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Article | Executive Pay Memo North America

Executive pay: Structured discretion is not an oxymoron 

Governance Advisory Services |Executive Compensation
COVID 19 Coronavirus

By Claudia Poster , Daniel Fang and Andrea Walsh | June 16, 2020

Conversations about structuring discretion  — even without specific decisions — will make a tough year-end pay process easier.

Why is discretion a big deal now?

As companies work to determine the potential impact of COVID-19 on their executives’ annual and long-term incentives and what, if anything, to do about it, most have taken a wait-and-see approach.

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About our series

We explore the use of structured discretion in the changing landscape of incentive plan payouts.

A Willis Towers Watson flash survey of nearly 700 companies in mid-May, found that while most companies are maintaining their previously approved annual and long-term incentive plan goals notwithstanding COVID-19’s impact, many are planning to use discretion to determine funding and individual payouts following the end of the performance period. In fact, discretion is by far the most common response for determining payouts from both short-term incentive (STI) plans and in-flight long-term incentive (LTI) grants.

52%
of respondents indicated they will or were considering discretion for their STI programs
54%
of respondents indicated they will or were considering discretion for their LTI programs
14%
have scrapped their STI for a purely discretionary plan
28%
indicated they were changing their STI plan
32%
indicated they were adjusting their STI plan
33%
indicated they were changing or adjusting their LTI plan

The planned use of discretion is not surprising. Modifying performance goals or metrics has limited appeal with so much uncertainty about the ultimate impact of the pandemic on business operations, not to mention required disclosure in 8-K filings that bring critical scrutiny from investors, proxy advisors and the press. Suspending a plan or announcing there will be no payouts can be demotivating to participants, especially less than halfway through the year.

However, in recent years discretion has become a dirty word. Not only can upward or positive discretion that boosts payouts lead to a negative vote recommendation from proxy advisors Institutional Shareholder Services (ISS) and Glass Lewis, but also many compensation committees prefer to use predetermined formulas. So even if discretion is the prudent approach to determining payouts in this environment, how will it work?

The critical question is whether compensation committees can arrive at an answer that will convince all constituencies — board, leadership team, employees, shareholders, proxy advisors and the press — that (1) incentive plan participants have been treated fairly but not too generously and (2) the competing considerations of motivation/retention and affordability have been balanced appropriately.

Why now?

While there is no discretion playbook to speak of, we believe it’s important for companies, even calendar year-end fiscal companies whose payments will not be determined until the first quarter of 2021, to start discussing the process and factors that will be considered. In other words, develop an approach for structuring the use of discretion and a common understanding between the compensation committee and management.

This initial conversation will not result in the definitive framework or methodology; it will likely be revisited and refined at least a few times before year end as the business impacts become clearer, market practice takes shape, and the board’s and management’s thinking evolve.

You may think that “structured discretion” is an oxymoron or just semantics for modifying the incentive plan metrics and goals. You might ask what is the point of waiting to make an informed decision once all the facts are in if we’re going to develop a structure now? Why not figure it out when we get there rather than figure out now how we’re going to figure it out later?

Here are some compelling answers to the “Why now?” question:

  • To connect discussions between the board and management of the impacts of COVID-19 on the business to the possible impacts on incentive plans

    Boards have been engaged in frequent intense discussions with their leadership teams about the impacts of COVID-19 on the business. Many have had to pivot to new business models; all have had to manage costs tightly. As strategic and tactical decisions are made and play out, we believe it is wise to discuss the impacts on incentive plans rather than wait until year-end when memories may not be as fresh.

    For example, top line growth may have been replaced as a pre-COVID-19 priority by cash position and human capital management. If growth is no longer realistic and its measurement not likely to impact incentive payouts, there should be an understanding of what will be considered most important in determining incentive awards instead.
  • To develop a framework, including principles, criteria and parameters for addressing the incentive plans once the year-end results are in, ensuring management and the board are on the same page conceptually

    Incentive plan discussions are often quite productive in the absence of numbers. If there is agreement on what should drive payouts and what the appropriate range should be, there is something to fall back on when the actual numbers appear too high or too low. Adjusting the numbers is much easier than determining the numbers on a blank sheet of paper.
  • To develop a rationale for disclosure of compensation decisions to employees, shareholders and the media

    Optics are important and paying incentives of any amount in a difficult environment will likely be challenged. If there have been months of discussion about what will drive incentives (key performance indicators), what will constitute award-worthy performance under the circumstances of your company and how the outcomes compare to that best-to-be-hoped-for performance, preparing compelling disclosure to skeptics will be a less onerous task.
  • To avoid surprises and mitigate talent management risk at the end of the year

    Incentive plan participants who are expecting to be rewarded for their hard work in a difficult environment will not be happy at the end of the year if they don’t receive payouts because pre-COVID-19 goals were not achieved. Morale, engagement and retention may all suffer as a result. Conversely, a surprise award will be well received but could perhaps have driven more engagement if the participants had known the criteria the board had in mind to make the awards.
  • To establish guiding principles for future significant business disruptions

    Unfortunately, this is likely not the last major event that upends businesses. Having a playbook on how to handle incentive plans would be helpful for the next one.

How to start thinking about the structured discretion playbook

As always it starts with the business. The impact of COVID-19 has been so different across sectors and can be quite different even within an industry by individual business model. Some companies are struggling for survival; others are thriving. All must think through the appropriate way to handle incentive plans. Even companies that will exceed their plan targets (e.g., tech, grocery stores) may want to think about the appropriate payouts given the environment.

By now boards and management have had many robust discussions about the impacts of COVID-19 and how to minimize and mitigate its impacts. Every company has a unique set of responses and priorities to survive the decline and best position the company going forward. The impact on the incentive plan metrics and goals should be discussed and documented, and the new set of priorities should be clearly understood, both in quantitative and qualitative terms. At the end of the year, outcomes relative to these shifting priorities and expectations must be considered.

Context is king in this crisis, more so than in past downturns such as the 2008-2009 financial crisis. With widespread suffering in terms of health, jobs, financial wellbeing, all employees and/or their families are affected. Many companies have had to lay off and/or furlough employees and cut salaries.

Segment the employee population

It will be important to segment the population, for example, between executives (and possibly between named executive officers (NEOs) and other executives), other incentive plan participants and the sales force, and to address each segment separately. Closely consider equivalency of philosophy and treatment among executives, rank-and-file employees, board of directors, shareholders, customers, vendors and other stakeholders. In this environment, incentive awards of any size will likely be challenged, particularly in hard-hit companies. They may also send a less-than-desirable message to employees and the external market about what (and who) the organization values, reducing employee engagement and public perception.

Executive behaviors and actions during the crisis may also need to play a key role in determining payouts and awards at year-end. Did executives act quickly to mitigate business and human capital risk created by the pandemic? Did they effectively lead the organization and employees through uncertainty with a laser focus on employee wellbeing? Did they respond to racial injustice and recent protests with appropriate words and commitments?

Finally, performance relative to peers may be an important criterion in the determination of incentive payments in this environment. Companies may want to track these performance comparisons periodically so don’t have to wait at year end to collect competitors’ performance information.

Talent management issues

Of course, these considerations must be balanced with talent management issues, including executive retention vulnerabilities. Those who say “where would these executives go” miss the point that there are almost always good jobs for the best talent, and executives who stay may not have the same engagement level as before if they don’t believe their goals have been fairly adjusted for COVID-19 implications.

There is also value in using incentives to focus executives on shared goals, especially important when they have shifted. Important questions to ask include:

  • What can strengthen alignment of leadership with short-term performance results?
  • Can appropriate “objective” goals be set for any measures over a short-term period?
  • Are there any creditor-related limits on using cash for bonus funding for 2020 (for executives or overall company)?

The frameworks below may help companies get started in structuring discretionary actions. As our clients flesh out the framework, we will provide case studies in future articles.

Finance

  • What is the financial impact of the shutdown on performance?
  • What is the impact of adjusting your bonus accruals?
  • What are the revised expectations for 2020: base case, pessimistic, and optimistic?
  • Will or did you take government aid?
  • Is extraordinary action required to survive financial distress?
  • Or would another perspective be the impetus for extraordinary action?

Social

  • The ascension of social issues generally and the prevailing view of the shutdown suggest compassion for employees is critical
  • Who is bearing the brunt of the pain in terms of salary and hiring freezes, pay cuts, reduced hours, furloughs with benefits, benefit reductions, and layoffs?
  • Are any employees getting hardship premiums to come to work? Paid to stay home?
  • How would any extraordinary action be disclosed next year?
  • How are employees, shareholders and other stakeholders going to react to incentive decisions?

Motivation

  • What is the company’s compensation philosophy and how would any changes support maintaining that philosophy?
  • Is special action required to give the company the best chance at financial survival?
  • Is action needed to uplift low engagement of plan participants?

Competitive

  • Has your response and performance been successful relative to peers?
  • How have the work forces of your peers and industry been impacted?
  • Are you more at risk of losing talent or acquiring key talent?
  • Retention may be a relatively mild impetus to act, given that the shutdown is impairing most economic sectors…but are certain valuable skills at risk?

Historical

  • How have incentives paid out in the past (e.g., three, five, or even ten years)?
  • When is the last time there was no payout?
  • How have recent say-on-pay votes gone?
  • What, if any, pay concerns are being voiced?

                   Size of Incentive Plan Pool / Payouts

≤ Threshold         ≥ Target
Financial
  • 2020 performance forecasts fall significantly below thresholds
  • Surviving financial distress is a top priority
  • Moderate financial impact due to the shutdown
  • Diversified business mix that offsets some of harder hit businesses
Social
  • Employees bearing a significant burden, e.g. furloughs or layoffs
  • Pay cuts for rank-and-file employees
  • Employees voluntarily taking PTO and reduced hours
  • Possibly some furloughs with benefits No layoffs
Competitive
  • Weak relative performance to peers
  • Operations and work forces are being reduced across the industry
  • Competitors are reducing pay at leadership levels
  • Retention is a relatively mild concern given that the shutdown is impairing most competitors
  • Strong performance and effective response relative to peers
  • Employees with critical skills have opportunities outside the industry
Historical
  • No zero payouts in the past five to ten years
  • Weak say-on-pay votes
  • Pay-for-performance concerns cited
  • Market-based past payouts, including one or two zeros over the last decade
  • Good say-on-pay results and related scores
Motivation
  • Philosophy of adhering to pay-for-performance
  • Action may be needed to motivate plan participants

Finally, there is a myriad of technical issues that must be considered, including language in the plan documents that may preclude certain actions, accounting treatment, disclosure requirements and considerations, and proxy advisor guidelines (the latter two may differ depending on whether NEOs are included). While they should not all necessarily drive decisions, companies need to be familiar with any constraints or negative implications.

The prevalence of companies making equity grants with performance conditions is much higher today as compared to the financial crisis of 2008-2009, so many companies and their compensation committees likely are addressing this issue for the first time. For an in-depth discussion of technical considerations in using discretion in short-term incentives or cash or equity long-term incentives, please see the Willis Towers Watson Executive Pay Matters dated June 4, 2020 entitled Beware accounting, disclosure impact of changes to incentive comp plan goals.

In conclusion

Structured discretion is an evolving topic, so we intend to update this blog as our thinking and more importantly our clients’ thinking evolve. For now, we encourage our clients to start or continue the conversation, even without specific conclusions or decisions. It will be a process that will make a difficult year-end process much easier.

Authors

Senior Director, Executive Compensation (New York)

Analyst, Executive Compensation (New York)

Head, Willis Towers Watson Chicago’s Talent Line of Business

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