Topics:   Compensation,Risk Management

Topics:   Compensation,Risk Management

July 8, 2020

Can Pay and Performance Outcomes Be Aligned in 2020?

July 8, 2020

The full economic impact of the COVID-19 pandemic will not be known for quite some time. To date, most companies have focused on broader employee issues, with a minority making reductions to executive salaries or board cash pay, some of which have recently been reinstated. It may now—or soon—be the right time for compensation committees to consider taking action around incentive pay programs, including in-flight performance share unit (PSU) awards.

PSUs are a very common long-term incentive vehicle, used by over 90 percent of large public companies, that frequently account for the majority of long-term incentive grant value. Most often, PSU awards can pay out from zero to 200 percent of the target number of stock units granted based on performance outcomes against three-year corporate performance goals. This means that at many companies there are now three outstanding (in-flight) PSU awards with incomplete performance periods: 2018–2020, 2019–2021, and 2020–2022.

Why act now?

Alignment of pay and performance is one of the primary goals of all executive compen­sation programs. As I write this, the stock price for many companies is now near, equal to, or above where it was immediately preceding the COVID-19 pandemic. (From March 11 to July 3 the value of the S&P 1500 and the component S&P 500, S&P 400, and S&P 600 indices were all up approximately 9 to 15 percent.) In contrast to the shareholder experience—recognizing that more than 150 companies reduced or suspended dividend payments—in-flight PSU awards at many of the same companies are now projected to pay out well below target or potentially not at all.

As a compensation committee, ask yourself: Does this reflect our intended pay and performance alignment? If our stock price has quickly recovered, why would we not act to better align executive pay outcomes with shareholder value outcomes? When PSU payout is based on financial metric goals, there can be a payout when stock price is down; but in those instances, the value of the underlying stock units is impacted by the decrease in stock price, which supports the argument for alignment with shareholder value outcomes.

In addition, compensation should be used as a management tool to support business strategy. This is why it is common for PSU performance goals to be based on financial metrics, such as earnings per share, revenue, or cash flow, that are aligned with the company’s three-year business plan. Also, a common component of executive compensation philosophies is the principle that factors completely or largely outside management’s control should neither materially enrich nor erode actual compensation.

The pandemic resulted in material changes to key near- and mid-term business objectives at most companies. For calendar-year companies (December 31 fiscal year-end), most three-year performance goals for 2020 PSU awards were established in February or March 2020, shortly before the pandemic was declared on March 11. Compensation committees should ask themselves: Do in-flight PSU goals continue to be aligned with the business plan or key objectives? Will performance outcomes that meet or exceed current mid-term business plan objectives result in commensurate PSU payouts? Do current projected payouts for in-flight PSU awards accurately reflect management performance considering what the leadership team can and cannot control through this period of disruption?

The retention of critical talent must be considered in both strong and challenging business environments. Even during economic downturns, top talent will be sought. Making changes to in-flight PSU awards will increase the holding power of those awards. Perceived value matters.

Risks. Ultimate pay decisions for executives should consider any compensation and benefit actions taken for the broader workforce. As part of the in-flight PSU award decision-making process, plans for the company-wide bonus program should be considered. The bonus program impacts a broader group of employees than PSU awards, but the bonus program also has different cash affordability and near-term expense considerations.

An argument to consider in favor of not acting now, or soon, is that discretion can be applied at year end, once full-year financial information is available. There are certainly merits to this approach, but PSU awards function more as a reward than an incentive under this framework, with limited line-of-sight for participants.

Another argument to consider for not acting now, or soon, is that setting new multi-year performance goals for in-flight PSU programs (e.g., 2020 grants) may be very difficult at this time; the required confidence in multi-year goal setting may not exist right now. One way that companies can address this issue is by using relative performance goals, where specific multi-year financial targets do not need to be set.

Finally, companies that act now, or soon, will be early movers (meaning they would not align with “typical” market practice). As a result, the press, proxy advisors, and shareholders will be more likely to put compensation decisions and executive pay programs at these companies under the microscope. Such attention can be addressed, but should not be a surprise to board members or the CEO.

Timeline. Changes to in-flight PSU awards should be viewed as a significant decision, with a litany of shareholder, employee, and technical considerations, including tax, accounting, and legal impacts. Any action should be carefully examined, well-vetted, and approved after discussing such action over multiple compensation committee meetings. Moreover, a multi-pronged communication plan for internal and external stakeholders needs to be put in place for any such changes to be effective.

Key takeaways. There are a number of internal and external considerations when making executive pay decisions, but a company’s unique facts and circumstances should be paramount. Would making changes to in-flight PSU programs at your company be in the best long-term interests of stockholders? Would making changes to in-flight PSU programs at your company support the alignment of actual pay and performance outcomes? For many companies, being conservative and playing defense (for the time being) may not lead to the best outcomes for employees and stockholders. Early birds may very well get the worm—or in this case, better outcomes for the company and its stakeholders.

Matt Vnuk is a partner at Compensation Advisory Partners, located in New York. He advises compensation committees and senior management teams on their companies’ most pressing compensation issues, including annual and long-term incentive plan design.


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