How to Create a Meaningful, Measurable Exec Incentive Plan

In talking with CEOs and board members it has been surprising to find that a significant number are not comfortable that the CEO incentive plan they have is either effective or appropriate. This is worrisome because it can contribute to poor performance and dissatisfaction by both board members and CEOs. Let me point out several features that an incentive plan should have that will effectively motivate the CEO.

First, the incentive plan should evolve from the CU's mission and vision. One challenge is that many mission and vision statements are so general that they provide no basis for setting direction. Some remind me of the motto on the university founder statue in the movie Animal House, "Knowledge is good."

Every part of the incentive plan should be based on a metric which is a standard for measuring or evaluating something; a basis for assessment. This quantification can include metrics such as net worth ratios, growth rates, charge-off rates, net promoter scores, etc. It can also include items such as opening a new branch on time. Without quantification there will always be disagreement over whether or not progress was adequate.

A subjective incentive is just an incentive for the CEO to butter-up the board members. One of the worst features of CEO incentive plans are those like "10% subjective." Most CEOs and board members tell me these are practically always fully paid out, which is really no incentive. When these butter-up awards are not paid out, they can become the source of rancor and dissatisfaction. The CEO should be able to track how he or she is doing through the year and finally be able to report to the board on the incentive that he or she has qualified for based on metrics. Butter-up awards preclude this.

The smaller the number of metrics the simpler it is for the CEO and board to focus on them. One or two are best; three should be the maximum. Four is tolerable but beyond that it becomes difficult to focus on what is most important to the board. Having many metrics can result in the comment I heard from a CEO who said that his plan didn't focus on anything specifically, it was just "do good work."

Once selected, the small number of metrics should be weighted to indicate the importance of one metric compared to the other metrics. Typically one is more important than another from year to year.

There should be caveats in the plan that if certain constraints are violated, then no incentive will be paid. Examples of these constraints might be a decline in assets below a certain figure, a fall in net worth below a certain ratio, CEO conviction of a felony, etc. These caveats should be few in number and should result in a complete loss of the incentive indicating the severity of failing to keep within these important constraints.

The amount of the potential incentive must be meaningful to the CEO. Twenty percent of annual base pay as an annual incentive is probably a minimum. By comparison, the for-profit banking world often has incentives that far exceed this figure.

The target numbers for the metrics should be based upon peer norms, the business and membership environment expected in the coming year, and credit union history. If board members are uncomfortable with their ability to confidently determine those numbers they should consult their CPA firm or other outside professionals to ensure that the target metrics are not set at too easy a level nor too difficult. Both are de-motivating.

It is best if CEO incentive plans are discussed openly between the entire board and the CEO as they are developed. The incentive plan should direct the CEO toward specific performance standards. Setting that direction is a responsibility of the entire board, not a committee or just the chair.

If in the end, the board still decides that it wants to make part of the CEOs compensation subjective then that part should be modest, be called a "gift" and awarded at the board's pleasure with their congratulations.

John Dolan Heitlinger consults with credit unions. He can be reached at john@dolan-heitlinger.com.