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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.

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Compensation in Volatile Times

Pay Governance understands that this time of considerable uncertainty and volatility can be challenging for everyone, especially as we settle into new work arrangements and routines. Still, our domain expertise is executive compensation consulting. Therefore, each week we will provide you with a short newsletter to keep you abreast of developments in the executive remuneration world.

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Featured Viewpoints

COVID-19 Stimulus Bill Expands Covered Employees Subject to Section 162(m) Tax Limits

Introduction

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.[1]


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.[2] 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.

COVID-19 Stimulus Legislation Expands Section 162(m) Coverage

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.[3]


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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1. Jean M. McLoughlin and Ron M. Aizen. “IRS Guidance on Section 162(m) Tax Reform. Harvard Law School Forum on Corporate Governance. September 26, 2018. https://corpgov.law.harvard.edu/2018/09/26/irs-guidance-on-section-162m-tax-reform/ .
2. Regina Olshan et al. “IRS Issues Final Regulations Under Section 162(m).” Skadden. December 23, 2020. https://www.skadden.com/insights/publications/2020/12/irs-issues-final-regulations-under-section-162m .
3. Ira M. Golub et al. “New COVID-19 Stimulus Bill Includes Significant Pension Reforms and Expands Scope of 162(m) Compensation Deduction Limit.” The National Law Review. March 10, 2021. https://www.natlawreview.com/article/new-covid-19-stimulus-bill-includes-significant-pension-reforms-and-expands-scope.

General questions about this Viewpoint can be directed to John Ellerman at john.ellerman@paygovernance.com.

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Featured Viewpoint

Inclusion of ESG Metrics in Incentive Plans: Evolution or Revolution?

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.

  • First, we wanted to establish if companies had already incorporated ESG metrics into either their annual or long-term incentive plans.
  • Second, we wanted to determine if companies that had not included ESG metrics in prior incentive plans were adding or considering adding them to their 2021 incentive plans.
  • Third, we wanted to ascertain if companies that had already incorporated ESG metrics in incentives plans were retaining the same approach or altering either the metrics or plan design.
  • Fourth, we wanted to develop a more detailed understanding of the specific ESG metrics selected and how they are measured to better equip companies that are considering including ESG in their incentive plans with key design details.
  • Fifth, we wanted to get a better understanding of shareholder input into the use of ESG in incentive plans.

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:

  • In 2020, 22% of survey respondent companies indicated they included ESG metrics in their incentive compensation plans; for 2021, 29% of companies reported they have incorporated ESG metrics in their incentive plans while 21% of companies indicated they were still uncertain if ESG metrics would be included in 2021 incentive compensation. This finding suggests companies are still hesitant to include ESG metrics in incentive compensation programs despite considerable social and investor support for the subject. Some of the hesitancy may be due to companies’ ability to accurately capture and report the data, establish appropriate targets for each metric and concerns over the potential fallout if ESG targets are not attained.

Companies incorporating ESG Metrics into Incentive Plans in 2020 vs. 2021

  • Of the companies that included ESG in incentive plans, 76% stated they used either solely quantitative or a combination of quantitative and qualitative measurements in the design of their 2020 incentive plans. For 2021, survey companies reported they plan on using these same measurement techniques for their ESG metrics. The use of quantitative goals suggests some companies are able to establish specific ESG targets and measure them with a relatively high degree of accuracy.
  • Most companies include ESG metrics in the annual incentive plans, with a minority of companies including ESG metrics in the long-term incentive plan. For 2021, our study sample reported a slight increase in companies intending to include ESG metrics in their long-term incentive plan. While most ESG metrics are intended to improve a company’s long-term results, annual measurement of some metrics may have better pay-performance outcomes for the organization. For example, a metric based on establishing employee resource groups and measuring their effectiveness on an annual basis may be an excellent approach for improving the company’s culture of inclusivity in the long term and may set the stage for setting a 3-year diversity goal in the future.
  • The scorecard approach, where ESG is measured within a scorecard category, but the individual ESG metrics are not individually weighted, is the most common approach for incorporating ESG metrics into incentive compensation (2020 = 48% and 2021 = 53%). However, many companies use more than one approach for incorporating ESG results in compensation decisions (for example, some companies used a measured metric and/or individual performance factors in addition to the scorecard approach). The scorecard approach has a significant advantage over a measured metric approach, as it allows a company to select a number of ESG metrics (e.g., diversity and waste reduction) in addition to other strategic metrics (e.g., market share) whereas a measured metric is often based on a single metric.


Approaches Used in 2020 vs. 2021 Incentive Plans with ESG Metrics

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.

  • The most common ESG category was social, with 84% of companies including a social metric in 2020 incentive plans and 87% in 2021 incentive plans. The prevalence of the environmental category increased significantly in 2021 with 63% of companies including environmental metrics in incentive compensation — up from 44% in 2020 — reflecting, in part, significant investor interest in environmental issues.

Type of Metrics Used in 2020 vs. 2021 Incentive Plans

  • Diversity was the most commonly used social metric (67% in 2020 and 88% in 2021); a related metric, inclusion and belonging, was also highly preferred (43% in 2020 and 50% in 2021).
  • Based on a closer look at the different types of diversity metrics, gender representation, race representation, and attracting and retaining diverse talent were the most prevalent choices.
  • Human capital metrics were also a commonly used social metric with many companies using employee engagement and succession planning/talent management in their 2020 and 2021 incentive plans.
  • The environmental metrics most often cited for use in incentive compensation plans were carbon emissions and greenhouse gases along with waste reduction and energy efficiency.
  • The survey also found that shareholders are taking an active interest in ESG, with 74% of the survey companies reporting they discussed ESG with shareholders in the last 6 months and 40% reporting that shareholders requested ESG metrics be included in incentive plans.

Our Conclusions

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.” [1]

General questions about this Viewpoint can be directed to John Ellerman (john.ellerman@paygovernance.com), Mike Kesner (mike.kesner@paygovernance.com) or Lane Ringlee (lane.ringlee@paygovernance.com).

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[1] William Thomson. “Electrical Units of Measurement.” Popular Lectures and Addresses, Volume 1, Page 73. May 3, 1883. https://archive.org/details/popularlecturesa01kelvuoft/page/73/mode/2up?view=theater.

Featured Viewpoint

How the COVID-19 Pandemic Influenced Incentive Plans

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:

  1. While approximately 60% of companies took some type of action for their FY 2020 or 2021 incentive plans, the majority of early filers did not make modifications to their AI or LTI plan payouts as a result of the impact of COVID-19.
  2. Modifications to 2020 AI plan payouts were more common among companies hardest hit by the pandemic (defined in our analysis as companies with a revenue decline of 10% or more). Such adjustments were generally viewed as reasonable by shareholders and proxy advisory firms, as the resulting payouts remained below target and applied to all plan participants — not just the named executive officers — and disclosure included a sound rationale and process for making the adjustments.
  3. Modifications to performance share units (PSUs) with measurement periods ending in 2020, modifications to in-flight PSUs, or special/one-time LTI awards intended to offset lost PSU award value have not been well received by shareholders and proxy advisory firms as PSUs are intended to reward long-term performance.
  4. Prospectively disclosed changes to 2021 AI and LTI plans were most common among companies severely impacted by the pandemic. Common changes included new metrics, and, for LTI programs, increased use of time-vested restricted share units (RSUs). Companies that shifted away from performance-based LTI vehicles (e.g., adopted 100% RSUs for 2021) were more likely to receive significant criticism from the proxy advisory firms.
  5. FY 2020 AI and LTI payouts were noticeably lower among the hardest hit companies than other fiscal year-end filers, which suggests companies adhered to a pay-for-performance philosophy.
  6. Institutional Shareholder Services (ISS) and Glass Lewis recommended “FOR” Say on Pay in the same proportion for companies that adjusted incentives and those that did not adjust incentives.

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.

Summary Findings

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:

  • Adjustments to 2020 AI payouts;
  • Changes to AI design for 2021; and
  • Changes to LTI plans for 2021.

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:

  • Excluding financial results for a portion of the performance period (e.g., April-June) affected by COVID-19;
  • Adopting revised measurement periods and calculating performance for each period separately;
  • Approving a plan adjustment to exclude the impact of COVID-19; and
  • Relying on non-financial metrics (predetermined or those adopted in response to COVID-19).

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:

  • Limited visibility into future performance expectations;
  • Likelihood of heightened scrutiny by proxy advisors and investors; and
  • Disclosure of the increased value of modified awards in the Summary Compensation Table and Grant of Plan Based Awards Table under the accounting modification rules and the added accounting expense.

Also shown below, special, one-time awards (cash and/or equity) have been observed, but prevalence remains low:

  • A limited number of companies made special cash or equity awards in 2020/2021 specifically in response to COVID-19; and
  • ISS and Glass Lewis have scrutinized companies making such awards and have generally had an unfavorable reaction regardless of the rationale.

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).

Considerations

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.

General questions about this Viewpoint can be directed to Mike Kesner (mike.kesner@paygovernance.com), Joshua Bright (joshua.bright@paygovernance.com) or Linda Pappas (linda.pappas@paygovernance.com).

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