As COVID-19 upset the balance of the business world, there has been a tendency to rethink everything as part of a “new reality.” But because compensation planning is designed for long-term vision, it’s not always wise to make wholesale changes based on what is expected to be an anomaly.
The jury is still out on how COVID-19 will affect long-term incentive planning. However, one thing we have learned from this pandemic is that unilaterally, we can prepare better for volatility and a crisis of any kind. This is the conundrum boards and compensation professionals will be focused on as they draw up (or redraw) equity and incentive plans in 2021 and beyond.
“Companies need to think about the ways they can plan in an uncertain environment,” said Craig Rubino, Head of Global Learning and Development for Morgan Stanley at Work in a recent Equilar report. “Volatility has taken a toll on some, while others have seen their best-ever year in terms of stock appreciation.”
But we can’t—and don’t—expect this disparity to continue. There’s a strong argument to be made that executive long-term incentive plans (LTIPs) were invented for scenarios like a pandemic. The purpose of pay for performance over a longer period of time is to avoid tying compensation to one-time windfalls (or market crashes), quarterly earnings or annual results, in addition to setting targets that executives can achieve for the company while earning compensation based on actions they can control.
For those setting incentive plans in 2020 and beyond, taking a long-term view—especially in the context where one to three years is considered “long”—seems particularly difficult, at least in this moment. So it’s understandable that many board compensation committees continue to take a “wait-and-see” approach as the pandemic settles out.
For example, data from the recent Equilar publication Equity Compensation Trends show that the number of employee equity plans offering only stocks increased by more than eight percentage points between 2016 and 2020 among the Equilar 500 (the 500 largest U.S. companies by revenue). Meanwhile, the number of plans offering both stocks and options decreased over seven percentage points (Figure 1). These trends—a move away from options to exclusive stock grants—continued in the same direction over the past five years.
The general employee population doesn’t have as much direct influence over the value of their shares in the same way an executive might; however, a well-organized company will set the right metrics at the top level with executives, and then that strategic vision should work its way down to the employees, giving them the levers to pull to ensure that they can contribute directly to their investment in the company. That’s why setting executive compensation through pay for performance is so critical, and also why the way that these types of awards are triggered may evolve.
“Equity compensation offers a powerful toolkit, and there are many possibilities on the table,” said Rubino. “As we learn to redefine success amid continued disruption, traditional measures like revenue and stock performance may give way to alternatives like time-based award structures or relative total shareholder return.”
As Rubino noted, one way to manage volatility is with relative metrics. That’s why relative total shareholder return (rTSR) continues to be the most popular metric employed in executive LTIPs, and it has also increased the most in prevalence over the past five years. From 2016 to 2020, the percentage of Equilar 500 companies awarding performance compensation to CEOs increased from 48.3% to 57.4% (Figure 2). Even in a pandemic, where some industries flourished and others crashed, rTSR still benchmarks company performance against peers. A company that navigated COVID-19 better than others should eventually come out in its share value.
Following rTSR, return on capital (ROC) metrics are the most common performance indicators tied to executive LTIPs, and they are increasing in prevalence as well. In 2020, 39.3% of Equilar 500 companies utilized this metric, up from 36.1% in 2016 (Figure 2).
These two scenarios also highlight why executive awards employ a range of performance indicators, most commonly including one to four metrics that determine payout on an individual award. RTSR is weighted as either 50% or 100% of the award in which it appears approximately two-thirds of the time, while ROC was most often weighted as 100% of an award—in 36.2% of awards where ROC was prevalent, it was the sole metric included.
As the performance periods inclusive of 2020 play out, these trends within LTIPs—increasing prevalence and heavy weighting of metrics like rTSR or ROC—may leave executive compensation largely unaffected by the pandemic.
Companies that are doing [HCM] well are being very transparent such as how they’re addressing employees, prioritizing their health and safety, answering all questions about job security and more.”
— Jessica McDougall, Vice President, Investment Stewardship & Corporate Governance, BlackRock
A more complete picture of the impact that COVID-19 has had on executive compensation will continue to come into view as time elapses further from its onset. Though it’s difficult to draw a unilateral trend line, many companies offered disclosures throughout 2020 that noted the pandemic’s impact on executive pay.
While 2020 proxy disclosures did not report a significant influence on incentive plans, some companies adjusted metrics and goals. According to Sharing the Pain: How Did Boards Adjust CEO Pay in Response to COVID-19?, a joint study between Equilar and Stanford University, only about 17% of Russell 3000 companies made changes to CEO pay that required disclosure during the first six months of 2020—chiefly referencing CEO salaries or director fees. A very small number, only 33 companies, mentioned LTIPs (Figure 3).
These cases were uncommon for good reason. Adjusting performance goals for long-term incentive plans is generally not viewed favorably by shareholders, as it’s seen as bailing out executives during tough times.
“Companies will most likely not be changing payouts for 2019 performance, but they should instead get ahead of the messaging,” said Shelly Carlin, Executive Vice President, Center On Executive Compensation, during an Equilar webinar hosted early on during the pandemic in April 2020. “They need to pair the communication of 2019 compensation with the changing goalposts of 2020 compensation.”
For example, Kaman Corporation (KAMN), an aerospace and defense company, disclosed in February 2021 that the company’s performance in 2020 dictated an annual cash incentive payout for its executives at 26.5% of target; however, the compensation committee approved an adjustment to 50% of target “consistent with the Company’s approach for other participants in the annual incentive program.” The reasoning followed that these executives performed their duties to the best of their abilities and went above and beyond to address what they could during the COVID-19 pandemic. At the same time, they still only received half of their target pay, reflecting the fact that all was not well.
In another disclosure, Volt Information Sciences (VOLT) reported that its NEOs received “only 30% of their respective long-term incentive compensation target opportunities in the form of equity-based awards.” Citing dual challenges, including a share price at historic lows, which would require granting more shares than desired and diluting the stock pool, and setting long-term financial goals at a time of such great uncertainty, the Company opted to offer the remainder of the incentive plan as long-term restricted cash awards.
Finally, in its proxy statement filed on April 8, 2020, Red Robin Gourmet Burgers, Inc. (RRGB) officially elected to move to rTSR as its sole 2020 performance metric, anticipating difficulty in setting any sort of operational or financial goal during the pandemic.
Overall, changing metrics or reducing or adjusting pre-set goals used to measure performance compensation wasn’t common during COVID-19. With that said, the pandemic has had an inconsistent effect on companies. The stock market hit an all-time high in 2020, and some companies benefited while entire industries were essentially shut down.
Jessica McDougall, Vice President, Investment Stewardship & Corporate Governance, BlackRock, explained in the April 2020 Equilar webinar that human capital has become an extremely valuable asset as companies respond according to how they were impacted by COVID-19. In that mode, human capital management (HCM) and environmental, social and governance (ESG) metrics may also become more popular ways to provide compensation for the important work that executives need to manage during a crisis, thus withstanding more pressure amidst volatile times.
“Overall, companies that are doing this well are being very transparent such as how they’re addressing employees, prioritizing their health and safety, answering all questions about job security and more,” she said, because business decisions made in the short-term need to be made with the long-term results in mind.
The bigger outstanding question is whether companies will reevaluate compensation plans to account for potential crises, whatever they may be. While the hope is that COVID-19 will be a once-in-many-generations global pandemic, there’s no guarantee of that. What’s more, natural disasters continue to cause more disruption on an annual basis, and international politics are perennially volatile.
“2020 taught us the value of preparation and agility,” Rubino added. “We don’t have to wait for the next unexpected global event to improve support for our executives and employees. Equity compensation provides a practical way to build a strong—but flexible—framework that allows leaders to focus on meeting the challenges of the day.”
Dan Marcec is Senior Editor at Equilar and Associate Editor for C-Suite.