Considering the current market volatility, Dan Ryterband, CEO, and George Paulin, Chairman of FW Cook, share their perspective on various issues companies are now facing.
Question: Both of you have advised leading companies on executive compensation matters through challenging market conditions before. What can you share that will help readers sort through the complex issues related to the disruption we are seeing in the current market?
Dan: It is important for leaders to maintain a certain level of calm as the markets absorb the day-to-day changes in news related to coronavirus. The timing of this crisis is especially challenging for many companies that are now setting performance goals for 2020 incentive plans, making long-term incentive grants, and considering adjustments to target compensation levels for executives and the broad employee base. As a first step, I recommend careful evaluation of historic practices in the context of the current, unprecedented circumstances. Take the necessary time to make informed decisions needed to maximize the motivational value of incentive plans, recognizing that there is no immediate rush and that the uncertainty that exists today hopefully will dissipate over the next several weeks or months and may be gone by the end of the year. We just don’t know. So, it’s important for leaders to have as much information as possible to make an informed decision.
George: This is not a one-size-fits-all situation and should be addressed from both strategic and tactical perspectives. Companies will be impacted in very different ways and some more than others like airlines facing travel bans, banks facing zero interest rates, energy companies facing not only virus-related issues but plummeting supply-related commodity prices, etc. For public companies, it is also important to have a perspective on what responses generally will be acceptable to the large investment funds and proxy advisors.
Since things changed so fast, there is one immediate fundamental distinction between companies related to executive compensation that is critically important to address. Many companies already have set their 2020 financial goals for performance-based incentives and made their 2020 long-term incentive grants based on market assumptions that have changed. Others have not yet set their 2020 goals and made their grants and can update their market assumptions to reflect the new realty, while much of the new realty remains unclear and uncertain.
Question: Can you speak to some of the practical/tactical things companies should be thinking about as they make compensation decisions during this period of uncertainty?
Dan: If a company is in the process of setting 2020 incentive goals, it may be appropriate to delay the decisions until more information is available. Unlike many uncontrollable events, the impact of the coronavirus is likely to be difficult to accurately measure, so adding a provision to adjust out the impact without application of substantial discretion is unlikely. A delay in goal setting, maybe until mid-year, may enable greater precision, thereby increasing the likelihood that the targets remain relevant and serve to motivate management. The increased precision also decreases the likelihood of needing to subsequently adjust goals or apply discretion, thereby mitigating potential scrutiny from shareholders. A delay may be especially appropriate if a company is re-evaluating its budget and reconsidering guidance recently provided to investors. Generally, the incentive plan goals should align to budget and guidance, although a severe reduction in expected results needs to be carefully considered from a target-setting perspective.
George: I agree with Dan that for companies who have not yet finalized their 2020 goals, there is no rush and using more-precise goals for the second half may make sense. It is important to reduce the perceived performance risk for participants in an uncertain time like this where the impact is largely beyond their control. As of today, goals generally will be lower the later they are set, threshold-to-maximum performance ranges will be flatter, and discretion to make appropriate adjustments at year-end will continue. Regarding goal-setting and year-end adjustments, companies with healthy balance sheets have flexibility. However, others are constrained by liquidity. Investors and proxy advisors are not likely to support additional debt to pay incentive compensation, so the ability to generate cash to maintain dividends and service debt must be part of the equation in the absolute level of financial goals.
Meanwhile, for those that have not made their annual 2020 long-term grants, I would expect to see many companies reducing the grant values to avoid otherwise excessive shareholder value transfer costs and potential dilution. One method would be by capping either the cost amount or dilution percentage, and another would be using a reasonable average price (prior 30-day average) for determining individual shares. This was common during the 2007-09 financial crisis, and it is difficult to imagine that the big investment funds and proxy advisors will relax their cost and dilution policies to support grant values that had gone up over time based on company market-cap value growth, before coronavirus-related stock-price declines.
Dan: To address the increased degree of difficulty attributable to coronavirus implications, it may be appropriate to rethink the goal-setting process. Many companies, especially those in growth industries, routinely set goals that exceed prior-year actual results. In many cases, this is a minimum expectation of investors. However, attaining the prior-year actual may not be possible in the current environment, and setting a goal that is viewed as impossible by management will not have the desired motivational impact. While I have always viewed an opportunity to earn a target payout as a core principle in incentive planning, it is not necessarily true that the opportunity to earn above-target should always exist. So, if a company sets lower goals in 2020, perhaps it makes sense to reduce upside above target or, in some cases, eliminate it altogether.
In addition, in market conditions such as this, the upside and downside possibilities may not be symmetrical. When the risk of under-achieving a goal is asymmetrical to the likelihood of overachievement, it is relatively common to create a “soft landing” by reducing leverage below the target goal. This enhances the motivational value of the plan and serves to keep management engaged during significant downturns, thereby aligning payouts with the shareholder experience. To balance the softer downside, companies might reduce upside potential to protect against windfalls if the economic environment quickly improves. This implies a non-linear incentive plan slope and, as mentioned earlier, possibly capping payouts at a level below historic practice.
There are other approaches companies can take if goals have not yet been set. For example, in the annual incentive plan, consider setting two separate six-month cycles. In the long-term plan, consider moving to three separate 12-month plans. In either case, companies should be aware that such changes will need to be defended at year-end since they are generally not viewed as “best practice.” Another tool is to measure results on a relative-to-peer rather than absolute basis, thereby eliminating the need to set specific targets. Companies can also include provision for a minimum payout tied to a relative performance outcome. For example, if a company uses EPS as a metric in its annual incentive plan, it would set an absolute goal but pay a specified minimum payout, such as 35% or 50% of the target bonus opportunity, as long as relative year-over-year change in EPS is at or above the peer median.
George: If your 2020 financial goals are already set, live with them. It is more important to establish an agreed upon process for measuring the coronavirus impact as the basis for considering whether and to what extent to adjust for the one-time, extraordinary item at year-end. Also, there has been a trend in recent years to have a modest (15-25%) element of annual incentives funded for non-financial individual and strategic performance, as a vehicle for rewarding high performers regardless of financial results. Companies should consider this as a design change because it has a further benefit of supporting the continuation of “stretch” financial goals.
Similarly, if you already have made 2020 annual long-term grants, you generally will have to live with below-target values until stock prices recover. There may be some special grants for recruiting and retention, but costs, potential dilution, and negative investor reaction should keep them highly selective and only as necessary.
Question: Can you address the issue of the use of discretion in the determination of incentive payouts during uncertain times?
Dan: It is important for board compensation committees to find the right balance between the shareholder experience, motivational value of incentives, and accountability for results. It is likely that many compensation committees will be under pressure to exercise discretion at year-end when bonuses are determined. I prefer to see committees establish programs that are thoughtfully designed so that the committee can base its decisions on plan parameters. In my view, it is better to build more flexibility into goals and plan mechanics than to rely on broad discretion. Certainly, discretion has its place, but it is harder to explain to shareholders, and many observers do not believe compensation committees are very good at it. Also, it is important to recognize that the need for discretion is often accompanied by a poor absolute shareholder experience. Even though management may not be responsible for poor operating results or share-price declines, investors and the proxy advisors often expect accountability and at the least will want an explanation for how the discretion was determined to be discussed in the proxy CD&A.
George: In normal situations, the use of discretion challenges compensation committees because so many investors view it negatively, and it is challenging to describe in public disclosures. Board compensation committees should assume that discretion will be necessary for a fair outcome on 2020 incentive compensation. Pre-agreed plans should be put in place now on where and how discretion will apply and be determined, with testing against proforma disclosure language.
Question: Many employees and employers have had a pretty good run over the last several years with above-target incentive plan payouts and increased equity award values. How should compensation committees be thinking about the prospects for lower payouts in this environment as it relates to participants?
Dan: Textbook compensation theory implies that over a specified period we should expect payouts to range across an array of outcomes, much like a bell-shaped distribution curve. Participants should occasionally expect a zero or maximum payout, each perhaps once or twice in ten years, with the other years ranging above and below target. If the goals are not yet set, I recommend against starting 2020 with an expectation that it become a zero-payout year, but also recognizing – assuming it is true – that past above-target payouts that may have been partly attributable to a favorable economic climate may justify a higher level of performance risk in 2020. It seems to me, looking out over hundreds of companies, that the average payout over the past few years has become a bit tilted towards above-target payouts. This doesn’t mean that the basic concept of bonus variability has changed, but it’s likely that investors will be expecting bonuses to be lower in 2020. Compensation committees and senior managers would do well to begin communicating what this might mean, without waiting until the end of the year approaches. I also believe that continuous communication to incentive plan participants will be especially important in 2020. As management and other incentive-eligible employees deal with anxiety over health risks, it will be important to take steps to keep their eyes on the performance bar.
George: Real pay delivery should align with performance over time, and like it or not, the reality for top executives is that shareholder-value creation remains the primary performance test. Without the shareholder-value creation we had during the longest bull-market in history that just abruptly ended, it will be difficult to maintain the same levels of pay delivery. Here, the response should not be higher grant values, but performance share and performance stock option structures with higher-than-traditional performance risk and leverage tied to recovery.
Dan: It is important to consider the economic and compensation-related implications of the coronavirus carefully. No single solution will work for all companies, and even the best-laid plans may ultimately be determined to be ineffective. Therefore, I encourage thoughtful planning and open-mindedness as the situation evolves.
George: In addition to compensation challenges, the coronavirus is creating unique top-management succession concerns. The CEO or other senior officers being run over by the proverbial bus seems a lot less probable than testing positive for coronavirus and being quarantined or worse. Thoughtful companies need a plan on who could fill-in temporarily and what would be the pay, so they can execute fast if the situation arises.
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.
George B. Paulin
Chairman & Head of Los Angeles Office
George Paulin is widely recognized as an authority on strategic executive compensation program design across industries. He actively advises many of the nation’s largest and most valuable companies. George was a pioneer in the role of independent advisor to public company board compensation committees, and was instrumental in establishing FW Cook as a national leader in executive compensation consulting services. George has testified before Congress on executive compensation matters, appeared on CNBC, and contributed to most major business publications.