Pay Governance LLC is an independent firm that serves as a trusted advisor on executive compensation matters to board and compensation committees. Our work helps to ensure that our clients' executive rewards programs are strongly aligned with performance and supportive of appropriate corporate governance practices. We work with nearly 400 companies annually, are a team of nearly 60 professionals in 13 U.S. locations with affiliates in Europe and Asia with experience in a wide array of industries, company life cycles and special situations.Find out how we work
Section 162(m) of the Internal Revenue Code (IRC) became effective in 1994. The intent of Section 162(m) was to limit the tax deductibility of compensation paid to the “covered employees” of publicly traded companies that was in excess of $1 million per year. Section 162(m) initially provided for an exemption for qualified performance-based compensation such as performance-based incentive plans that received shareholder approval and satisfied other performance criteria.
In December 2017, Congress passed — and President Donald Trump signed — the Tax Cuts and Jobs Act of 2017, which included certain amendments to Section 162(m). These amendments eliminated the exemption for performance-based compensation and expanded the scope of individuals who may qualify as covered employees subject to the $1 million annual compensation limitation deductibility. The covered-employees provision of the IRC Section 162(m) was expanded to include the CFO position in addition to the CEO and the three other highest-compensated executive officers during the applicable year. On December 18, 2020, the Treasury Department and Internal Revenue Service issued final regulations regarding the amendments made to Section 162(m) created by the Tax Cuts and Jobs Act of 2017.
In early March 2021, Congress passed — and President Joe Biden signed — the American Rescue Plan Act of 2021 (the “Act”), which is a $1.9 trillion economic stimulus bill. Designed to provide economic relief to the American people during the COVID-19 pandemic, primarily through the tax code in the form of stimulus payments, expanded employment benefits, and expansion of the child tax credit.
One of the lesser-known provisions of the Act is an expansion of the number of covered employees subject to the Section 162(m) compensation deduction limits. The Act specifies that for any taxable year beginning after December 31, 2026, the covered employees will include the company’s five highest-compensated employees for that year in addition to the CEO, CFO, and three other highest-compensated officers. As a result, the company will only be able to deduct $1 million in annual compensation expense for each of its ten highest-paid employees for the applicable fiscal year beginning in 2027. However, the five additional employees will not be treated as covered employees for all years thereafter and must be redetermined each year.
Because the impact of this tax law change is five years into the future, most U.S. companies have not yet fully assessed the economic consequences of its potential impact.
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Environmental, Social, and Governance (ESG) issues are some of the most prominent facing Corporate America: shareholders and other stakeholders have significantly increased the focus on a corporation’s social responsibilities, including promoting a fair and diverse workplace, providing employees with a living wage, and improving the environment. Large institutional investors are demanding enhanced disclosure of employee demographics and diversity efforts as well as a full discussion of the near- and long-term steps that will be taken to attain net-zero emission goals.
Given the intense focus on ESG, Pay Governance LLC conducted a survey of companies in January 2021 to document how companies have been responding to the focus on ESG and whether it is resulting in a change in the design of incentive compensation plans. We had several goals in mind in conducting the survey.
In reviewing the survey results, Pay Governance found some emerging trends and considerable insight into the mechanisms, metrics, weightings, and shareholder views for including ESG in incentive compensation programs. Some of the key takeaways from the survey include:
The weighting of ESG metrics contemplated for 2021 incentive plans is typically less than 25%. In general, most companies tend to weight non-financial measures less than 25%. Given the lack of experience some companies have in using ESG metrics in incentive plans, many are taking a conservative approach in weighting ESG metrics.
Our survey reveals that an increasing number of companies are including ESG metrics in their incentive plans in 2021, with most utilizing social and environmental metrics. The inclusion of ESG in incentive plans is perhaps one of the most significant changes in executive compensation in over a decade; as an emerging trend, several companies have selected approaches that provide a high level of flexibility (such as the scorecard approach) but have also incorporated metrics that can be measured quantitatively (e.g., employee engagement, diversity/representation levels, reduced waste, etc.) to provide goal clarity and measure progress towards longer-term objectives.
The survey also documents most companies are taking a “wait and see” approach to incorporating ESG metrics in their incentive plans. At the time we closed our survey (late February 2021), only 29% of the survey respondents had committed to including ESG metrics in their 2021 incentive plans. We believe that many companies will assess the proxy disclosures of their peers and other leading companies during the 2021 proxy season to evaluate how other companies are using ESG metrics while, at the same time, reviewing which ESG metrics best fit their business strategy and are suitable for inclusion in their incentive plans. Based on client experience, we also believe the uncertain financial outlook resulting from the COVID-19 pandemic has made some companies reluctant to institute significant incentive compensation plan changes until a full and robust economic recovery is underway. Another potential stumbling block to ESG metric adoption is the ability to properly measure certain environmental and social metrics as well as the lack of readily accessible databases with clear insights as to expected norms.
We expect many companies will use 2021 as a “launching pad” for finalizing and rolling out ESG metrics in 2022 given the strong interest of institutional shareholders and the investment community in ESG. As the old proverb goes, “whatever gets measured gets managed,” and linking ESG to executive incentives is a sure-fire way to make sure a company’s ESG priorities are given the attention required to ensure its sustainability.
William Thomson, the Scottish physicist also known as Lord Kelvin, once shared this sentiment:
“I often say that when you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot express it in numbers, your knowledge is of a meagre and unsatisfactory kind; it may be the beginning of knowledge, but you have scarcely, in your thoughts, advanced to the stage of science, whatever the matter may be.” 
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The COVID-19 global pandemic has had a profound impact on the economy and forced many companies to make dramatic changes in staffing, operations, supply chains, and short- and long-term business plans. At the time this article is being written, close to 10 million fewer people are employed in the U.S. than at this time last year. Many companies acted swiftly at the onset of COVID-19 in the U.S. by implementing base salary reductions, enacting furloughs, suspending 401(k) matches, and taking other measures to reduce cost, improve cash flow, and strengthen balance sheets. By the end of April 2020, as lockdowns eased, the major stock indices started to recover, and companies showed their resiliency by adapting their operations to fit the new COVID-19-dominated environment.
As companies reset business plans and priorities in response to the pandemic, compensation committees and senior management teams also began to assess the pandemic’s impact on their incentive plans — both what had happened and what may yet happen — and discuss what actions, if any, might be appropriate to address these disruptions in compensation programs that were established prior to the onset of the pandemic.
Pay Governance reviewed the proxy filings of S&P 1500 companies (available as of February 8, 2021) with fiscal years (FYs) ending between April 30, 2020 and October 31, 2020 (“early filers”). We focused on disclosure related to 2020 annual incentives (AIs), long-term incentives (LTIs) with performance periods ending in 2020, and “in-flight” incentive awards (i.e., incentive awards with a performance measurement period that has not yet concluded). We also reviewed forward-looking disclosures about 2021 compensation structures to identify the key changes (or lack thereof) and researched how shareholders and the proxy advisory firms reacted to the changes.
Our research revealed the following key takeaways:
The insights and data gathered from these “early filers” are not prescriptive, but rather one of several reference points for companies to consider as they determine go-forward annual and long-term incentive designs and draft CD&A disclosure related to changes that have already been approved/implemented.
Approximately 60% of early filers took some type of action for their FY 2020 or 2021 incentive plans. These actions included modifications to 2020 AI plan payouts based on discretion and revised 2021 long-term performance plan designs.
When we adjusted for business impact (as measured by changes in revenue), those companies that were more severely impacted were more likely to have made:
As Figure 1 below indicates, 2020 AI and PSU payouts (for cycles ending in 2020) tracked closely with business impact, as those companies with year-over-year revenue decreases in their last two fiscal quarters had noticeably lower incentive payouts as a percentage of target.
As shown in Figure 2 on the next page, most companies that adjusted AI payouts for the impact of COVID-19 relied on compensation committee discretion — either positive or negative. Other actions included:
It is important to note that companies with individual performance metrics appear to have incorporated modified performance criteria (beyond what was established at the beginning of the year) to include COVID-19-related actions.
As shown in Figure 3 below, the vast majority of companies that adjusted AI plan payouts kept the final payout below target.
As shown in Figure 4 on the following page, most companies did not adjust their in-flight PSU plans (i.e., those with ≥1 year remaining in the performance measurement period) due to:
Also shown below, special, one-time awards (cash and/or equity) have been observed, but prevalence remains low:
As shown in Figure 5 below, prospective changes to 2021 AI/STI and LTI plans (when disclosed) have been primarily related to metrics and weightings (and, for some AI plans, revised measurement periods).
Based on our experience, many companies facing continued uncertainty are considering (or have implemented) an assortment of changes to 2021 incentive designs: setting wider performance goal ranges, adopting an AI plan based on a bifurcated performance period (i.e., first half/second half), adding a non-financial component to the AI plan, incorporating relative metrics in PSUs, and using three 1-year performance goals to measure PSU performance. We anticipate many of these changes are temporary in nature and expect companies to revert to “normal” incentive designs in 2022.
We also believe that 2021 LTI target award values are likely to modestly increase over 2020 levels as companies in severely impacted industries may consider allowing participants to “earn-back” some of the lost value from AI plans and outstanding long-term performance cycles impacted by COVID-19. We also anticipate that lesser-impacted/stronger-performing companies are likely to reward performance and help retain their key talent due to the robust labor market in their respective industries. We advise caution in increasing LTI award values: a significant increase may be difficult to justify when revenue, earnings, and/or stock prices are down or the increase is of such significance it could be viewed as the equivalent of a special LTI award.
Finally, it is to be expected that, as disclosure for companies with calendar year through March 31st fiscal year-end becomes available (i.e., those that have a greater portion of FY 2020 impacted by the pandemic), we may observe increased prevalence of actions taken related to 2020 and 2021 compensation programs.
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