2010 goal setting: strike the right balance; The recommended steps to move from a 'mark-to-budget' approach to a 'mark-to-shareholder' approach.

• Author: Ferracone, Robin A.
• Position: COMPENSATION AT WORK

WITH THE END of the first quarter looming, boards of directors and compensation committees are in the process of finalizing 2010 performance goals for their senior executives, both to focus their executives on key objectives for the year and to comply with IRC Section 162(m). Therefore we are making goal setting the topic of our very first "Compensation at Work" column.

This year promises to be an especially challenging goal-setting year in that we are emerging from one of the most debilitating recessions in decades and still face highly uncertain times ahead. While almost everyone these days is clear that they will be paying for results, and not for effort, they still are left with a number of questions. Should they pay for shareholder, financial, and/or strategic performance? Should they pay for real performance improvement over 2009, even if they still are not likely to return to pre-recession performance levels in 2010? Should they pay for good relative performance, even if they are still performing poorly by historical standards?

In the end, it comes down to striking the right balance between establishing measures and setting goals that are motivational to executives with those that are accretive to shareholders.

Historically, most companies have taken an "inside out" approach, meaning that they have tended to set goals relative to a budget that is established from an internal perspective, and is considered to be "stretch but achievable." Internally-set goals have the advantage of providing line-of-sight between management actions and decisions, performance outcomes, and pay levels, and therefore are generally motivational to executives. We call this a "mark-to-budget" approach. The problem with this mark-to-budget approach is that the link between the goals and shareholder value may be weak or, even worse, nonexistent.

Instead of a mark-to-budget approach, we believe that companies need to shift more toward a "mark-to-shareholder" approach. A mark-to-shareholder approach sets goals that are calibrated to shareholder expectations, ensuring that the achievement of goals will translate into stock price increases over time, at least relative to competitors. This generally means gaining a competitive position or maintaining a competitive lead, and generating meaningful financial improvements that will lead to enhanced value over time.

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Neither the mark-to-shareholder nor the mark-to-budget...