Boards are used to working with uncertainty in setting incentive goals, but 2021 is forcing them to raise their game.
Setting goals for incentive compensation has long been one of the compensation committee’s biggest responsibilities. This task is especially difficult with the continuing uncertainty of the COVID-19 pandemic and corporate commitments to serving all stakeholders, not just shareholders. To add to the complexity, some business sectors are thriving while others face a very uncertain recovery.
Compensation committees are asking:
- What will good performance look like in 2021?
- Will management know enough at the beginning of the year to set reasonable goals?
- How volatile might performance outcomes be?
- What level of discretion might be appropriate to reserve for year-end?
- Will it be “safe” to set longer-term goals?
- For companies temporarily boosted by the pandemic, is it appropriate to set 2021’s goals below 2020’s results?
- How should incentive plan payouts consider the impact on all stakeholders?
While many of the same goal-setting considerations that apply in any year are still relevant, most boards will need new strategies. The application of these strategies will necessarily vary by industry.
Principles of effective goal setting
Goal setting has always been a balancing act. The aim is to motivate management while keeping payouts in line with results delivered to shareholders. This year, compensation committees must work through the deep uncertainty about the course of the pandemic. Increasingly, boards are weighing the needs of other stakeholders based on input from institutional investors.
In the past, many companies relied on standard principles for goal setting:
- Growth requirements from the prior year.
- Fixed ranges of threshold and maximum performance relative to target (e.g., +/- 10% or 20% from budget).
- Long-term growth expectations (e.g., 8% EPS growth rate per year).
- Expectations about the likelihood of achieving certain payouts (e.g., threshold exceeded with 90% probability, maximum achieved with 10% probability).
- Since these traditional inputs will not be relevant for many companies in 2021, here are additional perspectives and inputs for setting financial goals:
- Sensitivity testing to understand the performance required on underlying drivers of the incentive plan metrics (see figure 1, for a retail example). This analysis includes events that might play out over the course of the year and their potential impact on goal achievement. It helps boards understand the range of potential outcomes.
- External expectations for both the company and peers, based on analyst estimates and company guidance (see figure 2). These expectations likewise establish a range of goals.
- Incentive plan sharing rates to understand the incremental earnings paid out in incentives (see figure 3). Where earnings are thinner, the sharing between employees and shareholders must adjust accordingly.
Additionally, many companies are incorporating a broader stakeholder view into incentives, as explicit incentives in the plan, as part of a discretionary scorecard or when discretion is exercised at year-end.
Industries struggling in the pandemic
Many industries are seeing moderate to severe disruptions from the pandemic, with significant uncertainty in 2021. Boards must recognize these ongoing challenges and come up with incentive targets that fairly motivate and retain executives, for both the annual bonus and performance-based equity awards. Along with the approaches described above, companies in these challenged industries are undertaking some or all of the following strategies:
- Wider performance ranges for threshold and maximum performance levels.
- Lower caps on maximum payout levels to avoid windfall payouts, if the target goals are set conservatively.
- Flatter achievement ranges around targets to allow for volatility and steeper pay changes only farther above and below target.
- Partial-year performance periods (spring and fall, for example) for the annual incentive, often with changes to the payout opportunity (i.e., lower target or maximum payout opportunity), but with actual payouts reserved until end of year.
- Changes to incentive metrics, such as more emphasis on controllable metrics and metrics tied to the pandemic recovery (including margin or return metrics denominated in percentages, liquidity metrics and operational/strategic metrics).
- Greater allowance for discretion at year-end for the annual bonus, often based on a scorecard of metrics (including objective goals, but with any payout assessed nonformulaically).
- Metrics relative to a peer group in the long-term incentive plans.
- For the long-term plan, some shift to time-based equity vehicles and away from performance-based shares. (Note that investors and proxy advisers have expressed a strong preference for maintaining at least a 50% performance-based mix.)
Industries thriving in the pandemic
Boards in well-performing industries have the opposite challenge. Their companies had banner years in 2020, and now the key consideration for 2021 goals is how much of that performance can be sustained post-pandemic.
Many compensation committees will be reluctant to set incentive targets below 2020’s results, but for some companies it’s perfectly reasonable to expect a decline from 2020. Understanding the external perspective from analysts and peer company guidance can inform the decision about what is reasonable. Boards can reduce the risk of a disconnect between incentive payouts and shareholder expectations in multiple ways:
- Change the leverage curve: While targets may be lower than 2020 performance, if these are missed, the payouts decline quickly. As for the maximum payout levels, those should be harder to reach.
- Use a multi-year lens in goal setting, considering what is fair progress from 2019, or for 2020 and 2021 combined.
- Set different performance curves based on the macro environment. Boards could establish one set of performance goals if the broader economy goes down by 5%, and a lower range of goals if it goes down by 10%. The payout opportunity could be adjusted as well.
Boards are used to working with uncertainty in setting incentive goals, but the usual principles for goal setting need to be enhanced with creative solutions in 2021. The approaches will vary depending on the pandemic’s influence on a given company and industry, but most compensation committees will want to give incentive goals additional consideration to ensure they are motivating their executive teams and aligned with all stakeholders’ experiences during this uncertain time.
Blair Jones and Greg Arnold are managing directors at Semler Brossy.