is no need to calibrate targets. They therefore offer the opportunity to remove risk from remuneration and increase stability.
So do incentive systems still work?
Overall, the past few years have shown that incentive systems can develop their control effect even in volatile times, as long as they are designed to be robust, adaptable and easy to explain. At the same time, any form of additional flexibility requires a high level of governance, transparency and communication to ensure acceptance among investors, employees and the public. The adjustment screws listed can be the first steps to bring the systems into balance.
Regardless of the design, however, the following applies: variable remuneration requires the company’s economic performance. If this is not the case, even the best incentive system will reach its limits. Here, particularly for reputational reasons, it may be necessary to take measures that go beyond the actual system design, be it through voluntary waiver at board level, interference with target achievement or elimination of variable remuneration at downstream levels or similarly serious adjustments.
