A variety of factors can significantly impact performance-based pay during these uncertain times, including supply chain disruptions, inflation, regulatory changes, and labor market disruption. Eric Henken, managing director at FW Cook, said many companies learned that carefully calculated three-year goalposts became obsolete overnight during the pandemic.
“Many companies were faced with a scenario where multiple long-term incentive plans in place were paying out zero,” he says. “Clearly, that not only reduced participant motivation, but also exposed the company to retention risk. Suddenly, performance-based LTI no longer provided much value to participants, and some of companies are now poaching top talent from companies not affected by the pandemic.”
LTI design to reduce risk
For compensation committees, the unanticipated pay consequences of the pandemic have highlighted the importance of adjusting plan design to reduce risk. “The overarching theme is the importance of balance in plan design, without relying on a single performance metric or a single long-term incentive subsidy type,” Henken says.
Large companies appear to be considering and paying attention to various planning adjustments. A recent study by F.W. Cook examining the compensation programs of the top 250 publicly traded companies by market capitalization found that total shareholder return (TSR) remains the most common incentive compensation performance metric, with 72 of the top 250 companies. % of companies use it, but only a small number of companies use it as an indicator. The only performance indicator.
“While relative TSR creates a direct link with shareholders and is well understood and well-received by external organizations, there is an understanding that participants may have limited visibility into share price outcomes. ,” Henken explains. “This is especially true for industries such as airlines or large banks, where consolidation does not have a large number of relevant comparison institutions. The need to use a broad index for comparison reduces the relevance of the indicator. ”
Since the pandemic, the prevalence of TSR as a modifier for payments based on other metrics has increased by 50%, with companies looking to downplay the weight of TSR in overall payments. “Companies that use TSR in award design are increasingly using it in combination with at least one other performance measure, such as profit, capital efficiency, or revenue,” said Alec Lentz, principal at FW Cook. says. “They're trying to reduce the overall risk of their programs by making them more diverse and incorporating more levers into their reward programs.”
Set goals correctly
Companies are struggling to make the forecasts necessary to ensure performance targets for metrics such as revenue, capital efficiency, earnings per share, and EBITDA are relevant and motivating two and three years down the road. uncertainty also complicates goal setting. To account for the potential for external factors to influence performance, many companies use target breadth, or the distance between the minimum performance required for any payment and the performance required for maximum payment, for any type of financial performance measure. It's expanding. (See graph “Change in Median Performance Goal Width.'')
“The best practice is to spread the goals symmetrically on both sides, so one unintended consequence of that is that it becomes more difficult to achieve the maximum payout,” Henken said. . “But many companies are willing to accept that tradeoff, because the risk associated with paying 0% on one of these plans comes at the expense of some potential upside. Because it's much bigger than that.”
Remuneration committees should be mindful to ensure that target range expansions are tracked in line with external guidance provided to investors, Lentz added, adding that compensation committees should be mindful of any three-year period in which a company fails to meet its set expectations He pointed out that if a large dividend is paid at the end of the transaction, it may be subject to scrutiny.
Performance period selection
The majority of companies (89%) continue to evaluate LTI based on three-year performance, and multi-year end-to-end measurement periods also continue to be preferred by proxy advisors and investors. However, 12% of the top 250 companies use annual performance periods, a 50% increase from 2019, indicating a move to manage the impact of uncertainty on incentive pay.
“Increasingly, we see large companies looking at measuring their performance on an annual basis, so that strong performance in years one and two makes a very poor performance in year three more or less You can support them and still get paid a certain amount,” Henken explains.
“One interesting way to do that is to set a one-year financial performance target, which is much more predictable than a three-year target, and layer a three-year relative TSR adjustment on top of that,” Lentz said. I'll add. “Most of the remuneration is determined by one-year financial targets, but the three-year performance period of the TSR makes it look like a three-year performance award on your behalf. Not until three years after the date of the grant. “
Another approach involves resetting annual goals. In this case, the company sets an annual growth rate target for a specific metric at the beginning of a three-year period. Each year's performance is measured relative to the previous year's actual performance. “Because we set our goals at the beginning of the performance period, externally he passes the review as a three-year program, but allows us to flexibly adapt the results as business conditions change over the three-year period. ” says Mr. Henken.
“Companies considering such an approach, or using annual performance targets, plan to include a robust explanation in their proxy CD&A of how compensation programs are linked to performance. “Award-winning,'' Lentz added.
multiple combinations
Despite the changes in the compensation landscape, most (86%) of the top 250 companies continue to use multiple long-term incentive grant types. Performance-based incentives remain the most commonly used subsidy type, with 94% of companies typically using them in at least 50% of their incentive structures, and this is based on the preference of proxy advisors. is consistent with
“However, we still see companies using multiple grant types and less often allocating the combination to one grant type,” Henken says. “There is an understanding that increasing the unit of performance share too much increases risk and increases reliance on the goal-setting process.”
The number of companies using stock options/SAR benefits has remained stable at 52% since 2019, while the use of restricted stock grants has increased by 4 percentage points to 69%. Henken attributes this change to the stability his RSU brings to the mix. “Time-based restricted stock units are a foundational element of the program that create a long-term holding nexus and help weather potential macroeconomic uncertainties that can make performance stock units difficult to obtain. ” he explains. Both grant types are typically vested over a three-year period on a rateable schedule.
Key points from the top 250
Trends in compensation plan design among the top 250 companies highlight the need to reduce risk in the face of continued volatility. However, companies should take a careful and thoughtful approach when moving forward with changes to pay practices. “Long-term incentive pay designs must be customized for each company,” says Lentz. “You can’t just implement the most common metrics or grant types used by your peers or industry and derive from your peers’ data.”
“You shouldn't rush into a major redesign,” he says. “Ideally, it would take a year to examine the effectiveness of the current program, diligently consider alternatives, including weighing the pros and cons, and arrive at a new approach that has buy-in from all stakeholders. It's a process. There are a lot of internal and external influences that need to be considered before everyone can be convinced that it's the right thing to do.”
For more information on compensation trends for the top 250 publicly traded companies, visit fwcook.com/2023-Top250.
