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The financial impact of the current pandemic has affected most aspects of the compensation programs for executives and nonemployee members of the Board of Directors. Stock ownership requirements covering those individuals are no exception and will be reviewed by companies as they assess compliance with those guidelines.
Stock ownership guidelines are a near universal practice at larger publicly traded companies and are considered a governance best practice. Ownership guidelines require executives and directors to maintain meaningful stock ownership during their tenure. Officers have significant additional investments in the company — usually through several years of outstanding, unvested equity awards. In the case of performance shares, the award opportunity is leveraged to both achieve specified goals and stock price movement. This Viewpoint focuses on those elements of ownership guidelines often subject to greater volatility in company stock price and performance.
A common structure requires executives to achieve a specified ownership level within a five-year period. However, most companies now grant at least 50% of their target long-term incentive (LTI) opportunities as performance-contingent awards (e.g., performance shares) based on achieving financial and/or total shareholder return goals, often over a three-year period. With the current crisis potentially eliminating the opportunity to earn shares from one, two, or all three outstanding performance cycles, meeting the guidelines within a five-year timeline could be difficult. Increased stock price volatility brought about by the pandemic may exacerbate the situation, resulting in individuals shifting between compliance and non-compliance solely due to swings in stock price.
As a result, this may be an opportune time for companies to review the governance and administrative polices of their stock ownership guidelines to ensure they align with the company’s objectives and will not require numerous exceptions during periods of heightened economic and stock price volatility. Since stock prices decrease and increase, it is important to have policies that are durable in both down and up markets. For companies experiencing sustained and significant stock price declines (a decrease of 50% or more), instead of pursuing design changes some may decide to suspend updating the assessment (e.g., use the results of the prior year’s compliance review and consider the ownership guideline maintained or, for those building to compliance, “on track” as long as the individual’s number of shares considered owned did not decrease) until the stock price recovers.
The table below examines stock ownership guideline design provisions that mitigate stock price volatility and recognize that most companies emphasize performance-contingent awards in their regular LTI grants.
Thoughtfully designed officer and director stock ownership guidelines are an important part of a well-designed executive pay program. Guidelines should balance reasonable stock accumulation and retention of shares over time, external stakeholder perspectives, and desires for individuals to plan for financial needs in retirement. In the end, stock ownership guidelines are just that: guidelines. There are no “generally acceptable stock ownership principles” that must be met. However, proxy advisors and many institutional investors have well-established perspectives on executive and director stock ownership guidelines. As a result, companies should ensure their stock ownership guidelines and administration practices best align to their objectives, culture, officer demographics, and other factors they deem important.
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).
We believe there are two alternative approaches for modifying an executive’s variable pay mix:
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:
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:
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.
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.
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:
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.
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