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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

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Featured Viewpoints

Establishing Meaningful and Rigorous Financial Goals

Introduction

In developing annual incentive plans, the review and approval of meaningful financial performance targets can be a challenging task for the Board of Directors’ compensation committee. The frequent source of these financial performance targets is the company’s annual budgeting process. These performance targets are also often the basis for providing earnings guidance to the investment community. Absolute financial targets are the most difficult to establish and are the most common type of goal used in annual incentive plans. Many companies use relative financial performance goals such as relative total shareholder return (TSR) in their compensation program, but they are more frequently found in long-term incentive plans.

Absolute financial targets vary among companies and within industries, although the majority of these financial metrics are tied to company earnings. In certain industry sectors, another key performance metric is annual revenues. Annual earnings performance can be measured as either the quantity of earnings or the quality of earnings. A quantity of earnings measurement is tied directly to the company income statement and is typically expressed as net income, net operating income, earnings before interest and taxes, earnings per share (EPS), or another earnings target. In some cases, the quantity of earnings target may be presented in terms of growth over the preceding year’s actual results. The quality of earnings metric incorporates the company’s balance sheet in the equation by considering if the earnings generate a sufficient return on investment. This metric may take several forms — such as return on assets, return on equity, or return on capital employed.

The budgeting process at many companies often begins several months prior to the beginning of the performance year. In some cases, the budgets are finalized and approved at the beginning of the year based on the best available data and assumptions, which may not include competitors’ most recent financial results or their earnings expectations for the upcoming year. A company’s budget philosophy can also have a significant impact on the suitability of using budgeted revenue, earnings, and returns as the target goals in the annual incentive plan. Companies that establish “aspirational” budgets might conclude that achievement of budget targets should result in higher-than-target payouts. Conversely, companies that establish budgets that are deemed highly achievable and include significant reserves for uncertainties might set incentive plan targets above the budgeted amounts. Thus, there may be a number of reasons why the annual budget and annual incentive plan targets are not the same.

The thesis of this Viewpoint is to answer two questions:

  1. Are the company’s absolute financial performance goals sufficiently rigorous?
  2. What steps should management and the compensation committee take to test the rigor of the financial performance goals to ensure there is a proper degree of due diligence in this important governance process?

Establishing Rigorous Absolute Financial Targets

Annual incentive programs often include hundreds if not thousands of plan participants and can be a key driver of company performance. In the ideal world, incentive metrics are well-understood, plan participants can directly influence the selected metrics, and the goals are both challenging and motivational.

As noted, many companies use the annual budget as the starting point for establishing the performance targets used in the annual incentive plan. The annual budgeting process is typically rigorous and requires significant input from both corporate and business unit leaders and a review of external data, including economic forecasts and industry expectations, before the budget is presented to and approved by the full Board of Directors.

In addition to considering the underlying budget assumptions, there are several steps that can be taken to evaluate if the absolute performance metrics are rigorous, as discussed below.

Performance Targets Relative to Past Performance

Companies often establish future performance targets based on growth over the prior year’s actual results. These improvements may include top-line growth, expanded margins, higher returns on capital, increased cash flow, or — in some cases — a combination of higher and lower results such as accelerated revenue growth with flat or slightly lower margins. Some investors and the proxy advisory firms consider prior year financial results an “anchor point” for future performance targets and will react negatively to current year targets below prior year actual financial results, absent a compelling rationale (for example, a business divestiture or loss of a major customer). Author’s Note: In some cases, FY 2020 may not be a good starting point for evaluating improvements in earnings due the adverse impact the global pandemic had upon the Company.

A useful tool in comparing current year targets to the prior year’s actual results is the use of a “financial bridge” that details the key variables and assumptions used to bridge last year’s actual results to the current year plan. Projected changes in market growth, market share, product pricing, cost reduction/efficiency, foreign currency, etc. help explain projected improvements in, or challenges to, performance. These allow management to demonstrate to the committee that the current year performance targets are supported by reasonable assumptions, and the resulting goals are sufficiently challenging.

Performance Targets Relative to Peers

Several companies have a well-defined peer group that is used for performance comparisons by company management, investors, and analysts. Unlike the compensation peer group, these companies may be larger or smaller than the company. We recommend that a 10-year history (if available) be created to track the Company’s performance relative to peers in order to establish if it is more profitable and/or growing faster than its peers.

This data is an important step in evaluating the degree of rigor in performance targets: a company that has historically grown faster than its peers, or achieved higher margins or returns on capital, would be expected to maintain its superior position even if the peers are closing the performance gap. Conversely, companies that have historically lagged their peers would be expected to implement changes in the business to accelerate performance improvements and begin to close the gap with its peers.

In some cases, a company may only have two to three direct competitors for performance comparison purposes; while not as reliable as a broader data set, the data and analysis may still provide valuable insights on goal rigor.

Performance Targets Relative to Guidance and Market Expectations

Prior to the global pandemic, most large companies provided earnings guidance and prepared detailed investor presentations to set expectations for the coming year. In most cases, investor guidance is provided as a range — for example, revenue growth of 3%-5% and operating margin of 12%-14%. Earnings guidance is often set at a level that management and the Board have a high degree of confidence of achieving. While guidance may be somewhat conservative, there may be an adverse reaction from investors that creates downward pressure on the stock price if guidance is set too low.

Thus, it is incumbent on management to set realistic expectations.

The rigor of a company’s incentive targets can often be evaluated based on its position relative to guidance. For example, incentive targets at the midpoint or higher end of the guidance range would suggest a fair amount of rigor; targets above the high end of guidance might indicate the incentive targets are potentially aspirational and might warrant an above-target payout if achieved; and targets set below the midpoint or the lower end of the guidance range may require further explanation, as paying target incentives when actual performance is below shareholder expectations could be problematic.

Performance Results Compared to Prior Year Targets

Another effective technique to evaluate the rigor of performance targets, albeit with the benefit of 20-20 hindsight, is to compare actual performance to target over the past 5 to 10 years. If the company has generally achieved 80% to 120% of target payouts over multiple years, it may suggest the goal-setting process has been effective and the resulting outcomes have been fair to shareholders and plan participants.

On the other hand, if payouts are highly volatile or payouts are consistently well above or below target, it may indicate the goal-setting process should be reviewed to determine if the outcomes were warranted.

For example, one company may be falling consistently below target because the CEO or Board is establishing stretch targets that cannot be achieved. In another situation, the company’s business may be so volatile that setting annual performance goals has been a significant challenge, resulting in wide swings in incentive payouts over time. A third company may have consistently paid above target and can support the outcome with outsized shareholder returns and industry-leading growth and profitability.

Performance Relative to Total Shareholder Return

Another test for evaluating the suitability of the performance metrics and goal rigor is a comparison of annual incentive plan payouts as a percentage of target as well as absolute and relative TSR. Over long periods of time (7 to 10 years) the trend line for annual incentive plan payouts with a company’s absolute and relative TSR would indicate the market is rewarding shareholders at a similar rate as the company is rewarding incentive plan participants for achieving annual performance results.

Correlation analyses can also be performed to assess how closely annual performance results link to shareholder value creation. In some cases, the correlation may be quite high, but the payout history may not align with absolute or relative TSR due to potential issues with the goal-setting process. For example, revenue growth and return on invested capital may have a high correlation with stock price changes; however, past incentive payouts may not align with TSR, as revenue growth targets may have been set artificially high in several of the prior years.

Annual and Long-Term Incentive Plan Comparisons

Another test of goal rigor is to compare payout levels under the annual incentive plan to those of the long-term incentive plan (e.g., performance shares and stock options). For example, are the rolling 3-year average annual incentives similar to the 3-year performance share plan payouts covering the same period? If not, can the differences be explained?

It is also a good practice to compare the annual incentive plan’s underlying performance targets against the performance share plan metrics’ underlying performance targets.

Adjustments to Financial Results

One of the reasons a company may under- or out-perform its budget/incentive plan targets is the occurrence of unplanned events or significant deviations from the assumptions used to prepare the budget (e.g., a spike in commodity prices, a material change in foreign currency exchange rates, changes in tax rates, new accounting pronouncements, major acquisitions or divestitures, or a restructuring of the business).

Compensation committees often adjust for the effects of these items, both positive and negative, in order to properly measure operating results. These adjustments also have the benefit of allowing the committee to hold management accountable for achieving the agreed-upon budget/incentive plan targets, and they can reduce the need to build large contingencies into either the budget or financial targets.

Stress Testing

The impact of a 1% change in key variables on estimated financial results can be enlightening when evaluating if performance targets are solidly built or susceptible to modest changes in the company’s operating environment. Stress testing provides management and the compensation committee with an understanding of how volatile the incentive plan metrics may be and how achievable the approved targets are if the economic environment changes.

Stress testing can also help establish the width of the performance curve (i.e., the performance and payout levels at threshold, target, and maximum performance).

Other Performance Considerations

There are other considerations in the measurement of absolute financial performance that can have a direct bearing upon an annual incentive plan’s motivational impact. One design feature that we occasionally find in annual incentive plans is a performance modifier based upon the company’s relative financial performance or TSR. If the company exceeds its financial targets, and relative performance is below market, the modifier would serve to reduce the annual incentive payout; if the company falls short of its financial targets, and relative performance is above market, the modifier could be used to increase the annual incentive. As shareholders continue to evaluate the alignment of incentive compensation and shareholder returns, it is possible we may see an increase in the use of a TSR modifier or payout cap added to annual incentive plans.

Another design feature is the establishment of a “performance target range” in lieu of setting a single absolute financial performance target. For example, a company may establish a goal of $5.85 EPS for a performance period based upon the budgeting process. However, the company may elect to prescribe a 100% target payout for performance within the range of $5.75 to $5.95. The use of a performance target range acknowledges the lack of absolute precision used in the goal-setting process, provides the same reward to plan participants for achieving performance within an acceptable margin of error and is consistent with the earnings guidance provided to shareholders and market analysts.

Our Conclusions

As discussed in this Viewpoint, most companies use absolute (as opposed to relative) financial goals in the annual incentive plan that are derived in part or directly from the company’s budget. Management and the Board strive to establish budgets that are reasonably challenging to meet shareholders’ expectations as to both the quantum and quality of earnings.

The reliance on absolute performance goals in annual incentive plans requires that management and the compensation committee evaluate the approved budget for the degree of rigor built into the performance goals. A company’s budget philosophy can have a significant impact on the suitability of using budgeted revenue, earnings, and returns as the target goals in the annual incentive plan.

Management and the compensation committee should also review goal rigor using the techniques described in this Viewpoint to the extent that such analyses were not performed as part of the budgeting process. These analyses can be used to refine incentive plan goals to ensure they reflect the company’s pay for performance objectives and provide a high degree of motivation to plan participants.

Importantly, properly established performance targets may also reinforce the company’s credibility with shareholders and plan participants. Companies that consistently pay above-target incentives when stock prices are falling are likely to be criticized for a misalignment of pay and performance. On the other hand, companies that consistently pay below-target annual incentives are likely to experience a high degree of employee dissatisfaction and a loss of employee motivation. In both situations, investors and analysts are likely to question the reliability of a company’s earnings guidance.

Despite the best efforts of the management team and compensation committee, annual incentive plan targets that are established at the beginning of the performance year are bound to be affected by unplanned events. Most one-time, unusual items can be addressed with an agreed-upon list of adjustments to GAAP results when calculating annual incentives. Companies may also want to consider carving out a portion of the annual incentive for non-financial/strategic goals that position the company for long-term success (e.g., environmental, social, and governance metrics). It may also be appropriate to use a relative performance modifier in determining actual incentive plan payouts, such as relative TSR or earnings growth, to adjust for targets that, in hindsight, were either too aggressive or not aggressive enough.

At its core, the process for establishing annual incentive plan targets that are motivating and aligned with shareholder expectations requires significant input from top management and business unit executives, compensation committee due diligence, and a high degree of judgment that can and should be constantly refined in order to fully support the business needs of the company.

General questions about this Viewpoint can be directed to Mike Kesner at mike.kesner@paygovernance.com or John Ellerman at john.ellerman@paygovernance.com.


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Featured Viewpoint

Pay Governance Adds Two Partners Based in Dallas and Chicago

Pay Governance announces the addition of two new Partners to its experienced team. Chris Brindisi has been promoted from Principal to Partner with the firm, and Mike Kesner has joined Pay Governance as a Partner. In their roles, Brindisi and Kesner are responsible for working with client compensation committees and senior management teams across a wide range of executive compensation and governance issues.

Brindisi is a member of Pay Governance’s Dallas office and works with both public and private companies in a variety of industries. He has been an executive compensation consultant for nearly twenty years, having previously worked with Towers Watson and Citigroup before joining Pay Governance when the firm was founded a decade ago. Brindisi is also one of the leaders of the firm’s Financial Services practice. His research has been published in Harvard Law School’sForum on Corporate Governance, WorldatWork’s The Journal of Total Rewards and Bank Director magazine .​

“Chris is a seasoned professional whose commitment to our clients and thought leadership will continue to strengthen our firm and our offerings,” said Managing Partner Lane Ringlee. “He has significant experience advising companies in a multitude of industries, including deep expertise in the financial services sector.”

Kesner will be based in Chicago and has more than 40 years experience in the executive compensation consulting industry. He works extensively with S&P 500 clients in various industries across the United States. Kesner is a thought leader, featured speaker and author on the topics of executive compensation and corporate governance. He has served on the advisory board of Compensation Standards and was a member of the Blue Ribbon Commission on Executive Compensation. Prior to joining Pay Governance, Kesner was the national practice leader for Deloitte’s U.S. executive compensation consulting practice.

"Mike brings exceptional experience in advising large, complex clients," said Managing Partner Ira Kay.

Featured Viewpoint

Proposed Sweeping Changes to the Taxation of Executive Compensation

Introduction

For the past several months, the business community has been focused on navigating the economic turmoil brought on by the COVID-19 pandemic. While many companies have experienced salary reductions, staff layoffs and furloughs, and corporate restructurings, there have been developments in the executive compensation arena that have gone largely unnoticed. One such development is a proposed reform that would lead to an acceleration of the taxation of certain forms of executive compensation.

On February 27, 2020, Senators Bernie Sanders of Vermont and Chris Van Hollen of Maryland introduced the “CEO and Worker Pension Fairness Act” in the U.S. Senate. [i] The proposed legislation was a response by Senators Sanders and Van Hollen to a recent report from the Government Accountability Office (GAO) commissioned by Senator Sanders: “Private Pensions: IRS and DOL Should Strengthen Oversight of Executive Retirement Plans.” [ii]

The legislative proposal would significantly change the tax treatment of two major elements of executive compensation: non-qualified deferred compensation plans and stock options. This taxation treatment found in the Sanders/Van Hollen legislative proposal was first proposed in 2016 by the Republican Party as part of the Trump administration’s own tax reform legislation. The provisions in the Sanders and Van Hollen legislative proposal regarding the taxation of stock options upon vesting were ultimately removed from the Trump administration’s major tax reform legislation enacted in December 2017: the “Tax Cuts and Jobs Act of 2017.” [iii]

Non-qualified Deferred Compensation

In today’s corporate environment, there are two forms of non-qualified deferred compensation that are most prevalent: (1) an executive’s ability to voluntarily elect to defer base salary or annual bonus, or some portions thereof, until retirement or some other specified future date; and (2) an executive’s participation in a supplemental executive retirement plan (SERP) — an unfunded arrangement that provides additional retirement benefits to executives beyond those that are available through tax-qualified retirement plans. SERPs are considered an important retention tool. It has been our experience, as executive compensation consultants, that executive voluntary deferral elections are not as popular in today’s environment as they have been in years past.

This decrease in prevalence of voluntary deferral elections may be attributed to two considerations. First, executives are inclined to believe that their current tax rate on ordinary income is relatively low and unlikely to be lower at retirement. Therefore, it might be unlikely that the executive’s effective tax rate is going to be lower at retirement or at some other specified future date. The second reason that voluntary deferrals have declined is the introduction of Section 409A to the Internal Revenue Code (“IRC”). Several years ago, Section 409A was added to the IRC, and this provision has made it more onerous for an executive to defer either base salary or bonus under attractive terms. Section 409A has rigid requirements for the timing of deferral elections, prohibitions on the timing or scheduling payments on an accelerated basis, and other limitations, including the imposition of a 20 percent excise tax penalty should the deferral plan violate certain design or operational rules of the IRC provision.

The second form of non-qualified deferred compensation, the SERP arrangement, is the more popular form of deferred compensation. The aforementioned GAO study of the 500 largest U.S. companies found that there are approximately 2,300 executives covered by SERP arrangements in this sample of companies (based upon proxy disclosure of Named Executive Officers) and that these arrangements represent a total of approximately $13 billion in accumulated plan benefits.2 There are two types of SERP arrangements that are prevalent in today’s executive compensation environment. The first type of SERP is a plan which enhances prospective retirement benefits by considering additional elements of compensation (e.g., annual bonus) and/or increasing the benefit formula (e.g., adding years of credited service, increasing the contribution formula) above those available in the underlying qualified plan. The second type of SERP restores benefits that are lost in the qualified pension due to statutory limitations on compensation in the Internal Revenue Code. These latter types of plans, frequently referred to as restoration plans, are the most common type of SERP arrangement found in the marketplace today.

The new proposed tax legislation set forth by Sanders and Van Hollen would recognize taxable income to the executive when the non-qualified deferred compensation arrangement becomes vested — not when the deferred funds are received. This is a substantive change in taxation and could result in an executive being taxed even though they may not have access to the deferred funds (a highly paid executive must wait 6 months for the actual receipt of deferred monies after retirement or other official termination events under Section 409A). Other substantive changes to the taxation of deferred compensation include the following:

  • All revenue raised from the change in tax treatment would be transferred to the Pension Benefit Guaranty Corporation to shore up multi-employer pension plans (the estimated $13 to $15 billion accrued value in current pension values would result in lost corporate tax deductions for the same amount, but the resultant gain in tax income by the government would not go far in closing the estimated $1.28 trillion funding gap in multi-employer pensions). [iv]
  • The proposed legislation requests that the Department of the Treasury and the Department of Labor implement changes to the Tax Code recommended in the GAO report, including a formal definition of employee eligibility as well as new disclosure requirements of non-qualified deferral plans.
  • The bill will also require increased disclosure of deferred compensation by requiring such compensation be disclosed on Form W-2 on a mandatory basis (currently a voluntary provision).

Stock Options and Stock Appreciation Rights

The proposed tax legislation will require that all employees earning at least $130,000 annually be taxed on non-qualified stock option gains in excess of $100,000 at the time of vesting (the first $100,000 will be exempt). This is a departure from current tax rules which require that the gains recognized on stock options be taxed at the time of exercise. [v] While stock options have declined in prevalence, many companies still use them as part of their executive stock incentives. This tax proposal will reduce their incentive effect.

Stock options are typically granted with a stated term of 7 to 10 years. Options are normally granted with an exercise price (“strike price”) equal to the stock’s fair market value on the date of grant. Most option plans are designed to be fully vested after 3 to 4 years of service, leaving the executive with the ability to time their decision to exercise from the vesting date to the end of the option’s term. The executive’s decision to exercise their stock options is typically predicated on the stock’s current share price and the amount of potential gain to be realized, the executive’s access to capital to pay for the option exercise price and the accompanying tax liability, and other personal considerations.

The amount of tax to the individual executive on the exercise of a non-qualified stock option is the gain in share price from the grant date to the exercise date, with the gain being taxed as ordinary income. The company receives a tax deduction equal to the gain realized by the executive in the year in which the exercise occurs.

The Sanders and Van Hollen tax proposal has several unusual features that will require further clarification. Vested gains above the initial $100,000 are taxable. This will be especially problematic for executives in startup companies that may be privately owned and may not have marketability of their company shares. Also, the tax legislation does not have a grandfather clause, but the proposed bill does include a 9-year transition period so that the executive could have until 2029 to settle their tax liability. [vi]

As we noted in the Introduction section of this Viewpoint, the taxation of stock options at the vesting date was initially proposed in some preliminary versions of the 2017 tax reform legislation. When this concept was floated to the business community at that time, the reaction of corporate America was unfavorable.

Pay Governance Commentary

The concept of taxing individual executives at the time of vesting without the receipt of the income would negatively impact the current executive compensation environment. Although some critics may believe that executives are overpaid and under-taxed, the notion of taxing an executive when they have yet to receive their deferred funds or stock option gains is atypical. Taxation at the time of vesting would require a major overhaul of the Tax Code, and such tax concepts as constructive receipt, risk of forfeiture, and other elements of the Tax Code would need to be rewritten.

General questions about this Viewpoint can be directed to John Ellerman at john.ellerman@paygovernance.com or Ira T. Kay at ira.kay@paygovernance.com.

____________________________________

[i] “Sanders, Van Hollen Push to End CEO Tax Breaks to Protect 1.7 Million Workers’ Pensions.” Bernie Sanders Senator website. February 27, 2020. https://www.sanders.senate.gov/newsroom/press-releases/sanders-van-hollen-push-to-end-ceo-tax-breaks-to-protect-17-million-workers-pensions.
[ii] Richard Rubin and Theo Francis. “Bernie Sanders Aims New Tax Hike at Executive Retirement Plans.” The Wall Street Journal. February 27, 2020. https://www.wsj.com/articles/bernie-sanders-aims-new-tax-hike-at-executive-retirement-plans-11582815616.
[iii] Kevin Brady. “Tax Cuts and Jobs Act.” United States Congress website. December 22, 2017. https://www.congress.gov/bill/115th-congress/house-bill/1/text/.
[iv] Brian Anderson. “Sanders Bill Seeks to Limit Executive Retirement Plans.” 401k Specialist. March 2, 2020. https://401kspecialistmag.com/sanders-bill-seeks-to-limit-executive-retirement-plans/.
[v] Lauren Feiner. “Sanders’ New Tax Policy Raises Alarms in Silicon Valley.” CNBC. February 28, 2020. https://www.cnbc.com/2020/02/28/sanders-new-tax-policy-silicon-valley-reactions.html.
[vi] Dan Primack. “Bernie's Plan to Hike Taxes on Some Startup Employees.” Axios. February 28, 2020. https://www.axios.com/bernie-sanders-tax-proposal-973ef0b3-06e8-4a76-b15b-5ecbe1bb2a80.html.

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