Pay For Performance--More Timely Than Ever

A recession, which economists forecast is on the horizon (if not already upon us) is normally associated with sweeping job cuts and business retrenchment. But for many highly valued executives, an economic downturn can actually be a good thing.

Business owners, fearing that a loss of, or inability to attract, top talent could threaten their competitiveness in a contracting market, will establish or enhance executive compensation plans to recruit and retain the people they need. The demand for high-skilled and high-priced human capital, sources tell National Underwriter, has been a boon for advisors who specialize in executive compensation planning. But observers have noted another trend: an increase in the number of plans that tie non-salary-based executive pay to performance.

“When the economy is on the ropes, it’s more important than ever to identify and appropriately compensate those executives who are your top performers,” says Jim Magner, an advanced markets attorney for the Business Resource Center at Guardian Life, New York. “These are the people who consistently drive top-line growth, hit their numbers and keep expenses in check.”

Richard Pope, a financial representative at Guardian Life agrees, adding: “In the past 18 months, I’ve seen a marked increase in interest [in performance-based executive compensation plans]. As the economy worsens, employers are looking at ways to reward and retain not only execs in upper management, but also those in middle management. We’ve never seen this before.”

How are companies linking executive pay to performance? A common technique, sources say, is to tie compensation to specific revenue targets, for example a 5% or 10% increase in year-over-year sales. Company objectives might, alternatively, require increasing customer satisfaction, reducing costs or surmounting product development hurdles.

Many plan packages tailor bonus pay to the individual performance or to that of a group of executives. But it’s also often the case that compensation will hinge on the overall performance of the firm.

“If employees are not performing, the employer has the option to say, ‘we’re not funding the retirement plan this year,’” says Pope. “That’s even true of defined benefit plans, though generally the plan document has to be amended to allow for a suspension. And the suspension cannot be done in perpetuity.”

The prospect of an all-or-nothing deal can apply to individual executives as well: If they don’t meet company targets, they don’t get a bonus, irrespective of how well the company does. But many firms, experts say, also ratchet up (or down) performance-based compensation in tandem with tiered benchmarks. Hence, the executive might receive supplementary pay of 10%, 20% or 30% above salary if he or she achieves year-over-year sales growth targets of 10%, 20% or 30%, respectively.

However structured, the executive compensation, must meet with the approval of the employees who stand to benefit, experts say. If the executives deem the plan incentives as insufficient or the company benchmarks as unattainable, then job performance and job satisfaction are likely to suffer, and executives may be inclined to bolt from the firm–the very outcome the plan was intended to prevent.

It is important, therefore, to have a meeting of minds among company owners and the executives for whom the plan was devised. To insure their buy-in, observers say, the executives should participate in the drafting of plan documents. And advisors should be prepared to help arbitrate differences among opposing parties.

“The advisor should be the one to quarterback the plan, especially when dealing with key employees who aren’t owners,” says Gary Underwood, a chartered financial consultant and advanced markets attorney for Genworth Financial, Lynchburg, Va. “When the different parties have vastly different interests, it’s a good idea to encourage execs to consult with an attorney when drafting a plan. By quarterbacking the effort, the advisor can come out looking like a white knight.”

To be sure, it’s not always the key employees who stand to lose from a poorly structured deal. If the plan comes without golden handcuffs, sources say, the executives may opt to leave the firm–and potentially put themselves in competition with their former employer–upon receiving the promised pay.

To guard against this eventuality, many companies restrict access to compensation previously awarded by establishing a vesting schedule. Popular among such arrangements, observers say, is the IRC Section 162 restricted executive bonus plan, funded with permanent life insurance. Under this arrangement, the key employee owns the policy and the business pays the premiums. The policy beneficiaries enjoy a pre-retirement death benefit, but access to the contract’s cash value is restricted pending the employee’s completion of certain objectives or years of service with the firm.