How to Improve Incentive Plan Governance

Transcription

1 The Magazine of WorldatWork How to Improve Incentive Plan Governance Using discretion is key for compensation committee decisions on incentive plans. One of the biggest challenges facing public company compensation committees today is goal setting for incentive plans. No single issue consistently gets more time at committee meetings. The issues around defining the right measures and performance targets are now equally focused on annual incentive plans and longterm performance plans. After the global economic bubble burst at the beginning of the century, corporate governance horror stories By Eric C. Larré, Towers Watson 2013 WorldatWork. All Rights Reserved. For information about reprints/re-use,

2 is an essential tool that should be embraced by boards in the exercise... discretion of their business judgment... dominated the financial pages. With investors and proxy advisers demanding closer alignment between pay and performance, boards reacted by relying heavily, if not exclusively, on quantitative bonus plan formulas to provide cover from potential criticism that discretion was used to unduly reward executives. Unfortunately, this overreaction has constrained committees use of discretion to assess whether the payout formulas were right in the first place. The reality is that discretion is necessary at some Figure 1 Average Annual Bonus Distribution ( ) Incentive Payout Range 200%+ 150%- 200% 100% - 150% 50% - 100% < 50% Source: Towers Watson 8% point in administering an incentive plan. This happens either at the beginning when determining if incentive performance goals are reasonable or at the end of the performance period when assessing whether the plan s payout is appropriate for the level of performance achieved. In short, discretion is not a four-letter word. Rather, it s an essential tool that should be embraced by boards in the exercise of their business judgment to assure that the financial interests of executives 19% 22% 23% 28% and investors are aligned. Interestingly, a January 2013 report titled Remuneration Principles for Building and Reinforcing Long-Term Business Success issued by the United Kingdom s National Association of Pension Funds (NAPF) and a few large investment management firms emphasized that: well debated and explained decisions, on a broader basis rather than using simplistic mechanistic formulae, are the way in which trust between remuneration committees and share owners can be restored and maintained. Boards and remuneration committees have to ensure that their judgment takes a holistic approach to performance. We will support those committees that use this trust well and exercise their judgment in a way that we believe places long-term shareholder interests at the centre of their deliberations. This article explores how the disciplined use of discretion, coupled with a thoughtful analytical approach to measuring financial performance, can help companies achieve better pay-for-performance outcomes. Is Goal Setting Broken? Both shareholder advocates and board members are concerned when companies consistently outperform incentive plan goals, given the outsized payouts that accompany those results. A few objective indicators suggest that the incentive plan administration process bears reconsideration. 26 workspan september 2013

3 ... a focus on one or two internal metrics often does not promote sustainable value creation. As a baseline, research from Annual Incentive Plan Design Survey, conducted by the author s company, reveals that companies generally set (or strive to set) bonus plan objectives with the expectation that actual results will fall into a normal bell curve distribution over time (e.g., payouts in most cycles falling around target with occasional occurrences of significant under- or overperformance). But, consider the following data, which illustrate the reality of recent annual bonus payment levels. Figure 1 on page 26 illustrates that a cross-section of more than 200 Fortune 1000 companies whose Figure 2 Percent of Companies Paying Above-Target Bonuses ( ) 80% Source: Towers Watson 70% 60% 50% 40% 30% 10% 0% 67% 13% 48% -22% 13% 42% 73% 61% 7% 25% 15% 10% 5% 0% -5% -10% -15% - -25% pay practices were reviewed over a five-year period paid above-target bonuses 58 percent of the time, and above 150 percent of target (a sign of extraordinary or truly stretch performance) 30 percent of the time. Distributions may vary modestly over different periods, but the underlying conclusion still holds. From another perspective, Figure 2 illustrates that between 61 percent and 73 percent of those Fortune 1000 companies paid above-target bonuses in three of the past five years. Research by the author s company shows that many companies determine their bonus payouts based on internal metrics, such as earnings per share. To be clear, the point is not that strong internal performance doesn t merit rewards, but rather that a focus on one or two internal metrics often does not promote sustainable value creation. When these bonus payout results are compared with investor returns for the same companies over the same period, it is often difficult to identify any clear correlations from year to year. Although short-term stock price movement is not a reliable (or even fair) metric by which to judge short-term performance, it is the only readily mined and objective measure available to the average investor. Adding insult to injury, the Data Sample Company TSR Performance To read a book about this topic, log on to 28 workspan september 2013

4 situation faced by compensation committees is that investors (and proxy advisory firms) are increasingly focused on short-term results and tend to use short-term stock price performance as the litmus test for assessing the reasonableness of components of compensation. Why the Disconnect Between Executive Pay and Performance? There are a number of possible explanations, none of which falls into the fox-in-the-henhouse characterization often embraced by governance critics. They include: Management s conservative approach to providing street guidance, based on discomfort with setting long-range objectives in a volatile and uncertain economic environment Enhanced disclosure requirements, combined with increasingly activist investors, requiring detailed pay-forperformance metrics and detailed rationale for the use of discretion to change formulaic results Insufficient data/analysis to challenge or test management assumptions and/or align internal incentive metrics with long-term value creation (leading boards to rely extensively on stock options and relative total shareholder return performance plans to align executive rewards with investor returns) Oversensitivity to talent retention concerns and executive engagement Potential complexity associated with taking a more holistic/ multidimensional look at a range of performance measures, especially in the context of Internal Revenue Code 162(m). All these factors could be addressed through more robust financial performance analytics and thoughtful board discretion/judgment. Three Key Ingredients Compensation committees have three tools at their disposal to take full advantage of the business judgment doctrine set out in Delaware law. Taking an approach that embraces these three concepts can help ensure the alignment of investor and executive financial interests and continued delivery of competitive pay opportunities needed to attract, motivate and retain qualified executive talent: 1 Use umbrella plans. Employ a mechanism for allowing complete discretion in making pay decisions that includes having in place a shareholder-approved omnibus umbrella incentive plan, thereby minimizing Internal Revenue Code Section 162(m) constraints on discretion as a consideration in administering these pay programs. 2 Create a rigorous performance testing and assessment methodology. Having a rigorous process for testing and approving business/incentive plan objectives developed by management is an essential role for the committee. 3 Use discretion effectively. Have in place a process for assessing actual performance qualitatively and quantitatively at the end of any relevant cycle and applying business judgment Figure 3 Illustrative Composite Scorecard Income statement Revenue growth EBIT growth EPS growth EBIT margin Net income margin Cash-flow statement Cash-flow growth Cash-flow margin (aka discretion) to establish appropriate incentive payouts. Here s a closer look at these areas. The Umbrella Plan Mechanism Before a compensation committee can begin to exercise full discretion (negative discretion is permitted by Internal Revenue Code 162(m)), the company must have in place what has become known as an umbrella plan that takes care of the ministerial requirements of Internal Revenue Code Section 162(m). This section requires that any compensation in excess of $1 million annually paid to a named executive officer (NEO) other than the CFO must be performance-based in order to be taxdeductible to the company. To allow committees maximum discretion in appropriate circumstances, many companies have adopted a so-called plan within a plan, or umbrella plan, structure under which: The outside (umbrella) plan defines the maximum bonus for any particular NEO, typically as a percentageof-profit metric (e.g., 5 percent of operating income), a percentage of the overall bonus pool or a fixeddollar amount (e.g., $5 million) Balance sheet Return on net assets Return on common equity EBITA/interest expense 25 % 25 % Market-based metrics Price/earnings ratio Total shareholder return 25 % 25 % september 2013 workspan 29

5 The inside plan measures NEO performance against preset quantitative and qualitative goals, and allows the committee to exercise positive or negative discretion to determine actual bonus awards. Maximum awards in the outside plan are set above what the formulaic inside plan would typically award for maximum results, which then permits the committee to increase or decrease a bonus award based on nonquantitative criteria, using either positive or negative discretion to award something lower than the maximum. Performance Testing and Assessment Methodology With the umbrella plan in place, the compensation committee can set the actual bonus award opportunity for the NEOs based on a comprehensive view of corporate performance and sustainability. Although the emphasis on various financial metrics may shift from one industry to another, Figure 3 on page 29 illustrates a range of possible quantitative metrics boards should pay attention to. Obviously, specific measures and weights should be tailored to the organization. However, the author s experience reinforces the benefits of using a framework in which performance against key metrics in the income statement, balance sheet and cash-flow statement are all considered, as well as understanding the market or shareholder context. The views of institutional investors are typically driven by their respective portfolio managers who focus on precise industry-specific metrics. In addition, proxy advisory firms assess their sayon-pay voting recommendations on their own perspectives. In identifying and setting appropriate metrics, consideration should be given to the use of enduring standards of performance (e.g., annualized growth rate expectations, fixed/permanent return targets), which have the benefit of avoiding the annual goal-setting negotiation between management and the board, while concurrently providing valuable signals to investors about the future. Finally, understanding how performance in the incentive plan metrics stacks up versus peers is crucial in evaluating earned pay versus performance. Effective Use of Committee Discretion The ability of compensation committees to exercise discretion after the fact is a useful design feature to take into account qualitative considerations in addition to more traditional quantitative performance objectives. Per the NAPF, Remuneration committees must have the ability to exercise judgment over the overall performance of the company when determining rewards. In particular, the committee should consider how the results have been achieved, not just what was achieved. Applying an ex post facto lens to the quality of the performance delivered helps ensure that attaining the specified goals was in the best interests of shareholders, reinforced sustainable long-term performance and did not promote excessive risk-taking. Furthermore, discussions with institutional investors and proxy advisory firms reveal that they do not generally object to the use of discretion as long as there s a valid rationale that is clearly disclosed to investors. Comprehensive consideration of the following factors (as they may apply to each company s circumstances) is fair game for the board to exercise its judgment in determining appropriate pay levels for executives: Broad economic market assumptions Commodity prices Industry-specific market assumptions Interest-rate environment and monetary policy Employment and labor market data Changes in the regulatory landscape Influence of major stakeholders Relevant political context Reorganization or recapitalization Material changes in customer base, mix or penetration Unusual or nonrecurring events Shifts in corporate strategies (financial, customer, organization structure, operations) Individual performance and contribution to achievements and results. Conclusion In working with a range of board and management teams, what is effective is the establishment of an ongoing framework for exercising discretion. This would include specific factors that would be considered (e.g., currency fluctuations, nonrecurring events, strategic, quality or customer outcomes, etc.) and an indication of how outcomes may affect incentive funding either positively or negatively. With this information at its disposal, the committee can compare actual results to the assumptions built into the original business plan and street guidance to review whether and how those assumptions were borne out over the performance cycle and which performance variables management should (and should not) be held accountable for. A key to performing this assessment is for the compensation committee to document how it reviewed each of these factors. Only by combining this quantitative and qualitative assessment of financial and nonfinancial metrics and by properly documenting how it did so can a board exercise its best business judgment in the executive compensation arena. Eric C. Larré is a director at Towers Watson in Atlanta. He can be reached at eric.larre@towerswatson.com. resources plus For more information, books and education related to this topic, log on to and use any or all of these keywords: Incentives Compensation committee Goal setting + incentives. 30 workspan september 2013