The Perils of Setting Incentive Plan Targets: Revisiting Some Rules of Thumb

Amid the uncertainty we all inherited along with the downturn, the challenges of setting incentive plan targets are even more acute than usual.  What constitutes a reasonable target performance level?  Are we setting the bar too high ... or too low?  How do we put these decisions into some context?

In helping my clients navigate plan design and update, I've pulled out and shared my "rules of thumb" (for setting incentive plan threshold, target and maximum levels) a number of times in the past few weeks.  These were first shared with me by an attorney who specializes in defending reasonable compensation claims and charges; I have since had them confirmed by a number of sources.  Bottom line, they continue to make sense to me and they provide helpful guidance when navigating plan design and update, particularly through times when economic turbulence makes goal-setting and budget determination difficult. 

So I share them here with you again (I first trotted them out in a post back in 2006) in the hopes that you will also find them helpful.

Threshold:  This term usually refers to the minimum level of performance required for any incentive award to be generated.  The question is:  Where to set threshold?  Rule of thumb: Threshold is typically established at a level that you would expect to be reached in 8 or 9 out of every 10 years.  In other words, plans should be designed so that there is some level of payout (typically minimal for this level of performance) 8 or 9 times out of 10.

Target:  This term usually refers to the level of performance that generates a "competitive", "plan" or "budget" level award.  It typically means you have reached the plan goal.  The rule of thumb suggests that target is typically established at a level that you would expect to reach 5 out of every 10 years (or about half the time).  (Remember that you have to blow past threshold to reach target; this is the reason that these figures are not additive.)

Maximum:  This term usually refers to the level of performance which results in the maximum award available under the plan being granted.  For plans with no maximum or ceiling, perhaps this level is designated "outstanding" or "exceptional".  At any rate, the rule of thumb for plan maximum is that it is established at a level that you would expect to reach 1 or 2 times out of every 10 years.

Any other rules of thumb that you've found helpful in target setting?  Any experiences that would suggest the set I provide here is no longer relevant?  Feedback and comments welcome!

Image: Creative Commons Photo "Target by Jasper Johns" by cliff1066

Comments

[Brandon]

Thanks for the review. Any ideas on how to best determine what the target payout % should be? We're reviewing our incentive plan now and are trying to determine the payout.

[Ann Bares]

Glad that the info is helpful!

I would suggest you use a combination of competitive data (most compensation surveys cover incentive award as well as total cash data) and your compensation philosophy (what mix of fixed/variable pay do you intend to provide relative to the market) to guide your decisions on payout amounts.

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