2010 CFO Compensation Strategy [Survey]

Designing CFO Compensation strategy in 2010 isn’t easy at all. Companies should be more realistic in the CFO’s performance measurement [earning] target, or else, they will lose their CFO and other financial executives [see on the “recommandation” section of this post], at least according to Michal Matejka of Ross School of Business University of Michigan who has just released interesting report.

The report examines how executive compensation and incentive practices responded to the economic crisis of 2008–2009 and focuses in particular on the choice of performance targets in CFO annual bonus plans. The data come from a survey of AICPA members conducted during May-July 2009. More than 1,500 CEOs, CFOs, controllers, and other executives participated in the survey and shared detailed information about their compensation and incentive plans in 2008 and 2009.

The survey shows that the crisis has had an effect both on the choice of performance measures in CFO annual bonus plans and on the difficulty of bonus targets:

  • First, there seems to be a greater emphasis on financial performance measures (as opposed to nonfinancial targets or subjective evaluations). Also, some companies adjust the choice of nonfinancial targets in CFO bonus plans and are more likely to include targets related to strategy implementation such as market share or business development milestones.
  • Second, it seems that financial targets have become more difficult to achieve. This is in part because many companies set earnings targets at or just above zero and avoid negative earnings targets even if they realistically expect losses.

 

This post reveals the report in more specific and greater details with some recommendations at the end of this post. Read on…

 

Specific 2009 CFO Compensation Survey Result

Specifically, the survey findings are as follows:

Finding-1. On average, corporate CFOs in private companies earned 50% of their 2008 bonus for meeting financial performance targets, 9% for meeting objective nonfinancial targets, while the rest was awarded subjectively without preset targets. The bonus weight on financial targets increases with company size, ranging from about 40% in companies with sales below $50 million to 67% in companies with sales above $500 million. See Table 5 below:

2010 CFO Compenstion Plan

Note:

  • Tabulated is the percentage breakdown of total bonus paid to CFOs in private companies (does not include business units) for meeting each of the listed performance targets.
  • Percentages do not sum up to 100% because the category “other performance targets” is omitted.
  • 2009 data reflect expected weights hypothetically assuming all targets are met.
  • 2006 data come from the 2007 CFO Compensation and Incentives Survey

©2009, Michal Matejka, As a courtesy of the AICPA

 

Finding-2. 2008 bonus weights on financial targets in larger companies (with sales above $50 million) have increased when compared to the survey from two years ago. Average 2006 bonus weights on financial targets in larger companies ranged 45–58% depending on size, while 2008 bonus weights ranged 57–67%.

Finding-3. Although smaller companies (with sales below $50 million) did not increase bonus weights on financial targets in their 2008 bonus plans, they seem to have done so later in their 2009 bonus plans.

Finding-4. Many smaller companies report 0% bonus weight on financial targets (and rely primarily on subjective evaluations) and many larger companies report bonus weights on financials of 100%. Despite their common use, respondents rarely view these extreme choices as suitable for retention purposes or well-designed. In contrast, bonus weights in the range of 75–99% have the highest percentage of respondents indicating that their bonus plans are well designed. This percentage is also high for bonus weights in the range 50–74% which seem to facilitate retention as well.

Finding-5. Greater bonus weights on financial performance go together with greater difficulty of meeting targets—the average expected probability of meeting 2009 financial targets is only 43% in companies where 100% of CFO bonuses are based on financials. In contrast, the probability is 63% in companies where bonus weights on financials range 1–45%.

Finding-6. Companies that did not increase, or even decreased, bonus weights on financial targets and the difficulty of such targets commonly express concerns about retention of their executives. See Table 8 below:

2010 CFO Compensation Bonus

Note:

  • First column refers to the difference between 2009 expected bonus weights on financial performance measures in CFO bonus plans (hypothetically assuming all targets are met) and actual 2008 bonus weights.
  • Decrease” refers to 2009 expected weights being lower than in 2008.
  • Increase” refers to 2009 expected weights being 1–49% higher than in 2008.
  • Major increase” refers to 2009 expected weights being 50–100% higher than in 2008.
  • Data is aggregated across industries but similar results can be obtained by controlling for industry differences.
  • New CFO” is the percentage of companies where CFOs have been appointed in the last 3 years.
  • Increase in board involvement” is the percentage of companies where the influence of the board of directors on CFO incentives and work priorities is higher than in 2008.
  • Zero earnings budget” is the percentage of companies where 2009 budgeted earnings are exactly zero

©2009, Michal Matejka, As a courtesy of the AICPA

 

Finding-7. Many companies responded to the economic crisis also by adjusting the selection of nonfinancial targets in their CFO bonus plans. The most striking difference is the substantial increase in the usage of nonfinancial targets related to strategy implementation—30% of companies included targets such as market share or business development milestones, while it was only 14% two years ago. Also, 30% of the companies included operational targets such as quality or process improvement, while it was 23% two years ago. The increase in the usage of operational and strategic management targets in CFO bonus plans is accompanied by a decrease in the usage of targets related to traditional CFO responsibilities of timely and accurate reporting. See Table 9 below:

2010 CFO Compensation Plan

Note:

  • Includes CFOs in all entities (private/public, corporate/BU level) where respondents provided descriptions of nonfinancial targets.
  • 2006 data are from the 2007 CFO Compensation and Incentives Survey.
  • Tabulated are percentages of companies that include in their CFO bonus plans at least one nonfinancial performance target from the categories listed below.
  • The middle column highlights the difference between 2008 and 2006 if greater than 5%.
  • Strategic management” includes targets such as market share, business development milestones, growth, or R&D goals.
  • Operations” includes efficiency, quality, safety, process improvement, etc.
  • Customer orientation” includes customer satisfaction, on-time delivery, community involvement, supplier relations, PR initiatives, etc.
  • People management” includes employee turnover, staff development, recruiting, etc.
  • Support of internal decision-making” includes management satisfaction, setting BU performance targets, generating useful reports for management, etc.
  • Compliance & control” includes clean audit, no restatements, risk management, external/tax or regulatory reporting, etc.
  • Efficiency of reporting” includes timeliness, accuracy, reporting in new acquisitions, etc.
  • IT systems” includes ERP implementation, software upgrades, etc.
  • Obtaining capital” includes banking and other investor relations.
  • Short-term financial management” relates to collections, cash-flow, working capital, etc.
  • Mergers & acquisitions” also includes divestitures or capital investment evaluations.

©2009, Michal Matejka, As a courtesy of the AICPA

 

Finding-8. Earnings and other financial targets have become much more difficult to achieve as a result of the recession. Prior research shows that companies commonly set highly-achievable targets for incentive purposes—the probability of meeting targets is typically in the 60–80% range. Although we find the average probability of meeting a 2009 nonfinancial target is 68%, the corresponding average probability of meeting a 2009 earnings target is only 48%.

Finding-9. One reason why earnings targets become difficult to achieve during recessions is that companies strongly prefer earnings targets at or just above zero rather than negative earnings targets. Earnings targets equal to zero are typically much harder to achieve than (small) positive earnings targets. At the same time, missing out on bonuses due to the failure to meet targets set at zero has the lowest chance of being compensated with retention bonuses or other mid-year modifications to incentive plans. See Figure 1 below:

2010 CFO Earning Target

Note:

  • Data from a sample of 719 private and public entities (corporate and BU level), excluding nonprofit organizations, for which 2009 budgeted earnings are available.
  • The x-axis plots return on sales (earnings divided by sales) divided into ranges 1% wide. For example, 0% marks the range where budgeted return on sales is equal or greater than 0% and smaller than 1%.
  • The y-axis counts the number of entities with budgeted earnings in each of the ranges. In case of the 0-1% range, the darker shade represents the number of entities with 2009 earnings budgeted at zero (63) and the lighter shades represents entities with budgeted earnings greater than 0% and smaller than 1%.

©2009, Michal Matejka, As a courtesy of the AICPA

 

How to Better 2010 Executive Compensation Strategy [Recommendation]

Given the result of the survey, and in an effort to help CPAs provide practical guidance around executive compensation strategies, Matejka compiled the following advice [Note: This recommendation do not necessarily apply to all companies-exceptional circumstances in some companies may override the logic behind them. At the same time, the general advice seem here is supported by the findings of the survey and prior research and may apply to many different companies]:

Recommendation-1. When designing compensation plans, balance the importance on financial performance targets with emphasis on nonfinancial targets and/or subjective evaluations. Making 100% or 0% of annual bonus contingent on financial target is unlike to achieve desire result.

Recommendation-2. Understand there are risks involved in placing too much focus on financial measures in challenging economic times. These risks include:

  • CFOs and key executive may become preoccupied with improving short-term financial result and lose sight of long-term goals, which can be crucial for future profitability as the economy start improving
  • CFOs are the executives may primarily in charge  of financial reporting. Too much emphasis in improving short-term financial results may give the impression that their fiduciary duties and the integrity of financial reports are secondary.
  • Financial targets that are too difficult to achieve during an economic recession may conflict with goal of retaining key executives.

 

Recommendation-3. To alleviate therisks of a high emphasis on financial measures in CFO annual bonus plans, consider balancing bonuses with other incentive plan components, such as:

  • nonfinancial targets reflecting progress on important business milestones;
  • multi-year bonus plan rewarding persistent improvement in financial result; and
  • equity compensation.

 

Recommendation-4. Avoid setting unrealistic earning targets that may have adverse unintended consequences, such as:

  • limited or no incentive effect since they are unlike to be met anyway;
  • key executives might leave for jobs with better chances of earning bonuses; and
  • key executives may take on too much risk, or might give up taking painful actions, to improve profitability.

 

Matejka’s research also suggest at zero in situations where it is more realistic to expect small or even major losses has some merits. By consistently implementing a clear and explicit policy of no tolerance toward losses, companies can ensure longer-term financial sustainability and provide very strong incentives for prudent risk management and proactive measures to avoid losses in the future.