Avoiding-traps-when-reevaluating-short-and-long-term-incentive-plans

Reevaluating Short and Long-term Incentive Plans During a Crisis

For the past two months, boards and management teams have been working overtime to react quickly and grasp the impact of the Corona Virus. For the most part, organizations, such as yours, have undoubtedly been focused on immediate business concerns such as employee safety and financial viability. Up to this point, any compensation-related actions for the companies severely impacted have been primarily focused on cost reductions. But, compensation committees are likely getting ready to begin if they haven’t already. They are beginning to evaluate their current executive compensation plans to determine whether or not they align with the present circumstances we find ourselves in today.

While this article is primarily focused on publicly traded companies impacted by COVID-19, there are valuable insights and actions which are certainly applicable to private businesses as well. The scope of this review with respect to its context, is on performance-based incentives best characterized as “in-cycle,” such as annual cash incentives or bonus plans that you have for 2020 or any long-term incentives with predetermined financial targets, which may be outstanding. While most businesses have likely distributed 2020 awards, to the extent that a company hasn’t, there has been a lot of work on how companies should think about new equity grants. Furthermore, things like time-based awards are covered extensively in various other sources. The thrust of this article is squarely focused upon performance-based incentive compensation.

With the understanding that the state of business around the world post-Covid-19 (optimism mine) is a fluid environment and real-time, it is from this perspective that we evaluate the topic. Looking at the current changes in the market, we can see that most companies have yet to disclose any changes. Those that have (roughly 9%) indicate their focus has been on reducing executive compensation (base salaries). Companies that take charge of instituting changes first are inevitably the ones (in many cases) that are most severely and most negatively impacted. These companies are finding their priorities are centered around reacting to contain their costs and their cash.

Assessing the Impact of COVID-19

At face value, Pearl Meyer submitted data with their disclosed reductions (as of May 1, 2020), which is representative of percentages of reductions at the C.E.O. level, Non-employed Officer, and Non-employed Director cash retainers, indicates an interesting level of reduction. The data clearly shows that a significant percentage of cuts affect the C.E.O., Officer, and Director levels. Interestingly enough, the level of reduction in these instances is not substantial enough to cover the cash and cost containment that companies are going to need to put into effect. In addition to the cash savings, these are an indication to shareholders, employees, and the market in general that leaders of these companies are interested in sharing the pain of the impact. It is a prime example of a public relations strategy wrapped up in a financial plan, both serving the interest of the company at any length. Since the pandemic conditions appear fluid, it may prove that reduction percentages (which are typically correlated to specific dollar values) may quickly reverse if the response to the pandemic proves to be more aggressive than it needs to be. But what about the annual and long-term incentives? These have been mostly unaffected since their scope is a bit wider; however, time will tell how these programs have been affected (as we approach the end of the year).

As you begin to think about how you might address your compensation program you will need to assess the current impact that your organization has had resulting from the pandemic and the degree to which compensation plans might be affected. For example the impact of COVID-19 varies widely from industry to industry and in varying degrees within sectors and companies, from severely impacted sectors, such as retail, where there are significant layoffs, broad executive salary cuts, board pay cuts, and the need for government assistance. Moderately impacted sectors like those that produce consumer staples might be seeing merit freezes, hiring freezes, targeted layoffs and furloughs as well as incentive goals being outdated. For those neutrally impacted, like pre-commercial biotech companies, the impacts may be less substantial and might include supporting remote work forces, evaluating non-critical investments and will typically take a “Wait-and-see” approach. Of course, there are those who are more fortunate than the rest who are actually positively impacted by COVID-19 from the perspective that the result of the pandemic actually improved their circumstance. For example, those who manufacture and produce personal protective equipment. These types of companies are actively recruiting, offering special incentives and evaluating who the potential retention risks might be.

Pearl Meyer Database – Disclosed Reductions May1, 2020

Independent Research – S&P 500

Independent-Research-S&P-500

Independent research from S&P 500 (as of April 14, 2020) highlighting the current environment and percentages of companies that disclosed their reductions.

All of these categories will need to evaluate where they are and the “degree of impact” decisions that they will need to make based upon where they fall within the spectrum. For instance, those who are severely impacted might be contemplating whether or not to begin significant layoffs; whereas, those positively impacted will need to look at, and determine if the improvement is solely based on environmental factors and may not be significantly improved upon in the periods that follow in the post-pandemic economy. As businesses begin to make these determinations they will not only be focused on the specific dollar impact, but where they might land within this spectrum. One might expect to find that a significant portion of businesses will land in the severely and moderately impacted categories, while a much smaller percentage of businesses will be neutrally or even positively impacted by COVID-19. It may be that you are impacted operationally and can work through it, or the pandemic could be having an impact on revenue and you may find that your operational model is in need of change.

One critical factor to be considered is the longevity of the impact of COVID-19 on businesses and how the length of this term can influence movement within the degrees of impact. It might be that your business is neutrally impacted, but if the trends continue it is plausible that your business may end up more on the severely negatively impacted side of the equation if things don’t change, and soon. Interestingly, in a recent poll, of the number of participants surveyed, 17% of businesses labeled themselves as negatively impacted, moderately impacted (60%), neutrally impacted (19.3%), and positively impacted (3.6%).

From a high level view it is expected that businesses will have gone through various phases of action related to COVID-19 impact. Looking back at the March–April timeframe, as the impact of COVID-19 really began to accelerate, the first couple of months were seemingly centered around things like cost containment, cost reduction, severance or furloughs, hiring freezes, and vast amount of efforts focused on the communication to both employees and shareholders or investors. Of note, focus has also been on emergency planning, such as succession planning and operational adjustments in response to new operating protocols.  In the May–July timeframe businesses seemed to shift to evaluation and monitoring the changes and reactions to the previous months, especially around things like incentive cycles, employee engagement, but primarily focused on incentive evaluations. Of course, time will tell, but based on current trends, looking forward to the balance of the year we see the potential of a shift in focus to that of evaluating performance of leadership and the effectiveness of their responses and handling of business in light of the COVID-19 pandemic.

While there is much ambiguity surrounding the marketplace some patterns are beginning to emerge; however, it is still very early and robust data sets which might be used in the planning and evaluation process are, unfortunately, limited. As a result, the responses of businesses are more individually crafted based upon the unique circumstances of the individual business. There are some guiding principles which most businesses share, regardless of individual nuances, which can provide some insights and actionable measures. As far as how companies treat outstanding incentive cycles in light of COVID-19 it is interesting to note that of those surveyed 3.8% are content with holding fast to their current plan, 38.4% have not yet formally breached the topic, 45.7% have a plan in place but have taken no action, and 12.1% have discussed outstanding incentive cycles and have taken action.

Philosophical & Guiding Principles

From a philosophical perspective, committee members and directors can create some guiding principles unique to their businesses, but here are few common principles which can be shared equally and benefit all sectors. The first notion is the shared experience between executives and other stakeholders, including employees and stockholders, looking at their experiences (i.e. stock price performance, changes in the dividend payout, reductions in dividends, etc.), as well as the employee experience (furloughs, force reduction, salary reductions, etc.). From this perspective there is a shared response to the impact of COVID-19 on businesses.

A second, and important guiding philosophical principal involves not over-reacting too soon. The “wait-and-see” approach, which has been adopted by a vast majority of businesses seems to be an overarching response, but prudent businesses will use this time to identify triggers and plan responses to these triggers should the time come to implement certain strategies. While most are not merely content with being reactionary, in the current climate this is, for most, the viable alternative and perhaps the most sound alternative as over-reacting to the pandemic could be a catalyst for disaster and having to reel in and readjust at some future date when visibility becomes clearer.

Either way, it is obvious that businesses must be prepared to use discretion at year-end, particularly for those who have adopted annual incentives. It may be that the goals set at the beginning of the year are no longer attainable and companies will need to consider the basis for any recognition of management performance and balance this with shareholder and employee experience.

Finally, as it pertains to philosophical guidelines, companies must balance proxy advisor views with the company’s needs. There needs to some policy guidance and any actions taken outside of the planned norms are going to require good, documented rationale (specifically for publicly traded companies), but generally speaking it is likely that you are going to see the proxy advisory firms be a little more critical of companies that attempt to do something on the long-term incentives as opposed to the annual cash incentives.

Operational Measures

From an operational perspective, looking at annual incentives (annual cash bonus programs), some of the factors to consider are the level of impact to the company (as previously discussed), the status of cost cutting efforts to the extent that you may have executed furloughs or salary reductions. Have these been completed? Are your people now coming back to work? Are salary reductions finalized and employees compensation brought back to a normal level? And, of course, visibility into the second half of 2020 is going to prove challenging for many companies, but there are some companies that will have fairly good visibility and the ability to stress test what the feel to be reasonable assumptions. These companies may find themselves in a place where these kinds of decisions are easier to make than those who do not have that ability to assess visibility in the year end.

And so, the evaluations start with the impact to the company and move to the views of the shareholder and proxy advisors (as previously discussed) evaluating long-term history and the short-term as important factors in the process. For public companies that have to hold a non-binding say on pay vote, recognizing the history of vote support will be important in striking a balance and offering more flexibility in discretion.

Finally, the plan design is an equally valuable factor to consider in annual incentives. Where is your current funding level? Is the plan currently in the money or is there zero probability of any payout under the plan, which is another important input into the process. The nature of the measures you use in the plan are important factors as well. Most companies use absolute measures (i.e. targeting specific level or growth rates in terms of financial measures agains absolute numbers), but there are a small contingency of companies that use relative measures (i.e, the banking industry), and it is reasonable to expect that these companies would use a different path than those that use absolute measures. Finally the use of individual performance or strategic objectives in the bonus plan is something to consider. Some companies use 100% financial performance, where other companies use a hybrid of financial and strategic or individual performance and can utilize these as a mechanism for evaluating bonus and further funding bonuses in any given planning year.

Where the Rubber Meets the Road

While the following is not a comprehensive list, it does help show where the “rubber meets the road”, so to speak, as to the possible actions for short-term incentives.  Some companies may take the route of adopting no change. These companies may already have an annual incentive programs whose incentive mechanisms remain intact despite the impact of COVID-19 and don’t expect to have any changes in their incentive program. Other companies are proactively resetting performance goals. When you consider a plan, for example, that has revenue and EPS absolute goals, they may choose to keep the same framework of revenue and EPS but may choose to alter the goals to reflect a new pro forma evaluation of where they anticipate they might end up at the end of the year. This is especially relevant to those who have been materially disrupted in the wake of COVID-19 and whose targets no longer make sense, but based on visibility feel they can adapt and reset the plan that way.  Similarly, a company may have been materially impacted but don’t have the luxury of visibility into the second half of 2020 and may be reluctant to recast revenue or EPS goals. Still, they may have some goals they wish to accomplish as the year concludes, and opt to set these goals into motion tying them to dollars for additional incentive. Finally, some companies may adopt retroactive discretion at the end of the year but may face the challenges accompanying proxy advisors and their critical view of companies that apply loose discretion, and so careful documentation is necessary and should be carefully articulated. Of those surveyed, regarding the 2020, short-term cash incentives a number of participants (15%) said they were going the status quo route and will do nothing, others (19.3%) said they will do a reset of their goals, some (4.6%) are for adopting and developing a new plan, still, others (56.8%) will apply reasonable discretion at year end, while others (4.3%) are opting to take a different approach altogether.

Companies with good visibility have the intention and integrity of the original plan and are in a relatively good position to reset goals that are consistent with their culture. Still with so much uncertainty in the market, it may prove that the only way to avoid underestimating your performance, or to the other extreme which would be delivering windfall payouts, would be to adopt a year end discretion. With uncertainty as to how the pandemic will play out, underestimating can have negative consequences. The biggest hurdle for all businesses is that we are all aiming at a moving target, so to speak, and visibility is key to understanding. When you consider the framework around how you would apply the discretion these discussions should be taking place currently within your organization. Since it appears most businesses will opt for year end discretion, there are some important things to consider.

First, you want to review the plan language to ensure discretion is allowed.  There are some plans that prohibit any level of discretion, and while that is a minority practice you still want to make sure that the legal plan documents allow some level of discretion. Next, you will want to determine if the discretion will apply uniformly across your organization. Will you draw a distinction between how the general employee population is treated for short-term incentive purposes versus executives? It may very well be that you have a different outcome for those two populations. And while we touched on this earlier, it bears repeating, it is imperative that you establish a framework for informed discretion, and so here are some questions you might ask as a way to frame up discretion at the year end by implementing now.

  • Can your company quantify some or all of the material impacts to incentive goals that are related to COVID-19?
  • Are there any other goals or objectives that should be considered (balanced score card to evaluate)?
  • How do we report progress to committee regarding established goals?
  • What is the best outcome and what goals can be put into place to achieve the best case outcomes?

Of critical importance is documenting these decisions. The last thing you want to do is have informal discussions around these topics only to arrive at the funding level to realize that you have to disclose in your CDNA the following year that you used discretion with no good documented history as to the rationale behind it. The proxy advisory firms and general shareholders are going to be looking at, to the extent that you did exercise discretion, is the logical path you used to get there.

While the factors considered for long-term incentives are quite similar to those of short-term incentives there are some unique differences that are worth noting. Similar to short-term incentives, the level of impact will uniquely drive the decision-making processes, and will influence the types of changes to consider, and how extreme these changes will be. For publicly traded companies it is necessary to take into consideration the proxy and shareholder views.

As it pertains to the differences between long and short term incentives, the biggest differentiators lay in the plan design. The first thing you are going to want to look at is the current funding level and the likelihood of any funding or payout. For awards granted in 2020 on a standard three-year performance period, while still unclear, and difficult to justify any changes in the current performance period, the awards that have been out there and are getting ready to vest may have been severely impacted by the changes brought on by the pandemic. In these circumstances you may want to consider making some adjustments. It is important to evaluate the nature of the metrics, utilizing absolute metrics where you have a financial performance goal that is going to be suddenly unattainable is easier to justify than performance awards that have relative metrics similar to others in the same industry.

Action Categories

When evaluating long-term performance plans we see, at a high level, at least 5 different categories of actions that the board can take. The first is “taking no action.” You evaluate your plan and see that you have multiple years of performance where awards have time to make up ground or that have a history of strong performance and some level of payout predictability despite the impact of COVID-19. You could also proactively reset performance goals from and existing plan, but this method will require you to have some visibility into the future, but is a likely scenario for some companies. Another alternative is to truncate and extend the performance period (be careful here as 409 regulations are going to have an impact in these cases, especially if you are changing the vesting date). Alternately, applying a retroactive discretion at the end of the cycle, similar to short-term incentives, should be viewed in light of the entire performance period. Finally, the last option would be to upsize future grants. It may be that there is no payout this year, but rather than making any changes to the plan or the awards, we simply beef up the next round and can prove to be a good option provided that you are confident in the plan you are rolling out next.

Of those polled in a recent survey and asked what they expect their companies will do with respect to the current outstanding performance-based long-term investment grants, respondents said, they would either do nothing (31.8%), reset goals (6.1%), truncate or extend performance periods (4.6%), apply discretion (41%), make up new grants and awards (7.3%), or do something altogether different (9.2%).

These findings are broadly in line with expectations. When dealing with long term awards depending on the the use of equity versus cash awards, there may be significant accounting impact, and disclosure impact, which may incur some sort of criticism from proxy advisory companies. Taking a holistic view of changes or adjustments before executing is critical.

To assist you in your planning, here is a list of key “red flags” to be mindful of. The emphasis here is that if you see yourself doing any of these things, exercise caution, or at the very least make sure that you are comfortable with your approach and the justification for using these actions.

  • Incentive plan payouts greater than target if discretion is applied.
  • Modifying plans with relative goals which are specifically designed to deal with upsets in the market
  • The appearance of makeup grants without any ties to future performance. Any stock option repricing for executives or directors will attract a little bit of attention.
  • Modifications to awards without sufficient disclosure of rationale. Take notes.

While this is by no means an exhaustive list, it should serve as a framework around which you have these discussions.

Citations: 
NACD and Pearl Meyer Compensation Committee Series Webinar May 14th, 202

Leave a Reply