What is Annual Incentive Plan: Detailed Explanation

Annual Incentive Plan

It goes without saying that teams who are given incentives to perform at the highest level tend to be more engaged and motivated than those who aren’t. In the end, if an employee feels that their contributions aren’t appropriately acknowledged and compensated for, they are much less likely to perform well and are much more likely to look for employment elsewhere.

The level of employee satisfaction can be raised through annual incentive plans, which can then encourage actions that will benefit your company’s performance. What exactly is an annual incentive plan, and how can you create one that is tailored to your company’s needs? Let’s find out!

What is An Annual Incentive Plan?

An annual incentive plan is a type of compensation that is earned and paid in accordance with the accomplishment of performance objectives over a year. These programs encourage performance and match executive work with the short-term performance objectives of the company. Annual performance incentive compensation targets should support the business goals and long-term strategy of the company in a well-designed compensation plan. The majority of the time, opportunities for senior management and senior executives are expressed as a percentage of base pay.

For annual incentive plans, goals are set that take into account internal pay equity concerns as well as market opportunities for the position. Executives can improve personal performance over years, not just months, with the aid of long-term incentives. Stock options and annual bonuses that are based on performance level are two additional forms of pay that may be available.

What Defines a Well-Designed Incentive Program?

An incentive program that is well thought out will provide pay opportunities that closely match responsible performance. When providing compensation, there must be a balance; don’t put all your eggs in one basket. Your plan should strike a balance between reducing risk and taking into account the working environment.

When designing an incentive program ask the following questions:


  • What will draw these businessmen?
  • What will spur these executives to keep up their excellent work?
  • What is going to keep these executives?
  • What will influence corporate performance?
  • What will motivate our executives to meet strategic goals?
  • How can we use compensation to leverage what needs to be done this year?


  • What are the actions of our rivals?
  • What are the trends or accepted practices in our sector?
  • What do our investors think of this strategy?
  • What do the rest of our stakeholders and partners outside of the company think of our compensation structure?

Develop a Philosophy for Your Annual Incentive Compensation Plan

Annual Incentive Plan

Your performance metrics should be in line with your business strategy and reflect the important factors that will help you achieve corporate performance and shareholder value goals. In order to focus on their efforts and map out their accountability, you should establish a clear line of sight for key employees. Set attainable objectives. Your objective will not be achieved if your executives believe they cannot reasonably expect a payout based on your unreasonable expectations.

Achievable and inspiring goals are what your organization should set. In relation to the standards you have established, these objectives should show sustained performance. Along with any potential future projects, you should take historical performance, volatility, and market expectations into account.

When creating a philosophy for your company’s incentive compensation plan ask these questions:

  • How effective is the budgeting/business planning process?
  • What will be the reward for meeting the goal?
  • The threshold, what is it?
  • What is the maximum?
  • What are the parameters we should use?
  • What level of compensation is ideal?

Types of Performance Metrics

Numerous performance metrics should be considered when developing a compensation plan. The various categories of performance metrics include financials, which include earnings, net income, EPS (earnings per sales), and operating income. Additionally, revenue and sales from free cash flow and cash from operations should be weighed against returns. Included are returns on assets and returns on equity, which are increasingly common over time. Operating income margin, EBIT margin, and efficiency ratio are among the ratios pertaining to these categories.

Management by Objectives (MBOs) and Key Performance Indicators (KPIs) are two performance metrics that are non-financial in nature.) We discover that this list of smaller metrics, such as diversity in the workplace, health and safety measures, talent development, and more, can be included in these performance-based objectives.

Some examples of non-financial performance metrics include:

  • Individual goals
  • Strategic goals
  • Health goals
  • Safety goals
  • Environment goals
  • Customer satisfaction experience
  • Company performance goals

An earnings metric, which includes CEO bonus plans, is used by more than 85% of the top 200 companies.

Source Stephen Hall & Partners

A bonus plan’s earnings make up half of it. Earnings should be the main priority, and from there you can diversify. Additionally, certain shareholders are encouraged to include sustainability and environmental considerations in incentive plans.

Annual Incentive Plans – Trends and Hot Topics

Goal-setting Challenges

Shareholders and proxy advisory firms are putting increasing pressure on and examining goal setting. The performance indicators driving growth are given more attention. What are the forecasts that the business and Wall Street are presenting to shareholders?

Ask these questions to determine the scope of annual shareholder incentive plans:

  • How do these objectives stack up against those of the opposition?
  • How do these metrics compare to benchmarks set by the industry?
  • How do these metrics compare to those from earlier years?

Making a projection or comparison based on the performance of the current market can occasionally be very inaccurate because of unforeseen market conditions. Future performance can be difficult to predict, which can lead to forecasts being wildly inaccurate. If you need to develop a projection and use sub-plans to further divide your incentive planning, take more than 90 days. In year-over-year results, we also advise you to set a project deadline.

IRC Section 162(m)-compliant annual incentive plans are the norm at public companies. In this setup, incentives are paid in accordance with a plan that has shareholder approval. Payment is based on objective performance standards developed by a committee of external, independent directors. Written certifications from the compensation committee are required, and the compensation must match the objectives attained. The payment may be reduced at the compensation committee’s discretion, but it cannot be increased.

Unless it is a formula-based plan, these plans need to be approved again every 5 years. The performance exclusion under Section 162(m) may be eliminated in upcoming proposed tax cuts and jobs acts.

The impact of non-recurring events on bonus programs includes restructuring charges like:

  • Loss or gain on sale of assets
  • Acquisitions/transaction costs
  • Litigation expenses
  • Changes in accounting or tax rules
  • Exchange rate volatility

Discretionary Plans

Enhanced disclosure requirements caused a shift away from discretionary plans towards more formulaic “cookie-cutter” approaches. It takes courage to exercise discretion, and it can be challenging to explain, justify, or defend these choices in public.

The ISS holds discretionary plans in low regard. Moving the goalposts is a common way to describe modifications or adjustments to the established plan. Due to economic volatility and related difficulties in setting performance targets, businesses and committees are turning back to the idea. In many situations, discretion is a useful tool for reducing risk, particularly in light of recent currency fluctuations. Globally active corporations have been harmed by recent currency fluctuations’ size. The subject of discussion among committees right now is how much management should be held responsible for a situation that is largely beyond their control.

Companies have adopted several approaches to adjustment including:

  • No adjustments
  • Corridor approach (do not consider impacts that fall outside of a specified range, i.e. 110/15%)
  • Fully neutralize
  • Board discretion
  • Adjustments determined on a case-by-case basis

Additionally, some businesses have increased the explicitness of their constant currency disclosure in CD&A and other IR documents.

Sharing Ratios

How much of the profits should be donated? Analyzing the slope of the payout curve, as well as the threshold, target, and maximum payout levels is an alternative method of gauging bonus program design components. Planning for succession is another way to evaluate pay-for-performance alignment. The annual incentive plan is now used in compensation plans to support the CEO’s succession planning objectives as well as those of highly esteemed employees.

The relationship between short-term outcomes and stock price, however, is broken.

The use of a variety of performance metrics is advised for businesses. All of them ought to offer a suitable and balanced focus on achieving those strategic key objectives and making sure you have enough to be able to keep executive talent. Regularly review your plans. It doesn’t have to remain that way forever just because you put something in place now. Plan changes are permitted. Plans should be reviewed on a recurring basis by businesses to make sure they still support the strategic goals of the company. The plan might alter. You might change your mind about what the important metric is. Continually, the world is changing. Ensure that your strategy and plan are compatible.

Know the effects of those modifications. Make sure you are aware of the legal and accounting implications before making any significant modifications. Additionally, be aware of what will fall under the purview of shareholder advisory services firms, what your shareholders want to know, and how you must respond to those changes.

It’s critical to evaluate risks. Ensure that performance goals are reasonable, fair to executives and shareholders, and attainable. You don’t want people spending excessively beyond their means or taking dangerous risks that put the business at serious risk in order to get payouts. Maximum goals are great, but you don’t want them to be out of reach because that might encourage risky behavior. You don’t want to promote excessive risk-taking among your staff members. They ought to be carefully chosen and complementary to other objectives used throughout your entire program, on both the short- and long-term sides.

The success of any incentive program depends on its ability to be effectively communicated to its participants, so do so if you want it to be effective. Additionally, it needs to be shared with all of your stakeholders, both internal and external.

Annual Incentive Plan

Where Annual Incentive Pay Plans Fall Short: “Equal Pay”

You run the risk of stirring up some resentment among your workforce if your company’s incentive plan links payout amounts to the specific performance levels of your employees. There is a chance that some employees will learn which top performers are getting paid more than the rest. This may result in rumors of favoritism or grievances about unreasonable expectations.

You might be tempted to avoid actually paying the best performers more under these conditions. In hopes of achieving a more “equal” system, you may give only slightly different incentive payouts to all employees, regardless of the differences in their performance levels. Although these wealth-spreading strategies may calm frustrations, they can also minimize the importance of high-performing employees.

So is that really fair for either party? The pay that your best employees deserve for their roles isn’t being given to them. However, how will their coworkers feel if they receive a true-value incentive?

Describe the agitation among the workforce.

How to Create a “fair” Incentive Pay Policy

There is no requirement that your company adopt a single, universal incentive program. Because you and your employees make up your company, it stands to reason that a standardized solution cannot provide the perfection you seek.

You shouldn’t.

The most popular option is an annual incentive pay plan because it can accommodate most business requirements. But you can make up for its shortcomings by supplementing with the addition of one or more alternative incentive plan options out there:

  • Bonuses: A one-time reward for attaining a goal (not necessarily year-end, within any agreed-upon time period)
  • Commissions: Financial reward is given as a percentage of each incremental sale (best for sales employees)
  • Piece rate incentives: Compensation based on the level of individual output produced (best for manufacturing or production roles)
  • Stock options: Time-sensitive option to purchase shares of company stock at an exclusive rate

In order to develop a strategy that is more widely accepted and successful, it can be helpful to weigh the advantages and disadvantages of each plan.

And choosing which ones to include isn’t as difficult as you might think.

Start by researching the incentive programs that your rivals are using in the market. Has their efficacy been proven?

Think carefully about how your company runs. A bonus program may be more motivating for many individual contributors than a commission-based incentive if your workforce is primarily sales-oriented.

Talk to your staff as a final step. You’ll be in a better position to adjust your plan to meet their needs if you can understand their perspectives.

It can be difficult to find the time to thoroughly analyze your current incentive plan and implement changes. especially when added to the regular duties of running your business.

Final Words

Don’t just go along with the crowd, last but not least. You don’t have to act in the same manner as everyone else. If you have a metric that isn’t widely used but that you think will drive shareholder value and deliver that value, stick with it. It’s not the best justification to not use it yourself if nobody else is using it. Put your faith in what you’re doing. Move on and do what you think will drive that TSR if TSR is not what you want to concentrate on. That’s the key we want you to remember: don’t just copy other people; act according to your convictions and your strategy.