1. Definition of incentive compensation
Incentive compensation is a type of compensation based on the performance of an entity. Often incentive compensation plans are designed to attract and retain key employees, identify with shareholders, and align interests of employees and the company. For instance, in the Unites States many corporations pay their executives and employees incentive bonuses based on multiple performance measures. Executives might receive the following forms of compensation: a base salary, annual bonus plan, stock options, and additional compensation (e.g. long-term incentive plan, retirement plan, restricted stock). Compensation plans are often based on net income and stock prices of the company or some other performance measure.
Performance can be assessed using various measurements, both internal and external. Internal measurements might include financial indicators (e.g. stock price, earnings per share, net income, total shareholder return, return on equity, revenue growth) and non-financial targets (e.g. product quality, customer satisfaction, building excellent investor base, managing risk and reputation). Performance can also be evaluated in relation to the performance of a peer group of companies (e.g. earnings
per share, total shareholder return).
There is a wide spectrum of incentive compensation arrangements: annual cash bonus plans, deferred bonus plans, stock grants, restricted stock grants, stock appreciation right plans, phantom stock plans, etc. For instance, under the stock appreciate right plan, a plan participant has the right to receive the appreciation in stock value. In restricted stock grants, employees are awarded company’s shares, subject to a vesting schedule.
The following criteria might be considered when drafting an incentive compensation plan:
- Performance measurements
- Plan period
- Award size and frequency
- Vesting schedule
- Formal plan
Some of the advantages of incentive compensation may include the following:
- Aligns managers’ incentives with the objectives of the shareholders
- Tax deductible to the company
- Doesn’t dilute shareholder equity
- Either nontaxable to the individual or taxable but deductible
- Requires no investment by and downside risk to the individual
Some of the disadvantages of incentive compensation may include the following: