Behind the Scenes: Performance Target Setting of Annual Incentive Plans

Abstract

This paper documents the performance metrics used in annual incentive (bonus) plans for chief executive officers (CEOs). Our detailed analysis using earnings per share (EPS) shows that at the time of plan approval, in general, EPS growth targets are set lower than earnings expectations such as EPS growth implied by analyst consensus and the historical EPS growth of the firm and that of the firm’s industry over various horizons. A lower EPS target in the annual incentive plan increases the probability of achieving the target and enhances the ex-ante value of the annual incentive payout for the CEO. However, the slack in setting performance targets is small. Moreover, we find that performance targets are more challenging at firms with strong corporate governance and when the performance measure is more important. Interestingly, while not linked to subsequent performance or risk-taking at the firm, an easy performance target increases the amount of the ex-post payout for the CEO.

Keywords: performance targets, annual incentive plans (bonus programs), executive compensation

JEL Classification: G34, J31, J33