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E-MailRyan Resch is Managing Director; Becky Huddleston is Senior Director; and Andy Goldstein is Managing Director at Willis Towers Watson. This post is based on a WTW memorandum authored by Mr. Resch, Ms. Huddleston, Mr. Goldstein, and Don Delves. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).
COVID-19 (coronavirus) has thrust the global community into a health and financial crisis that changes daily. We have seen marked stock market declines, an unraveling of crude oil inventory controls and a significant drop in oil prices amid increasing supply and decreasing demand. The economic outlook has changed considerably since the beginning of the year as markets weigh the increasing probability of global recession and a credit crunch. Among the questions that arise is how will COVID-19 affect executive compensation programs.
To answer that question, we first take a look back.
Comparing the 2008 financial crisis to the COVID-19 upheaval
We can better understand the current market environment by comparing it to the 2007/2009 financial downturn:
| 2007/2009 | 2020 |
|---|---|
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Guiding principles for this uncertain time
Based on our consulting experience and lessons learned from the 2008 financial crisis, we suggest that boards and companies consider the following principles when assessing the effectiveness of their executive compensation programs and whether to make any changes:
- Take a long-term perspective—We are less than one month into this bear market and need to consider the potential for a quick recovery, possibly within the same bonus year. We also need to look at executives’ actual realized pay during the prosperous 11-year bull market relative to the value “lost” over the past few weeks.
- Balance alignment between shareholders and executives—Shareholders’ lost value and the alignment with executive pay need to be considered. While there is not a direct one-for-one relationship (i.e., executive pay has a greater risk/leverage dynamic), there are reasonable expectations to see directional alignment in the change of realized executive pay relative to shareholder value.
- Understand the impact of long-term pay programs on executives—These programs are likely to have a more material reduction in overall realized pay for executives because their pay mix has a greater emphasis on long-term incentives that track share price. Cash compensation (such as salaries and annual incentives) may not be as impacted to the same degree if it aligns more with underlying day-to-day activities and/or annual objectives that are likely going to be much more difficult and complex through 2020.
- Consider the symmetry of business impacts—Executives that benefited from market strength through the 11-year bull market may not be fully protected through the downturn. There might be specific issues outside of their control for which the risks could not be addressed in advance. In these cases, when all relevant facts are understood about the changing market, discretionary adjustments may be possible.
- Maintain your underlying compensation philosophy—Companies with incentive arrangements that are more leveraged and/or designed to have a greater risk profile to benefit from a strong market/financial performance may not be fully protected in the downturn because of a more liberal use of stock options, performance targets based on enduring standards or performance stock units that are fully at-risk and based on relative total shareholder return.
- Focus on a holistic approach and materiality—Many factors impact different parts of the business and a variety of operational, financial and market measures. We need to step back and focus on issues material to executive pay and consider the potential trade-offs or interactions associated with certain decisions and their impact on overall executive pay through the cycle.
Potential impacts on executive compensation
We expect boards and companies to experience a number of challenging situations through 2020 depending on their industry (e.g., travel as compared to food and beverage) and the direct impact to their organization’s operational, financial and market performance.
- Addressing in-year performance cycles—Although we expect many companies will likely pay bonuses at the lower end of the range, some companies may need to consider the application of discretion if full-year performance results are outside of the performance range, resulting in a potential zero award and plan participants’ loss of motivation relatively early in the 2020 fiscal year.Some companies have been considering a split performance year, allowing for the 2020 incentive cycle to be reset for the latter half of the year which may still be challenging as there are still many unknowns making target setting difficult even in a couple of months.We suggest that discussions occur early and frequently to understand the potential impact and to discuss options to address the situation.
- Setting performance targets—Increased performance variability and a number of unknown externalities may necessitate consideration of a wider 2020 performance corridor that better captures the potential range of performance (for companies that have not yet finalized their incentive goals or are considering adjusting the original targets).
- Share granting practices—While most calendar-year companies have likely already made their 2020 equity awards, those that have yet to make their grants will need to consider the year-over-year change in share price and may need to consider ways to monitor the number of units granted in order to manage annual run rates and mitigate the potential risk of windfall gains.
- Customizing performance plans—Company priorities may shift through 2020, and it may make sense to customize incentive measures to focus more on near-term priorities, such as cash flow, cost containment and operational efficiencies.
- Retention of key executives—We believe it will be important to monitor the value of unvested equity awards to better understand the current “retention hooks” that exist for key executives that are critical to supporting the company through a potential period of significant volatility. Not all companies will emerge from the economic downturn at the same time. Selective retention awards may need to be considered to retain your top talent.
- Underwater stock options—Although the proportion of underwater stock options has likely increased significantly over the past few weeks, it would be premature to make any immediate decisions on potential remedies. However, equity holdings should be monitored as noted previously. Companies in certain industries with longer performance challenges (e.g., natural resources) may find this an opportune time to reset outstanding equity awards.
- Share ownership guidelines—Many executives previously in compliance with share ownership guidelines have likely fallen out of compliance based on current share prices. While many organizations review compliance at the end of the fiscal year, providing time for the markets to recover, companies may need to consider alternative measurement approaches. These include higher of cost or market, long-term average price and/or fixed share requirement, or a temporary suspension of the minimum ownership requirements.
- Communication—Many executives who need to stay focused on managing the business in difficult times will likely be concerned by the sudden drop in share prices, driven by the extended bull market’s end and COVID-19’s impact on business and on executive compensation. It will be important to recognize these concerns and the additional stress. The company will have to indicate it’s aware of this impact, and that there will be ongoing discussions between management and the board to make sure that executives and employees are fairly treated given the circumstances.
Take a long-term view
Every economic downturn is unique, but even so, downturns occur with some regularity. The lessons they offer help companies make well considered decisions that balance the interests of executives and shareholders. A long-term view is needed that positions a company for future success and is defensible when disclosed in next year’s proxy circulars. History has shown that companies have successfully managed through extraordinarily challenging periods and events, and this will hold true for the current crisis as well.
