Trends include everything from ESG to politics
As 2019 approaches its end, it is time to look forward to 2020 to think about what the New Year will bring for compensation committees.
There will be a continuing evolution of some trends (e.g., pay equity and diversity, environmental, social and governance (ESG) issues) as well as some new issues that may be more unique to 2020 (e.g., election year politics and potential economic uncertainty).
Below is a highlight of the key issues for the coming year and what committees should be doing to address them.
- Pay Equity and Diversity
Over the last couple of years, gender pay equity and minority pay equity have received heightened attention from compensation committees, activist shareholders and legislators. At this point, most committees we work with have requested that management perform an analysis of gender pay equity and minority pay equity. In most cases, the companies that have conducted this analysis have found that the pay gaps between men and women and minorities and non-minorities are modest once employee role, level, and tenure have been controlled for.
What we see on the horizon is an increased demand from shareholders for disclosure of the pay equity analysis results. We also expect that the focus will shift to the levels of representation of women and minorities in higher-paid positions and the executive levels of companies.
What committees Should Do:
- Understand the facts at your organization: are there gaps in pay between men and women or minorities and non-minorities at your organization that cannot be explained by reasonable factors? Are there differences in the representation of women and men and minorities and non-minorities in more senior or higher-paying roles in your organization?
- Identify how management plans to address gaps in payor representation: If there are pay gaps, what are management’s plans to reduce the gaps? What processes will be put in place to ensure that gaps do not arise in the future? What approaches have been put in place to ensure that women and minorities are included in the hiring process and promotion decisions?
- Determine how much you want to disclose: Disclosure around the topic of pay equity can range from a statement that the company does not discriminate on pay and has policies to prevent discrimination, to disclosure of the ratio of pay for women to men or minorities to non-minorities, controlling for role/level, tenure and other individual factors. Examples of companies that have disclosed this type of information include Citigroup, Intel and Mastercard among others.
- Environmental, Social and Governance (ESG)
Many shareholders are concerned about the broader mission and activities of corporations. Even the Business Roundtable released a statement, saying that businesses should balance the needs of shareholders with customers, employers, suppliers and local communities.
For example, a study we conducted in early 2019 found that 52% of Board members thought that diversity and inclusion measures should be incorporated into the incentive plans for the CEO and executive management team. While most people agree that ESG measures should be monitored, it is unclear that they should be incorporated in incentive plans.
What committees Should Do:
- Identify the Key ESG Measures for Your Organization: Based on the nature of your business, what are the most critical ESG metrics (e.g., environmental emissions, energy consumption, employee safety, pay equity, diversity)?
- Determine what the goals are for improving ESG performance: What level of progress is required to meet the objectives of the organization or be an industry leader?
- Assess whether there is a role for ESG in compensation decisions: Should ESG measures be incorporated into the individual performance assessment for the CEO and other members of management? Are there any ESG measures (e.g., employee safety, diversity or environmental progress) that are critical enough to be included in the incentive plan for executives?
- Economic Value Added (EVA)
Institutional Shareholder Services (ISS) is expected to announce that they will incorporate EVA into their financial performance assessment. In the near term, this means that if a company you work with raises a level of concern on ISS’ other quantitative tests, they may also review your performance on EVA in determining their ultimate voting recommendation on say on pay. In the longer term, there is a question of whether or not EVA is coming back as a performance metric in incentive plans.
To date, our experience would say that EVA remains unpopular as an incentive measure due do its complexity and its lack of relevance for some industries (e.g., high growth, biotechnology). That being said, shareholders are increasingly focused on return metrics (e.g., return on capital/equity) and their use in incentive plans has increased in the last few years. An incentive structure that incorporates earnings growth and a return metric should be directionally aligned with EVA, while avoiding the complexity of EVA.
What committees should do:
- Understand How Your Company Performs on the EVA Measures in ISS Test: Review your ISS report from 2019 to understand how you performed on their four EVA-based performance measures
- Determine the Degree of Relevance of EVA for your organization: Does the finance team use EVA internally as a tool for capital allocations or financial reporting? Do any of your shareholders focus on EVA in making investment decisions?
- Understand How Your EVA Performance is Expected to Evolve Over Time: If you currently perform poorly on ISS’ EVA Test, it may be useful to know how your finance team projects your EVA will evolve over time to understand if your performance is expected to change under ISS’ test?
- Election Year Politics
As an election year, one thing is certain about 2020: It will heighten the degree of uncertainty about the future direction of economic policy. Under the Trump administration, there has been very little new regulation and a lack of progress on pending regulations (e.g., implementation of remaining items under Dodd-Frank). In addition, under the Trump administration there were significant changes to tax policy. The 2020 election will create uncertainty about what the business environment will be in 2021. Will taxes be increased following the election? Will there be a change in regulatory direction?
We expect that not much new will get done in the election year, although there is the possibility that the Trump administration will attempt to complete some pending regulatory matters before a potential change in administration. We do not think that the election uncertainty will push us into a recession, but there is some potential that reluctance to make long-term investments or other decisions in an uncertain environment may dampen the economy.
What committees should do:
As committees think through the uncertainty around the political environment, we strongly recommend management present sensitivity analyses around earnings and other key metrics. For example, what will happen if tariffs continue for the foreseeable future, Brexit happens, the economy slows, etc? These factors should be considered in how goals are set for incentive plans as well as the range around the targets for threshold and maximum payouts. Just as important is for the Committee and management to have a framework for how to make decisions around adjustments to the incentives for factors we cannot predict today.
- Pressure test the compensation structure
For the last several years, economists have anticipated a slowdown of the economy and a likely recession. So far we have dodged a recession, but many believe we are living on borrowed time. Regardless of when, if history is any indicator, a recession will eventually happen, and Committees can take actions to limit its impact on compensation programs. Therefore it is important to test the company’s compensation structure to make sure it will allow the company to continue to attract and retain talent through a recession.
What committees can do:
- Understand How Pay Programs Will Perform in a Recession: 1) Are our salaries competitive, especially since at the senior executive level it may be the only guaranteed component of compensation 2) Would we be comfortable paying out zero bonus in a given year, would there be pools of talent we would want to reward regardless and do we have the mechanism and communication in place to make that happen? 3) Is our long-term incentive too highly leveraged (e.g., over-reliance on stock options) such that it has worked really well in the upswing, but may be overly punitive on the downside
- Consider Modifications to Design to Perform Better in a Recession: Can we use relative performance measurement for a portion of our annual incentive or long-term incentive? Should we use time-vested restricted stock units for a portion of our long-term incentive to assist in executive retention?
We expect 2020 to be an eventful year. Compensation committees should be proactive in addressing how broader governance trends around pay equity and ESG measures are being addressed by their organizations. While we may be lucky and avoid a recession in 2020, we think committees will be well served by understanding how their compensation programs are likely to perform in one.
Eric Hosken is a partner with Compensation Advisory Partners, LLC. Eric’s areas of focus include compensation strategy development, evaluating the pay and performance relationship for senior executives, annual and long-term incentive plan design, performance measure selection and board of director compensation.
Daniel Laddin is a founding partner with Compensation Advisory Partners, LLC. He consults with Boards and management in all areas of executive compensation, including annual and long-term incentive design, performance measurement, target setting, and regulatory/compliance issues, as well as outside director compensation programs.