Submitted by EveTahmincioglu on Thu, 01/25/2018 - 15:42

In December, Netflix eliminated performance-based cash bonuses for top executives in anticipation of the new tax plan. The streaming-video company made the move because the new plan ditches the bonus deduction for executives making more than $1 million.

While Netflix was one high-profile example of a company increasing base salary levels in response to the change, will other companies follow suit?

From tax reform to pay equity, there are a host of questions and items that will be on board agenda’s this year, making this year much more complex than 2017.

Compensation committees will be wise to consider the following top five issues in 2018:

1.              Tax reform and executive compensation

2.              Internal pay equity

3.              Pay for performance and GAAP

4.              CEO pay ratio

5.              Total shareholder return and incentive pay

1.         Tax reform and executive compensation

Over the long-term, the tax reform will be a positive for companies as the corporate tax rate has been reduced from 35% to 21% and a more balanced approach has been established for the treatment of foreign profits.

In the near term, however, the tax reform raises some executive compensation issues. Even though tax reform does not take effect until 2018, 2017 financial performance may be adversely impacted for companies that have material deferred tax assets or positively impacted if the company carries deferred tax liabilities.

For long-term performance plans, the compensation committee will need to make adjustments to 2017 performance, as well as 2018 and 2019 performance to “back out” the impact of the change in the tax rate on performance. Aside from after tax earnings, possible impacts on long-term incentive plans (LTIPs) include repatriation of capital and changes in return calculations due to changes in the balance sheet for deferred tax assets (liabilities).

When goals were set for annual and long-term plans, tax reform was not anticipated, so most companies will not want to allow management to benefit (or potentially lose) in 2017 from the change in the tax code.

Compensation committees should ask management to confirm whether or not adjustments to reverse the impact of changes to the tax code were embedded into the award agreements. If not, management will need to consider the potential accounting and tax impact of making a change.

A key aspect of the tax change, as in the Netflix example, will impact future executive compensation because the “performance-based” exception under 162(m) has been eliminated from the tax code.

This means that any compensation above $1 million to covered executives in tax years beginning after Dec. 31, 2017 will no longer be tax deductible for the company. The tax rule allowed for grandfathering of written binding contracts entered into before Nov. 2, 2017. However, there is considerable ambiguity over whether or not outstanding long-term performance plans will be treated as “written binding contracts” since the compensation committee often has some discretion in determining final awards under these plans.

Until the IRS provides guidance on transition rules we may not have definitive answers on these issues.

While Netflix increased base salary levels in response to the change to the performance-based exemption under IRS code section 162(m), we do not expect many companies to follow as shareholders and shareholder advisory firms have made their preference for performance-based pay clear.

2.         Internal pay equity

Gender pay inequality was becoming a key focus in 2016 and early 2017 when many companies received shareholder proposals (4% of the Fortune 100 in 2016 and 12% in 2017) related to the issue. And the harassment scandals across political and corporate America further highlighted the focus on equal pay in the workplace.

While we do not expect the federal government to require gender pay equity disclosure in the near future, there is potential that individual states may take action. Some states and cities have already enacted laws forbidding potential employers from asking candidates about their pay history to avoid perpetuating pay disparities and they have proposed taxes to penalize companies with high CEO pay ratios.

Compensation committees should start asking management teams the hard questions about pay equity in their organizations:

  • Are there unexplained differences in pay levels for men and women in the same jobs with similar performance histories?
  • Are promotional opportunities for women as available as they are for men?
  • Are women systematically in lower paying jobs than men?
  • How often do we review these issues and how are they validated?

It is likely that at some point, either shareholders or regulators are going to demand this type of disclosure and it is better to fix the issues before disclosure is required.

3.         Pay for performance and GAAP

Beginning this year, Institutional Shareholder Services (ISS) is going to incorporate an analysis of relative generally accepted accounting principles (GAAP) financial performance into their pay for performance test. The analysis will compare financial performance vs. peers based on three to four key metrics over a three-year period. The new test is called the Financial Performance Assessment and it can influence the overall level of concern triggered by the quantitative assessment of the pay and performance relationship.

In principle, incorporating financial measures into the assessment of pay and performance is a positive change as total shareholder return (TSR) is not always well aligned with a company’s underlying financial performance over any discrete period of time.

However, the ISS financial performance assessment is problematic for several reasons, including:

  • The measures used are not typically going to be the same measures the company uses in its incentive plans and may not be relevant
  • Performance on a GAAP basis may be skewed by one-time non-operating items (e.g., asset write downs, gain on sale of a business, change in tax law, etc.)

While the company may not be able to influence the ISS assessment of the pay program, it is helpful to understand in advance whether you anticipate any pushback. 

We recommend that the compensation committee ask management to model the expected outcome under each of ISS’s four quantitative tests in advance of filing the proxy statement. The results of the quantitative tests provide a good indication of whether or not ISS is likely to recommend “against” on your say on pay vote.

4.         CEO pay ratio

One of the challenges with the CEO pay ratio for the inaugural year of disclosure is not knowing how your pay levels for the median employee, your methodology used to calculate the ratio, and your CEO pay ratio will compare to peers.

In this proxy season, a lot of information will be available to help put the CEO pay ratio into a relative context.

Compensation committees should ask their management teams to provide them with information about how the pay levels for the median employee compares to peers once proxies are out. If there are big differences, it may be worthwhile to examine the methodology used by the peer or to understand differences in the employee makeup and consider if your company’s approach should change; though keep in mind, the difference may be driven by other factors. If there are not big differences, it may provide the committee with some comfort that the disclosure may not raise employee-relations issues.

It will also be of interest to see how the CEO pay ratio compares to peers. While most directors understand that the CEO pay ratio is of limited value, it is reasonable to expect that the press and critics of executive pay will shine a spotlight on any companies that are at the high end of the spectrum. If the CEO pay ratio is high relative to peers, the company may want to develop a clear explanation for employees, the press and shareholders in case they ask questions about why the company appears to be an outlier.

5.        Total shareholder return and incentive pay

The use of total shareholder return as a stand-alone performance measure in performance share plans is on the decline. In our database of 100 large cap companies, we found that 40% of companies used TSR as a stand-alone metric in 2011 but only 9% did in 2016.

In companies where TSR is used as a measure in the performance share plan, compensation committees should ask management whether or not they think it is effective in motivating the team to perform – in our experience, it rarely is. While TSR is an effective measure of the outcome to shareholders on a relative basis, it is not always as motivating as financial metrics as an incentive measure.

Many compensation committees and management teams find that TSR is most effectively used as a modifier in performance share plans, where TSR is used as an adjustment factor to the payouts based on financial measures (e.g., earnings person, return on equity, etc.).

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.