The rise in annual bonus levels in the UK's FTSE 100 has been accompanied by a decrease in the number of directors receiving zero bonus. This is more a function of bonus design than of targets getting easier. In fact, bonuses seem to be the part of the incentive package that works best.

The last five years have seen bonus opportunities double in the FTSE 100. At the same time, the proportion of CEOs receiving no bonus has fallen to a low of 5 per cent in 2006. Does this mean that bonus targets are getting easier at the same time as incentive opportunities are getting larger? Can bonuses still truly be considered variable pay if it is so certain that they will pay out?

Figure 1

Source: Annual Reports

In reality the decreasing incidence of zero bonuses is a function of bonus design rather than of targets getting easier.

Changes in Bonus Design
Bonuses used to be simple things. Beat the budget profit target and you would get a bonus. Miss it by more than 5 per cent and you got nothing. This is no longer the case. Almost all bonus plans in the FTSE 100 now involve a basket of measures comprising a combination of financial, operational, non-financial and personal targets. Typically 25 per cent of a chief executive’s annual bonus is now based on personal targets. These changes recognise there are many aspects of performance that need to be managed well in order to create sustainable shareholder value.

Figure 2

Source: Annual reports / IVIS

The variety of measures used, whether or not the bonus is constructed formally as a balanced scorecard, means it is more likely that at least one element of the bonus will pay out.

Correspondingly, achieving maximum bonus becomes more difficult as it requires all measures to come in above target at the same time.

Figure 3 shows the proportion of FTSE 100 chief executives achieving various levels of bonus payout in the most recently reported year, expressed as a percentage of the maximum bonus.

Outcomes are centred around just under 70 per cent of the maximum - this can be explained by the figures relating to a year of relatively strong corporate performance. Only 15 per cent of chief executives received a bonus at less than 40 per cent of the maximum and fewer than 10 per cent received maximum bonus.

Figure 3

Source: PwC Analysis

The introduction of baskets of measures will inevitably reduce the incidences of bonus pay-outs at the extremes. With more targets to shoot at, zero and maximum bonuses become less likely. However, this is not itself a problem. With bonus opportunities increasing significantly, and forming around half the potential cash package, there is much less tolerance of bonus pay-outs that are either on or off as performance is rarely bad (or good) in all respects.

Bonus as Part of Total Compensation
We have effectively moved to bonus being used as a variable part of total compensation, rather than an occasional additional payment for exceptional performance.

This approach has advantages. Compensation fluctuates up and down with the assorted elements of performance; providing incentive, cost flexibility and some element of alignment with shareholders. The fact that the incentive plan will produce some payment in most years means it becomes more relevant and motivational to executives.

Clearly, there is a need to ensure that bonus targets are robust and that personal objectives do not merely become a way of guaranteeing an element of bonus. The relatively small proportion of chief executives receiving maximum bonus, even in a year of generally strong performance of the UK economy, suggests that overall targets are sufficiently stretching at the top end.

Experience also indicates that bonuses on the whole do work well and are the most effective element of the incentive package. The increased focus that companies are placing on short-term incentives supports this view.