Introduction

As uncertainty over the future of the COVID-19 pandemic continues, organizations may struggle to develop an accurate earnings forecast for their next fiscal year — particularly companies with a new fiscal year starting in calendar year 2020. Many high-profile companies like Abbott, ConocoPhillips, and PepsiCo have already suspended future earnings guidance, citing the uncertainty surrounding the extent and length of the pandemic’s impact on business operations. Several of our recent Viewpoints have explored options to address the challenges of dealing with 2020 incentive plan goals established prior to the pandemic, including placing a higher scorecard weighting on non-financial goals and using discretion in determining payouts. Looking to 2021, companies facing continual challenges in setting financial goals may want to consider shifting the mix of an executive’s variable pay from annual incentives to long-term incentives (LTI).

Options for Shifting Variable Pay Mix

We believe there are two alternative approaches for modifying an executive’s variable pay mix:

• Alternative 1: Shift the portion of the annual incentive opportunity based on financial goals to an LTI award while keeping the portion based on non-financial goals
• Alternative 2: Deliver the entire target bonus opportunity in an LTI grant

Alternative 1 may be appropriate for companies that have a meaningful weighting on non-financial goals (e.g., 25%+) whereas alternative 2 could be applicable at companies where financial goals comprise a larger majority of the annual plan (e.g., 80%+).

In terms of delivering the additional LTI compensation, two potential options include:

• Grant additional LTI awards based on the current LTI mix
• Skew additional LTI awards toward restricted shares

Since the majority of companies deliver at least 50% of their LTI awards in performance shares, granting the incremental award based on the current LTI mix ensures that the majority of incentive pay is performance based.

However, increasing the weighting on restricted shares may be appropriate: restricted shares provide more payout certainty during a time of significant uncertainty while the ultimate value at vesting is aligned with shareholder gains (or losses). Increasing the restricted share weighting would make particular sense at companies where the overall weighting on performance shares would remain at 50%+.

Additional considerations associated with shifting variable pay towards LTI include:

• If no portion of the current LTI awards vest one year from grant date, consider granting cash-settled restricted stock units that vest after one year with a value equal to an executive’s foregone target annual incentive award in order to keep their overall payout timing consistent with current incentive awards.
• If the enhanced LTI opportunity is delivered in restricted shares, it may be appropriate to “discount” the additional LTI opportunity given the lack of a performance component.

Companies with broad participation in their annual incentive plan or a separate plan will need to decide on an approach for these employees. Alternatives could include a lump cash opportunity that is discounted from target (e.g., 10%) or restricted shares with a 1-year vesting period.

Conclusion

While we normally would not suggest transitioning compensation from annual to long-term pay, these are not normal times and this approach could provide certain advantages. For example, it may eliminate or mitigate the need for committee discretion in determining annual incentive payouts. Further, not only would it eliminate the need for setting one-year financial goals, it would also eliminate the possibility of a significant payout on goal achievement that is below historical levels. In an earlier Viewpoint, we suggested that “ Everything Should Be On The Table ” in formulating a response to the impact of the pandemic. As companies begin looking ahead to 2021, given the unprecedented disruption, we believe shifting the compensation mix should be part of the discussion.

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General questions about this Viewpoint can be directed to Richard Meischeid at richard.meischeid@paygovernance.com or Keith Jesson at keith.jesson@paygovernance.com.

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Companies are facing unprecedented challenges as the spread of COVID-19 has drastically changed the business landscape, as discussed in our March 23rd Viewpoint, "Everything Should Be On The Table. " One of the many issues that companies are grappling with is how to ensure that incentive plans reflect business realities. In the absence of clarity on what the remainder of the year could bring, committees and management are beginning to discuss if or how FY2020 incentive plans should be amended.

While it may be too soon for companies to reset financial goals, companies with an Individual Performance Factor (IPF) in their annual incentive plan should consider how well the predefined objectives align with the redefined priorities of the business. Even if business priorities have not generally changed, effective leadership may mean something different today and need to be viewed through a lens with consideration of this new reality.

While some individual goals — such as employee engagement — are still relevant, others may need to be shelved in favor of more pressing objectives. Goals related to preparedness, crisis management, innovation, and critical execution are likely to be the most common new additions to IPF scorecards. Additionally, new IPF criteria will likely be more subjective in nature than is often preferred, as objective outcomes will likely be impossible to estimate or predict.

In our earlier Viewpoint, “The Role of Non-Financial Metrics in Annual Incentive Programs,” we laid out examples of enterprise-wide non-financial objectives that committees may include in their assessment of 2020 performance. For companies with an IPF in their annual incentive plan, examples of potential “new reality” performance criteria may include evaluating the success or effectiveness of:

• Maintaining previously developed business plans in response to a global pandemic
• Executing the continuity of the business plan in response to COVID-19 requirements
• Prioritizing the development and communication of an emergency succession plan
• Setting a “tone at the top” by maintaining a positive and productive work climate in light of current events
• Striking an appropriate balance between the needs of various stakeholders — namely employees, customers, and communities — and business plan objectives
• Navigating a quickly changing landscape
• Directing creative and innovative solutions where a “playbook” did not previously exist
• Pivoting strategy, where necessary, to reduce risk and/or capitalize on opportunities
• Quickly mobilizing the appropriate resources to execute the change in strategy
• Executing the reopening/back-to-work process
• Directing the capital management plan

Revising the executive team’s IPF objectives to reflect the “new realities” of the business is a positive, low-risk opportunity for committees to retool incentive plans, ensuring management is motivated and accountable to these new priorities. Additionally, it will provide management and shareholders with a clear indication of what committees value from their leaders in this “new reality” and will signal their engagement on these important responsibilities to all stakeholders. The CD&A should provide a thorough description of the rationale and process for realigning the IPF criteria and the evaluation approach used to assess this performance.

General questions about this Viewpoint can be directed to Richard Meischeid at richard.meischeid@paygovernance.com or Chris Brindisi at chris.brindisi@paygovernance.com.