The extra money is worth the risk

To illustrate the sort of win-win outcomes performance-pay programmes should deliver to managers and their firms, Brent Miller of Watson Wyatt says a performance management system should be set up so a CEO of a company with $40 million in annual revenue receives 30 per cent of base salary ($200,000) for target company performance, and 45 per cent for superior to maximum performance.

According to standard weightings, 75 per cent of that performance pay is measured against "company performance" (the hard numbers), and the remaining quarter is paid out on "personal performance".

While company performance is relatively easy to quantify - profit before tax (PBT) - Miller says care must be taken in selecting appropriate criteria for personal performance targets.

So assuming this CEO delivers, how much would they earn? If the company sets a PBT target of $4 million - along with individual performance measures - here's what they earn:

Incentive based on target company performance: 75 per cent of 30 per cent of $200,000 = $45,000.

Incentive based on individual performance: 25 per cent of 30 per cent of $200,000 = $15,000.

Total incentive for the year = $60,000 or 1.4 per cent of the PBT figure.

But that total incentive jumps to $90,000 (1.5 per cent of the PBT figure) - based on 45 per cent of base salary - if the CEO achieves the stretch performance target of $6 million.

Miller says the director should be laughing all the way to the bank knowing it has only cost them $33,000 more in performance pay to achieve an incremental $2 million in profit.

While these figures sound impressive, Miller says too few boards send the right messages - through performance-pay programmes - about where they want senior managers or CEOs to have the biggest impact.

"Companies trying to attract managers into jobs offering fixed pay and benefits risk being uncompetitive against alternative roles offering an 'at risk' incentive pay component," says Miller.

"The first thing an executive wants to know before taking a job is what it's worth and how much [salary] is guaranteed. Then they need to understand the market they're entering and the upside potential for achieving the 'at-risk' component."