As 2020 mercifully comes to an end, we are looking forward with some optimism to a better 2021. We expect that there will be continuing uncertainty as questions loom about how quickly vaccines will be distributed and how open the population will be to vaccination; however, there is a real possibility that by the close of 2021, the COVID-19 pandemic will be behind us.
From the perspective of the compensation committee, there will be several areas to concentrate on, some related to the impact of COVID-19 on compensation programs and others related to longer term market trends that gained momentum over 2020. Here we share what we consider the top priorities.
Short-term incentive plan design in an uncertain environment
The COVID-19 pandemic made 2020 incentive plans unworkable for many companies, as goals that were set in Q1 2020 were in many cases unattainable by the beginning of the second quarter. For 2021, management teams and compensation committees know that the COVID-19 pandemic is continuing and need to incorporate that into their goal-setting process for 2021. However, much uncertainty remains about how severe the pandemic’s impact will be on financial performance in 2021 and whether the impact of the pandemic will lessen during the latter half of 2021. We strongly recommend that compensation committees consider some or all of the following for short-term incentives for 2021:
- Assess strategic priorities and measures for 2021. 2021 may not be the year to focus on top-line growth. Many companies may be focused on cost reduction, cash generation and preserving the long-term viability of the business as they continue to weather the storm in 2021. It may be unwise to assume that the measures that worked before the pandemic remain the right measures for 2021.
- Widen performance ranges for financial metrics. This approach acknowledges challenges in goal setting and reduces the likelihood of a zero bonus payment or a windfall maximum payment due to an inability to project the economic environment.
- Incorporate relative performance measures. While it can be challenging to identify the right peer set or to conduct true “apples to apples” relative to performance assessments for EPS growth, return on equity or other financial measures, using relative measurement can help reduce the pressure on the goal-setting process in an uncertain environment. Hardwiring a relative metric may not be the answer for everyone, but to the extent a committee decides to exercise discretion, relative performance should be a consideration.
- Consider bifurcating the 2021 annual incentive plan. Companies may be well served by having six-month incentive plans for 2021 with more conservative financial objectives for the first six months of the year and reevaluate goals for the second half of the year in June/July when there may be more clarity around the pandemic’s continued impact.
Long-term incentive plan design in an uncertain environment
Similar to short-term incentives, we expect companies to face similar challenges with long-term incentives, particularly performance share plans. Many compensation committees will consider the following alternatives:
- Modify existing performance share design:
- Widen the performance range.
- Shorten the performance period from three years to one year with two years of additional time vesting.
- Use relative financial measures (e.g., relative EPS growth or relative return on capital) or relative total shareholder return.
- Change long-term incentive mix to move away from performance shares given the goal-setting difficulty.
- Shift toward time-vested restricted stock to bolster executive retention, though these should be relatively modest changes with the intent to migrate back to a greater weighting on performance shares when there is more certainty.
- Shift toward stock options to limit need to set goals while maintaining a performance orientation.
Ensuring retention of executive talent post COVID-19
For many companies, the COVID-19 pandemic has radically devalued outstanding unvested equity awards for executives. Many performance share plans for outstanding cycles are tracking well below target, if they are paying out at all. Better news is that stock prices have recovered for many industries, but that are some areas that continue to lag, particularly in oil and gas, food service and travel. Compensation committees may need to think outside of the box, particularly where they view key talent as a potential flight risk. Potential approaches Committees can take to address retention, include the following:
- Modify outstanding performance plans, which may require new supplemental compensation table disclosure.
- Restore value to outstanding performance cycles by resetting the performance goals to be more realistic and achievable.
- Change performance measures from existing measures to relative total shareholder return.
- Make special one-time grants of equity to restore retentive value via:
- Restricted stock.
- Performance awards linked to stock price appreciation or financial milestones.
- Stock options.
We should note that institutional investors and proxy advisors have made it clear that any actions on long-term incentives will be scrutinized, very compelling rationale must be provided and special grants to the CEO in particular will receive significant pushback. We recommend that Committees review draft disclosures to shareholders describing potential plan changes before approving modifications and carefully consider design features that can demonstrate to shareholders that the Committee has balanced retention concerns with shareholder objectives (e.g., extended vesting, caps on upside, robust performance criteria, limited participation for the CEO, etc.)
Incentivizing ESG performance and accountability
Environmental, social and governance (ESG) concerns are a focus for institutional investors and as a result need to be considered by compensation committees. Recently, there has been increased pressure on compensation committees to link executive pay decisions to progress on improving performance on key aspects of ESG (e.g., reduction of carbon footprint, employee diversity, employee safety outcomes, etc.). The board and the compensation committee will have to use judgment to determine the ESG priorities for the company, the best measures of progress, appropriate goals for progress and what role, if any, ESG measures will play in the compensation program. In our experience, we see ESG measures coming into compensation programs in many ways:
- Qualitative performance assessment for CEO and executive team: Progress on ESG measures assessed on a qualitative basis following a review of objective data on progress (e.g., diversity measures, safety measures, environmental measures).
- Objective weighted measures in annual incentive: Primary ESG measures (e.g., safety for a manufacturing or industrial company; diversity for a financial services firm) weighted as 10%-20% of the total annual incentive opportunity for the management team.
We think that the key step is to measure and report success on ESG measures before jumping in with making it an explicit metric in an incentive as once you put it in, it will be challenging to take it out, even if the rationale is compelling. In addition, it is challenging to measure success on a purely quantitative basis for these measures as there is also an element of the quality of how success was achieved and the difficulty in meeting the objectives in different contexts.
Supporting the company's human capital strategy
For many compensation committees, the responsibility of the committee has extended beyond compensation to include talent development, succession planning, oversight of diversity and inclusion efforts and the company’s overall human capital strategy. Human capital strategy has become an increased area of investor focus and there is a new SEC requirement for disclosure on the company’s human capital strategy:
- Expands disclosure from number of persons employed to “a requirement to provide a description of the registrant’s human capital resources, including in such description any human capital measures or objectives that management focuses on in managing the business, to the extent such disclosures would be material to an understanding of the registrant’s business taken as a whole.”
- Disclosure will be principles-based so there has been significant variance in how companies are responding to the disclosure requirement.
- We have seen compensation committees expanding their responsibilities to encompass the following activities:
- Reviewing management’s employee training and development programs, including efforts at reskilling segments of the population that may be displaced by technology.
- Oversight of pay equity by gender and/or race.
- Reviewing key talent and development information by segment of the business and the business overall, including:
- Succession candidates for leadership roles (external vs. ready now vs. ready later).
- Gender and racial diversity statistics within the business segment and recruitment and employee retention strategies.
- Employee engagement scores.
We expect these efforts to expand as investors will place greater demands on companies for information about how effectively they manage human capital. If this responsibility does not fall to the compensation committee, it is critical to make sure the board is focused on it through another forum.
We think it may be overly optimistic to think that the activities of the compensation committee will return to normal in 2021. We expect that the early part of 2021 will require a continued focus on modifying incentive compensation arrangements to address the impact of the pandemic and ensure that executive talent is retained. As the committee moves towards the second half of the year, we expect the focus to be on ESG and human capital management, as institutional shareholders have identified these as priority areas.
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 boards of directors’ 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.