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Lessons from recession increasing focus on incentive compensation programs

MANUFACTURING INSIGHTS  | 

As the economy moves out of recession, manufacturing companies are accelerating the move away from traditional fixed-cost compensation plans for executives and other key team members. Companies increasingly are emphasizing incentive compensation options that allow them to better align compensation dollars with key organizational strategies, and that serve to strengthen bonds between the organization and the key performers behind the company’s success.

Over the past few years, as manufacturers struggled through the recession, there was little emphasis on compensation strategy beyond cost control. Companies were focused on survival, and employees at all levels were happy to keep their jobs. Bonuses and raises were minimal if awarded at all. Now, however, with the economy slowly recovering, companies need to reconsider how best to reward and motivate their people without adding too much cost.

The recent recession raises another concern from the executives’ perspective. Many are finding their retirement savings falling behind. With defined benefit plans all but gone except in the public sector, these executives must rely on a combination of 401(k) plans, private savings and investments, and Social Security to fund their retirements. Yet many saw their plan balances, private portfolios and home equity take a severe hit during the recession. They are now looking to make up ground.

A lesson driven home for companies during the recession was the downside to traditional compensation programs, where performance, and often mere longevity, was rewarded with raises. Companies often found that they were rewarding all employees more or less equally, and, in the process, driving up their fixed payroll costs without any commensurate increase in productivity or other strategic benefits. Now, many companies are focusing on linking compensation more directly to performance, and looking for ways to focus their compensation investment on their high-performing employees without ratcheting up compensation costs across the board.

At the executive level, this often means designing long-term compensation strategies that tie the success of key performers as directly as possible to the performance of the company. For larger, publicly traded companies, strategies like stock options have always been a popular option. However, for smaller, closely held enterprises, the dilution of ownership attendant to any distribution of stock raises other concerns, so alternative methods must be found.

Following are three methods many manufacturers are using to tie executive pay to performance, to bind high performers more tightly to their organizations, and to help alleviate some of the retirement savings issues their key people face.

Phantom Stock Plans
In a phantom stock plan (PSP), key performers are offered “shares” that economically mimic actual shares in the company, but that do not dilute ownership. These shares are designed to track enterprise value the same way that actual shares would, but do not reflect actual ownership in the enterprise. Because these are meant to act like real shares, they have a dollar value on the day they are awarded. Because they have this initial value, PSPs are often most appropriate for long-term employees who already have played a key role in building the value of the company. The day-one value of the award recognizes past performance, while the ongoing participation in the company’s success is both an incentive and reward for future performance.

Stock Appreciation Rights
Stock appreciation rights (SARs) act much like phantom stock plans, except that they have no value when they are first awarded. Instead, SARs are based on a fractional interest in the difference between enterprise value on the day the SARs are awarded and enterprise value at a future settlement date. Because SARs focus exclusively on future appreciation, they are often most appropriate for either new hires, or for employees just entering the executive ranks.

Performance Units
In some closely held companies, the CEO or a small cadre of owners still make the majority of the strategic decisions around debt, acquisitions and other issues that are likely to have a profound impact on the overall value of an enterprise. Tying incentive compensation to enterprise value in such cases would be ineffective because the key players the company is trying to motivate would rightly feel that the decisions of the actual owners disproportionately affect enterprise value, leaving the success or failure of their compensation program in someone else’s hands. In such cases, incentive programs can be tied to other, specific performance metrics within the organization over which plan participants do have direct control, such as sales or market share.

All three of these plan options offer participants incentives by tying compensation to performance. They help companies avoid the pitfall of ever-increasing fixed payroll costs. And, because these plans can be designed so that the award for performance is or can be deferred, often for extended periods, these plans also can serve to strengthen key employees’ retirement positions.

Spiraling costs, uncertainty have employers questioning health benefits
Consistent increases in the cost of providing health benefits to employees, uncertainty as to the long-term costs of such benefits and concern over the effects of the Obama administration’s sweeping health care legislation have many companies reconsidering their long-term commitment to providing health coverage for their workers.

Consider the following statistics. According to the 2011 Milliman Medical Index report, the cost of health care for a typical family of four has increased from $9,235 in 2002 to $19,393 in 2010 – more than doubling in just eight years. Not surprisingly, a recent Towers Watson & Co. survey of more than 500 employers with at least 1,000 employees found that, while 73 percent of respondents in 2007 were confident that their organization would still be offering health care benefits a decade from now, only 38 percent expressed the same confidence in 2010.

“As we work with companies struggling with the exploding costs of health benefits, more and more are considering dropping them altogether,” said Rosemarie Panico-Marino, managing director at McGladrey. “They are looking at the current and projected costs of benefits and finding, in many cases, that the penalties they would owe for not providing benefits under the provision of the Obama health legislation would actually be less than the cost of dropping the benefits and letting their employees seek coverage through the state exchanges.”