The COVID-19 outbreak has caused major disruptions across businesses worldwide, and there are wide-ranging implications for the administration of compensation programs. For many companies, the most direct and immediate compensation-related challenges posed by the COVID-19 outbreak are (a) potential pay reductions at the senior executive and board level, and (b) goal setting for annual and performance-vested long-term incentive (LTI) awards in an uncertain and rapidly changing economic environment.
At This Point in the Disruption
Media coverage fosters a perception that pay concessions among senior management and independent board members are widespread. We are tracking public disclosures and, currently, approximately 10% of the Russell 3000 and less than 15% of the S&P 500 companies have taken action to reduce pay. There are two common threads among these companies, most of which are concentrated in the hardest hit industries:
- A need to preserve cash to enhance liquidity or to meet specific financial targets due to debt covenants or other requirements, and
- A sense of “shared sacrifice” between top leadership and the broad workforce if large numbers of employees have been laid off or placed on unpaid or reduced-pay furloughs
One might ask why pay reductions have not been more prevalent given the impact that the COVID-19 crisis has had on stock prices. Part of the answer is that there is little need to foster “shared pain” between top management and shareholders as the construct of top officer pay packages creates strong alignment. The typical pay mix for an S&P 500 CEO is highly weighted to variable and equity-based incentives in which value is dependent on achieving prescribed performance goals over 1- and 3-year periods as well as changes in share price. Salary often represents only about 10% of total compensation and the remainder of the pay opportunity has been devalued due to reduced likelihood of achieving target goals and share price depreciation. As a result, the “shared pain” issue is more a future rather than immediate concern that will depend on how companies address a variety of decisions as discussed below.
So, what are the emerging challenges that companies are beginning to discuss?
1. Will continued economic distress and the uncertain environment pressure a larger number of companies to consider cuts?
- Time will tell, and it is obvious that growing liquidity pressures and a continued need for “shared sacrifice” can lead to cuts among companies that, as of now, are less affected. As noted below, pressure on share availability and dilutive considerations may also lead to longer-term pay cuts, just as it did after the financial crisis in 2009
2. How will companies determine year-end incentive payouts if the original goals are obsolete?
- There is widespread discussion about the use of Board or Compensation Committee discretion. However, not all companies will be equally affected by the crisis and there are some that are benefiting financially. This makes it important to preserve flexibility and maintain a performance-oriented approach during the crisis because discretionary adjustments will be closely examined by both incentive plan participants and investors for fairness. Striking the right balance will be a major challenge, and avoiding premature decisions will preserve flexibility when full information becomes available
- Some companies are considering a near-term reset of performance goals. Doing so when forecasting precision remains poor can lead to a need to do so again if conditions worsen or a windfall if they improve, both of which may be viewed by investors as implying an “entitlement” mindset. To preserve flexibility, a company could leave existing goals in place but communicate to employees an intention (without specific promises) to apply appropriate judgment at year-end. Alternatively, a company could truncate performance for the first half of the year and adopt a new plan for the remainder. We generally recommend against resetting now and intending to further use discretion, since a “multiple bites” approach may be misinterpreted as misaligned with a pay-for-performance culture
- Regardless of the approach taken, clear and frequent “top down” internal communication about evolving challenges and performance expectations is important to ensure maximum focus on results, especially as more companies rescind past investor guidance
3. How will companies convert dollar-denominated long-term incentive targets and board member equity retainers into shares?
- Lower share prices mean increased share usage, with a disproportional impact on the companies with the largest decreases. For example, share price reductions of 25% and 50% result in share use increases of 33% and 100%, respectively, assuming no change in grant values. An 80% reduction, which is not uncommon among the hardest hit companies, results in granting five times as many shares
- To avoid excessive dilution and prematurely exhausting the pool of available shares, companies can consider using an alternative share price to convert target award values into shares. A similar effect can be achieved by applying an explicit haircut to grant values
- Data from the financial crisis in 2008 and 2009 indicates that typical practice was to “split the difference,” where grant values were reduced by roughly half of the decline in share prices
- The net effect of any of these approaches is to reduce target compensation opportunity and, absent share price recovery, we expect that these forces will reduce reported pay levels. However, the impact will differ by and within industries with the hardest hit companies taking the most significant actions
- This may lead to competitive disadvantage in attracting and retaining talent, and the hardest hit companies may need to make innovative revisions to their programs
4. How will investors and the proxy advisory firms react to the myriad compensation decisions made in response to COVID-19-related pay challenges?
- We expect the “social justice” concerns about executive pay to elevate as a result of COVID-19, not abate, since crises are often felt disproportionately by the lower ends of the economic spectrum
- To mitigate criticism, we recommend considering every decision in the context of how a reasonable investor may react and evaluating the actions holistically rather than piecemeal. While individual decisions may seem fully defensible when standing alone, companies should recognize that they will be assessed collectively in the next proxy statement
- Early guidance from the two major proxy advisory firms indicates an intent to scrutinize actions that misalign with their historic views on best practices, and this provides important context for the environment in which decisions made between now and year-end may be viewed from a governance perspective
- Glass Lewis’ tone is particularly harsh, noting that they anticipate a devaluation of human capital as a result of the crisis and a corresponding decrease in pay. They state that “trying to make executives whole at even further expense to shareholders and other employees is a certainty for proposals to be rejected and boards to get thrown out—and an open invitation for activists and lawsuits onto a company’s back for years to come.”
- ISS guidance indicates that companies should maintain pay-for-performance alignment and avoid “problematic pay practices,” and that companies should be transparent with goal setting. They also indicate that stock option repricing proposals will be evaluated under historic governance standards, meaning that support will be contingent on value-neutral exchanges and exclusion of proxy officers, among other things. This could mean that option repricings may not receive the required shareholder support, which raises shorter-term planning implications for companies facing potential attrition risk
5. What will the new “normal” look like post-crisis, and will the lessons from this crisis reshape the executive compensation landscape? The answer to this question is speculative, especially considering that we may be in the first inning, but several observations are already clear:
- The most obvious observation is the value of a deep bench at all levels of the organization. Most succession planning has historically focused on the top tiers and the proverbial “meet with the bus” scenario. The crisis has demonstrated the importance of deeper planning, including for disaster scenarios, because people who work closely together could become incapacitated simultaneously
- We anticipate evolution of new strategies intended to discourage “free agency” and to, instead, reward long tenure and commitment to company vision. This could occur through simple approaches, such as lengthening the vesting schedule on stock awards, making grants at multiple times throughout the year to ease the impact of volatility and spread vesting dates, or via implementation of programs that replicate the “career” retention power provided in the past through defined benefit pension plans, which are nearing extinction. It is also possible that the gap between CEO and other proxy officers’ pay may narrow as companies recognize more fully that the CEO is part of a team, as opposed to disproportionately creating value on his/her own. Pay parity throughout the entire organization may elevate in importance as companies reevaluate the definition of “essential” within the workforce
6. Will restrictions imposed on companies that accept financial assistance under the CARES Act create unintended consequences?
- Companies that accept assistance will face restrictions on compensation and severance payable to employees whose total compensation in 2019 exceeded $425,000, generally until one year after the loan has been repaid. The restrictions are more severe for executives whose compensation exceeded $3 million
- This will create competitive opportunity for unencumbered companies. It also creates a need for restricted companies, virtually all of which already face elevated attrition risk due to devalued equity awards and possibly low or no incentive payouts, to implement cohesive strategies to keep the leadership team intact
- As indicated above, the availability of discretion and increased equity leverage through larger share awards may meet with resistance from investors and the proxy advisory firms. It is not too early to begin developing innovative solutions to these challenges
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Balance has always been the key to effective executive compensation design because it leads to durability over time. The current crisis creates risk to all organizations, but also a fresh opportunity to rethink past practices in the context of cultural challenges and a new paradigm.
Daniel J. Ryterband
Chief Executive Officer
Dan Ryterband consults to organizations on all aspects of executive compensation strategy and design, including the related tax, accounting, and securities law implications, as well as matters of corporate governance and investor relations. He has over 30 years of consulting experience and his clients include U.S. and overseas multinationals in a variety of industries, as well as smaller start-up organizations. Dan has extensive experience working with Board Compensation Committees and is a frequent speaker in industry and academic forums.