Performance-based awards are one of the hottest trends in stock compensation today. According to a recent study by the National Association of Stock Plan Professionals, usage of these awards has surged by almost 200% in the past decade and already surpasses usage of service-based stock options for executives and senior managers.
There are many reasons for this increase, but there are two key factors that we believe are most responsible for the trend. First are United States accounting standards, which changed in 2005 to treat performance-based awards similarly to service-based awards. Before this change the financial consequences of performance awards discouraged adoption.
The second is the growing call for linking compensation to performance. More than ever shareholders and the public at large are challenging corporations to add greater accountability to corporate compensation practices. To be sure, this call for accountability focuses on the executive level much more than the general workforce. Performance-based awards are, nevertheless, a tangible response to compensation challenges that corporations can highlight.
In this light, performance-based awards serve real and timely needs. When it comes to implementation, however, the devil is in the details. Performance-based awards are inherently more complex than service-based awards. As a result they present a significant challenge when it comes to employee education. This reality should give us pause, since educational activities are typically an afterthought in the program designing process.
When it comes to performance awards, education and communication should be top of mind during the design phase to account for and force consideration of all the awards intricacies and challenges. A well-designed program will cause far fewer headaches when it is time to roll it out, as even a great educational program cannot make up for poor plan design. Among the many important considerations to work through during this phase, metrics, targeting against peers, and payout structures tend to be the stickiest. With this in mind, there are three guiding principles to consider in designing a performance-based plan:
Use common and well understood metrics. The metrics that tie to performance are a primary consideration in the design phase. Choose business metrics that are already regularly reported and used by the intended award recipients when making business decisions. Ideally, award recipients will understand how their individual performance contributes to the overall metric. Choosing the right metrics can alleviate much of the need for education that will otherwise be required.
Measure against the usual set of peers. Consider selecting peers against which executives already measure company performance. The consistency will help reduce the number of questions that come in as you roll out the program.
Keep the payout simple. Finally, resist the draw of an overly complicated payout structure. If employees cant compute what their payout will be, the awards will feel more like a lottery ticket than like the meaningful incentive companies desire. Ideally, arm award recipients with a relatively simple formula that they can apply to calculate their potential payout. Where vesting is tied to multiple targets, consider providing a matrix of potential payouts.
Performance awards are growing in prominence and can be an extremely valuable tool in driving employee performance. Their complexity, however, makes them significantly more challenging for employees to understand. With proper design matched by thoughtful education, employees will understand the performance targets and will feel motivated to achieve them -- creating a win for everyone.
Paul Hutchison is president of E*TRADE Financial Corporate Services and Barbara Baksa is executive director of NASPP.
