Responsible Executive Compensation During Times of Crisis

Shai Ganu, Don Delves and Ryan Resch are managing directors at Willis Towers Watson. This post is based on their Willis Towers Watson memorandum. Related research from the Program on Corporate includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

Against rising concerns of mortality, livelihood and recessions driven by COVID-19, “How much should executives get paid?” is, understandably, not the most pressing question to be answered. This pandemic is, first and foremost, a human-capital crisis.

The prominence of people in the economic equation has been made apparent, effectively revealing the importance of people versus physical and financial capital. With a direct impact on people’s lives, there is a great deal of uncertainty in terms of basic human needs—food, shelter, health—and concerns regarding the long-term economic impact and the relative pace of the recovery. All of this makes the coronavirus-driven downturn different.

Given this, boards should be looking at executive compensation plans as an important tool to focus management’s efforts on surviving the crisis while at the same time ensuring the health and wellbeing of all stakeholders: Employees, customers, supply-chain partners, communities and shareholders.

A Critical Role for Executive Compensation

Experience from past downturns is fueling concerns that large corporations—and their executives—will unfairly benefit from the current situation. Companies are often seen as having an asymmetric risk-reward relationship: They are encouraged to assume a lot of risk in upturns (e.g., debt, growth focus, M&As), but protected by government bailouts in times of crisis. While this is more perception than reality, companies and their boards will need to be more sensitive than in prior downturns to how they are viewed by investors and other constituents.

Companies are under immense pressure from all stakeholders and constituents—including institutional investors who are calling for exemplary leadership. The various public pronouncements on how companies are reacting to the crisis, including the number of executive pay cuts taken at the same time as employee layoffs are announced, are emphasizing the connections between financial decisions (including share buybacks and dividend policies), employee actions and executive compensation.

We encourage companies not to focus solely on their shareholders, but to focus on stakeholder primacy and include all stakeholders, especially their employees, supply chain relationships, the environment and the communities in which they operate”.

Sacha Sadan | director of corporate governance, Legal & General Investment Management

Recent communication to boards of directors from large institutional investors captures this sentiment well. For example, Sacha Sadan, director of corporate governance at Legal & General Investment Management (LGIM), recently said: “We encourage companies not to focus solely on their shareholders, but to focus on stakeholder primacy and include all stakeholders, especially their employees, supply chain relationships, the environment and the communities in which they operate”.

The concept of long-term sustainability would suggest that companies that come through this crisis and do well would be exactly the kind of companies you would look to as role models…”

Michelle Edkins | Global Head of Investment Stewardship, Blackrock

BlackRock’s Global Head of Investment Stewardship, Michelle Edkins, has similarly stated that: “The concept of long-term sustainability would suggest that companies that come through this crisis and do well would be exactly the kind of companies you would look to as role models … Companies can still demonstrate that they have effective leadership. In times of crisis, that becomes more apparent, not less apparent.”

This is where executive compensation programs can play a critical role. Boards and management can use them to channel energies during the crisis by:

  • Creating alignment
  • Clarifying objectives
  • Setting strategy
  • Establishing priorities
  • Defining accountabilities
  • Motivating performance
  • Reflecting the company’s purpose and what it values

Now more than ever, it is important for companies to take a principles-based approach to executive compensation. Amid all the uncertainties, a core set of guiding principles can serve as guideposts for companies to govern their executive compensation programs.

Guiding Principle 1: Purpose

Every company exists to fulfill some need in society. We are living through an unprecedented economic upheaval that will change the core nature of many businesses.

Have the fundamentals of your business changed in meaningful ways? Have your mix of products, services, customers, pricing, margins, suppliers, competition, strategy and objectives changed? Have your priorities or timelines changed? Has the risk level of your business changed and in what ways?

For many companies, the answer to at least some of these questions will be “yes,” regardless of whether your company is badly hurt, modestly affected or in a booming industry. The economic order is shifting, and how we measure and pay for success will shift too.

Understanding Purpose

Purpose captures why the organization exists, what its mission is with its various constituents, and its strategy and objectives.

Management’s focus during the COVID-19 crisis:

  • Mission: staying true to the company’s purpose and strategy over the long term, while adjusting in the short term
  • Wellbeing: health and safety of employees and partners, social distancing protocols
  • Survival: ensuring the company continues to exist and provide value to stakeholders
  • Crisis management: business continuity plans, deliberate and calm decision making

Guiding Principle 2: Alignment

Executive compensation has always (or at least since the 1980s) served to align the interests of management with those of owners. It will be critically important to continue demonstrating this alignment and sharing the pain (and gain) with shareholders.

At this critical time, there also is a profound need to make sure that executive compensation is aligned, to some demonstrable degree, with the interests of employees, and other stakeholders. Shared pain during the downturn, and evidence that all are in this together during the recovery is important.

Also, consideration should be given to incentive performance measures that incorporate the degree to which employees are hurt by the downturn and benefit from the recovery.

Understanding Alignment

This principle ensures management is aligned with, and acting in, best interests of shareholders and all stakeholders.

Management’s focus during the COVID-19 crisis:

  • Employees: if company is experiencing furloughs and employee pay cuts, then executives taking a bigger pay cut
  • Supply chain partners: credit facilities
  • Customers: discounts and payments terms
  • Shareholders: policy on share buy-backs or dividends; process for LTI award number of shares in event of depressed stock prices
  • Regulators: availing of assistance programs and satisfying associated requirements
  • Proxy advisers: monitor COVID-19 specific guidance
  • Governance: principle-based decision making with stronger board discretion

Guiding Principle 3: Accountability

Executive compensation and incentives are a primary vehicle through which the board holds management accountable for performance—and through which senior managers hold others accountable to achieving key goals and objectives. This link is key to the effective operation of any enterprise.

While it may be necessary in certain cases to re-set goals, extend performance ranges, introduce shorter performance periods, change performance measures, exercise discretion and implement new incentives, all of this must be done in ways that hold managers accountable for their actions and results. Discretionary adjustments to plans that are not tied to performance and achievement of challenging goals should be avoided.

Understanding Accountability

Accountability describes the relationship between pay elements, performance, individual actions and governance systems.

Management’s focus during the COVID-19 crisis:

  • KPI focus: agreeing on strategic priorities, but dynamic target-setting given uncertainties
  • Financial goals: cash flow, capital management, cost containment
  • Cash preservation initiatives: cash deferrals or base salary reductions as appropriate
  • Stock options: considerations for underwater stock options, as appropriate
  • Share ownership: promote management purchasing shares with long-term holding locks
  • Retention: special program for critical talent, across all levels of the organization

Guiding Principle 4: Engagement

Executive compensation must help motivate the whole management team and drive performance and results. That said, executives and managers are motivated by many other things including career success, moving up in the organization and being an effective leader—especially in challenging times.

Incentives need to be adapted to new economic realities and mission-critical goals and objectives. Performance measures, goals, ranges and payout curves will need to be re-examined. Key value drivers will need to be re-assessed. The mix of pay elements and vehicles may need to be adjusted. And new measures incorporating human capital and other stakeholders may be introduced or expanded.

Understanding Engagement

Engagement encapsulates human behaviors, motivation, retention, and engagement.

Management’s focus during the COVID-19 crisis:

  • Leadership: instill confidence, deliberate calm, bounded optimism
  • Communication: proactive and transparent engagement with shareholders, employees and the public
  • Resilience: document learnings from outcomes of pandemic to longer term executive compensation strategies

Additional Considerations

The crisis also may necessitate some unconventional short-term approaches; for example, linking executive compensation to management’s actions to mitigate the spread and impact of COVID-19, ensuring employee wellbeing, developing workforce resilience, effectively leading through the crisis (e.g., business continuity plans, working from home, social distancing, health protocols).

Over the longer term, the crisis will likely change the nature of work, role of organizations in society and expectations from leadership. Correspondingly, we may also see an evolution of executive compensation plans to reflect:

  • Longer-term orientation with larger proportion of LTI, deferrals and share ownership requirements
  • The risk-reward asymmetry, deleveraging of plans with lower upsides and downsides
  • Accelerated adoption of Environmental Social Governance (ESG) metrics—with greater focus on human capital governance
  • Boards holding management accountable for both financial performance improvements, and maintaining a healthy, high performing, optimally capable, sustainable workforce.

Crises force commonality of purpose. Hopefully, companies will see through this crisis with an enhanced appreciation of how much the value of human capital has increased, and the critical importance of better management and governance of people and risk.

Now more than ever, tending to corporate financial health will be key, but demonstrating leadership, commitment and alignment with employees, customers and supply-chain partners will be equally important. Well-designed executive compensation plans should focus management’s efforts in achieving healthy balance sheets, motivated employees, satisfied customers and thriving communities on a sustainable long-term basis.

Companies will do well to be patient and see how things unfold in the coming weeks and months. We are all in this together, and we will emerge out of this together, as people.

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