Challenges to Compensation Committees in 2021

This article originally appeared in the March/April 2021 issue of Boardroom Insider and is republished here with permission.

Over the past year, corporate executive pay setting has gone from being difficult to excruciating. The COVID-19 crisis, stakeholder concerns, and pay equity pressures now force compensation committees to juggle uncertain, fast-changing, and often contradictory demands.

The global pandemic and social unrest of 2020 presented many challenges to businesses around the world. For 2021, boards of directors continue to grapple with the human and economic toll caused by COVID-19. Within this environment, they are compelled to weigh a broader range of corporate stakeholders. As such, boards must consider how these forces have changed their roles, what new expectations there may be, how best they can meet them, and what the implications are for company performance and executive pay.

To understand the board compensation committee’s job in 2021, we examine three shifts that were under­way in 2019 and early 2020—greater consideration of critical stakeholders; ensuring pay equity; and the setting of rigorous performance goals (and how the pandemic accelerated or altered them).

 

Shift No. 1: Elevation of Critical Stakehold­ers

Traditionally, the primary stakeholder has been thought of as investors. However, before the pandemic, this definition was already starting to broaden. In August 2019, the Business Roundtable released a statement signed by 181 CEOs saying the purpose of a corporation is to promote an economy that serves all Americans. This expands the previous focus from shareholder primacy to specify additional stakehold­ers such as employees, suppliers, customers and the community. Though some considered it somewhat controversial, committees are now focused on think­ing about how executive pay should be structured to address the impact of these additional stakeholders.

 

Stakeholders and Compensation: Adapting Pay Plans to New Needs

 

Underscoring the recognition of human capital as one of a company’s primary drivers of stock price and company value was the SEC’s Regulation S-K amendment in 2020. It requires companies to disclose information about their human capital resources, including measures or objectives that they use to manage their businesses. Compensation committees are likely to embrace this human capital strategy, including employee engagement, talent development, succession planning and oversight of diversity and inclusion efforts.
 
Linking executive pay to the performance of stakeholders as well as other aspects of environ­mental, social and governance (ESG) criteria poses challenges. Based on our analysis of the BDO 600 companies, about 14 percent mention specific ESG metrics used in their short-term incentive plans. To move the needle, the committee will need to fully understand the value drivers of the company, which metrics should be used to gauge progress, and the extent to which goals achieved can and should be reflected in executive pay.
 

As businesses face another wave of the pan­demic, the incorporation of ESG measures into pay plans will likely take a back seat to other metrics.

 
Institutional investors’ growing focus on ESG is reverberating through incentive discussions as com­panies evaluate the use of ESG goals or metrics in their 2021 annual bonus and performance share unit plans. Ultimately, though, use of ESG metrics needs to be guided by their linkage to company performance.

As businesses contend with another wave of the pandemic, the incorporation of ESG measures into pay plans will likely take a back seat to other metrics, specifically those relating most directly and im­mediately to company performance. For companies that do use ESG metrics, they will likely represent a nominal portion of incentives. This is because there is limited ability to track the impact of many ESG measures on company success and inadequate objective scoring with ESG measures.
 
With the expanded definition of stakeholders, com­pensation committees have to consider where they will focus their attention. Boards need to question whether having additional stakeholders will “dilute” or shift the focus away from investors, or whether investors will trump the other stakeholders and thus dilute the focus on them.
 
From a public company perspective, the overarch­ing strategic objective is to create shareholder value. With the increasing awareness of the importance of other stakeholders, boards face the challenge of determining the role of these stakeholders in creat­ing shareholder value, and how to best manage and cultivate this value.
 

When COVID-19 hit, many employees had their pay reduced as companies sought to save cash to navigate the effects of the pandemic recession.

 

Shift No. 2: Pay Equity

Another compensation shift underway at the end of 2019 was pay equity. Before the pandemic, there was increased focus on gender and minority pay equity. When the pandemic hit, many employees had their pay reduced as com­panies sought to save cash to navigate the effects of the pandemic recession.
 
As of December 2020, women had lost the most jobs since February, 5.3 million versus 4.6 million for men, according to the U.S. Bureau of Labor Statistics. While many of these jobs reside in service-oriented industries, the pandemic’s disproportionate impact on women and minorities may result in increased cul­tural and societal pressures for pay equity in general.

BDO’s study on CEO/CFO pay found that 14 percent of board members, 19 percent of CEOs, 17 percent of CFOs and 17 percent of NEOs (named executive officers) took a pay cut, in part to show solidarity with their employees. However, these reductions were tem­porary, generally lasting about six months. As some employees have struggled, committees will need to ensure that executives are not benefiting financially as a result of employee layoffs or pay reductions.
 
Compensation committees also need to be mindful of the possibility that executives are being overpaid relative to performance. Many have seen their pay rise with the value of the stock that comprises a significant portion of their compensation.
 
According to the BDO 600 report, equity and other long-term incentives comprise over 55 percent of the CEO’s compensation package. This means stock price performance has a very significant impact on the level of executive pay, and could risk equity plans overriding the performance impact of other incentive plans.
 
Boards also need to watch for employee pay reduc­tions that result in generating better profits for the company. Better profits may, in turn, result in funding an executive bonus.
 
COVID-19 increased scrutiny of “excess pay” by proxy advisory firms, amplified existing compensa­tion issues and created urgency for change. The CEO pay ratio for companies in the S&P 500 was up to 264:1 in 2019, and companies should be mindful that any year-over-year increases to the CEO pay ratio will be closely scrutinized.
 
In March, 2020, Glass-Lewis observed “Trying to make executives whole at even further expense to shareholders and other employees is a certainty for proposals to be rejected and boards to get thrown out—and an open invitation for activists and lawsuits onto a company’s back for years to come.” As the pandemic continues into 2021, boards would be wise to heed these words.
 
However, the reality is that to retain executive tal­ent, some companies will still need to ensure their executives get paid bonuses. Executive retention is a priority for companies looking to stabilize operations and business continuity.

 

Shift No. 3: Marketplace Disruption and Goal Setting for 2021

For 2021, disruption in the market­place and the persistent uncertainty around a recovery make it difficult for boards to set reliable and realistic goals. Boards face two significant challenges for selecting incentive performance metrics and setting goals: a high degree of uncertainty in the upcoming year, and the heightened scrutiny and accessibility of information about their decisions. Directors will be well served to use a rigorous framework for selecting metrics. This can help balance the need to ensure real value creation versus the impact of the market on executive pay. This can be accomplished by con­sidering each metric based on its “dimensionality:”

• First dimension: Metrics that focus on top line revenue, sales, or market share.
• Second dimension: Metrics that focus on not only top line, but also consider expenses. The most prevalent of these metrics are EBITDA, cash flow, net income, or operating margin.
• Third dimension: Metrics that focus on top and bottom line, but also include finance, investment, and capital funding metrics. The most prevalent of these metrics are EPS growth, ROIC, ROE and ROA.
• Fourth dimension: Metrics that represent the first three dimensions, but also include future expectations, converting intrinsic value to fair value. Largely, the only measure that incorporates future expectations is the fair market value of the stock, making total shareholder return (TSR) the most prevalent measure.
• Strategic dimensions: As a final catch-all, there are some other KPIs or strategic goals that do not focus on the financials or stock prices. These impor­tant measures are sometimes seen with ESG goals, discretion, and other specific business outcomes.

 

A balanced portfolio of short- and long-term incentives can help ensure incentive plans will operate to create long-term value and represent all stakeholders.

 
Creating a balanced portfolio of incentives (both short and long term) along each of these five dimen­sions can help to ensure that incentive plans will operate to create long-term company value, and represent all of the stakeholders identified in the Business Roundtable.

There are several actions that can be taken to struc­ture incentive plans to make them more responsive to today’s economy:

• Review peer group. Boards may want to con­sider reevaluating their peer group, especially if their company has undergone a restructuring, reorganiza­tion or change in strategy. Having a peer group that accurately reflects the state of their company gives perspective on how they are performing given external market pressures and dynamics.
• Implement relative performance measures. Because goal setting is more challenging in this volatile environment, benchmarking against peer performance is a commonsense approach that boards can employ. Using relative measures in place of ab­solute company performance measures mitigates the risk of “penalizing” management for circumstances beyond their control. This approach enables the board to evaluate how the executive team performs relative to others under similar external circumstances. However, it increases the pressure on the selection of peers. Since payouts may be earned for good rela­tive performance but poor absolute performance, it is important to have a good communications plan. If companies decide to use absolute measures, compen­sation committees should be highly aware of whether goals may be considered too easy to achieve by either proxy advisory firms or investors.
• Expand performance ranges. With the potential for increased volatility of financial indicators, com­panies should consider an expansion of performance ranges, widening the spread between thresholds, tar­gets and maximums. This may seem counterintuitive because expanding the range could mean lowering the threshold. However, it also means that a higher level of performance is required to earn awards above target, and yields a flatter, less leveraged incentive curve.
• Lengthen stock holding periods. To help ensure that executives are committed to the company’s long-term performance, implement longer holding periods and strong ownership guidelines.

For companies struggling to meet performance targets, adjustments may be inevitable. However, compensation committees should consider the unap­proving view that proxy advisory firms have for any upward adjustments to annual executive performance incentives. Changes that trigger a negative response from investors could result in further opposition from them down the line.

For companies that are outperforming targets, again, adjustments may also be inevitable. For com­panies in industries that are performing well, the question is whether bonuses, which may be quite lucrative, should be paid in full. This is a sensi­tive issue if the goals were exceeded as a result of COVID-19-related circumstances rather than actual executive performance.

While executive retention is an imperative, it is also important not to disenfranchise employees and other stakeholders by paying large incentives to executives while others struggle. Compensation committees need to think about whether and how to talk to the board about downward discretionary adjustments.

Boards are still contending with the ongoing ef­fects of the global pandemic and the lack of certainty around how and when it will come to an end. As such, they have to plan for multiple economic scenarios.

Their role is to ensure that that the company they serve is doing the utmost to provide the goods and services needed and wanted in a way that supports a healthy and robust economy in which Americans can thrive. This means taking a step back to pull all stakeholders into the picture, and make careful decisions based on a full set of information.

Restructuring performance-based compensation programs to reflect the current realities of doing business during a crisis is challenging. At this point, boards likely know the specific imperatives they need to prioritize in order to navigate the COVID-19 pandemic successfully—that includes retaining executive talent.

Balancing the needs and interests of a growing body of stakeholders while steering potentially em­battled companies through to stability is no small feat. Compensation committees need to analyze how to successfully drive the company’s strategy, via effective compensation plan design.

 

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