Foreword
We are in a period of great uncertainty that we have not seen at any time in recent history. And that uncertainty will extend well into 2021 — and possibly beyond. Fall 2020 is the time to start planning how to adapt and re-design 2021 annual and long-term incentive plans for this new reality. This article describes several time-tested incentive design practices to respond to these economic challenges.
With fall on the horizon, companies need to start thinking about their incentive compensation plans for 2021. Most of us are recognizing that the pandemic and related economic woes are not going to end easily or quickly. Companies need to plan for the many challenges that they and their workers and families will face well into next year.
The timing and speed of an economic recovery is debatable, but one thing we know for certain is that we are living with much greater uncertainty and risk today than before the pandemic. We also know, or can assume, that we will be living with that uncertainty and risk next year. The economy going into 2021 will be weaker than it was going into 2020. (This year’s business plans and projections were optimistic compared to 2019.)
As organizations begin to evaluate their annual and long-term incentive plans for 2021, there are several initiatives companies should consider:
- De-risk the incentives. In a higher risk business environment with greater uncertainty, it usually makes sense to reduce the risk and leverage in incentives. This means less upside and downside, and less incremental payout per unit of incremental performance. This can be accomplished with:
- Flatter payout curves.
- Lower maximum and minimum payouts (25% to 150% of target, rather than 50% to 200%).
- Flatter targets. Instead of making target performance one number or point on the payout curve, make it a range, say between 97% and 103% of the business plan.
- Set lower goals. Given the likely economy in 2021, most companies will be looking at lower goals for 2021 than they had for this year or 2019. If companies reduce goals, they should consider the total cost of the incentive plan relative to the lower profit or other performance goal to make sure appropriate sharing ratios (total incentive plan cost as a percentage of net income, EBITDA or other measure) are maintained within a reasonable range.
- Change performance measure mix. In a more uncertain, lower growth environment, it may make sense to place a higher weight on EBITDA and a lower weight on revenue, for example. This will depend on what opportunities and challenges a company is facing and how different they are from their pre-COVID business environment.
- Consider strategic measures/objectives. This may be the time to make key strategic moves like making an acquisition, exiting a business, repositioning assets, accelerating new technologies, shifting costs and investments between businesses, taking advantage of market inefficiencies and dislocations. Introducing a “milestone” component to the incentive plan based on achievement of one or more key strategic objectives may be worth considering.
- Consider relative performance measures. In uncertain times, performance relative to peers is a good way to gauge how well a company is performing and avoids the difficult challenge of setting goals. However, other than relative Total Shareholder Return, relative measures are difficult to use. While measuring your own company’s financial performance may be easy, making direct comparisons to other companies is fraught with challenges with definitions, adjustments, inconsistent reporting and timing of data availability. Relative performance is best kept to relatively simple GAAP metrics such as revenue growth or unadjusted GAAP EPS growth.
- Adjust long-term incentive mix. 2021 may be an appropriate time for companies to increase the percentage of time-based restricted stock in the mix. The lower risk of the pay mix could be offset with longer vesting periods — say four or five years — or backloaded vesting (50% after year two and 50% after year three, for example), or adding holding requirements.
- Consider annual goals for long-term performance plans. Since setting three-year goals may be nearly impossible, companies should consider a plan with three one-year goals. Or, rather than setting three-year cumulative goals, consider average performance over three years, or simply focus on performance in the third year of the plan (for example, achieve a certain level of revenue or profit by year three).
If companies change their 2021 incentive plans, they should consider whether the changes are temporary to reflect these unusual times or are more reflective of longer-term changes in the business landscape and strategy.
Some aspects of the pandemic-driven recession are temporary, but others will be more permanent and reflect fundamental shifts in the economy and how business gets done.
A version of this article appeared on Workspan Daily on August 13, 2020.
