With the coronavirus pandemic (we hope) tapering off this summer, boards are looking ahead to more normal compensation programs for 2022. They can pull back on the extraordinary measures and structures of 2020–21 and return to their long-term paths to strengthen or transform their organizations. Those paths were already a bit obscured by ongoing disruption in many industries, but then the pandemic pushed them decisively to the side. Companies can now get out of reactive mode and start to control their future again.

Still, it’s important for boards to resist the temptation to pick up where they left off in 2019. The pandemic and other developments have changed the landscape for corporate behavior and strategy. Executive compensation must adapt accordingly for companies to capture fresh opportunities and overcome new challenges.

Taking Stock

2020 was especially difficult for many boards. For their compensation programs, many resorted to new measures, goals, and performance periods, or used discretion. Others introduced special awards to promote retention or maintain motivation. Many of these approaches veered from the typical path but were deemed necessary to administer relevant and fair rewards amid the crises.

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Eager to give greater attention to stakeholders beyond investors, corporate boards have been adding environmental, social and governance (ESG) issues to their agenda. Prompted by institutional investors and proxy advisors—and from other stakeholder groups— they’ve begun considering translating those concerns into their executive pay packages. At Semler Brossy, we’ve seen a dramatic increase in client inquiries on this challenge.

Linking ESG metrics to executive pay is a powerful way to drive change, but compensation is a sensitive instrument, so we urge caution. Compensation real estate is limited. Each new metric may dampen the emphasis on existing metrics. It is important to balance all incentive metrics to gain the most powerful effect. Companies can be most effective with ESG metrics starting with just the most relevant issues for them and their industry or sector, rather than trying to address all ESG elements.

Companies can assess a number of worthy goals against the company’s specific strategy for customers, employees and other stakeholders. Where can you make the biggest impact or where do you have the biggest gaps? What metrics best drive competitive advantage? Are you looking to limit a major risk or capture a big opportunity?

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Since the Business Roundtable’s 2019 call for greater attention to all stakeholders, corporate boards have been elevating environmental, social, and governance issues in their discussions. Last summer’s widespread protests over racial injustice put extra attention to diversity, equity, and inclusion (DE&I) issues. Boards have begun the difficult work of determining which ESG goals are especially important for their company, and how to translate those goals into incentives for executive compensation where appropriate.

General Reflections

ESG has not yet become a mainstream issue for executive compensation. But the level of inquiry from our clients (predominately corporate boards) has increased dramatically. Those clients say they in turn are getting questions from investors. Often these are about ESG-oriented initiatives generally, but they frequently circle back to executive compensation.

One financial services client, for example, met with large institutional investors recently and spent almost a full hour on ESG. A consumer products client had a similar experience. The investors asked some pointed questions:

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Even just a year later, it may be difficult to remember the uncertainty and confusion of the early months of the coronavirus pandemic. Corporate boards soon realized that the crisis was far more extensive than the 2008-2009 downturn, but they scrambled to understand the implications for their industry and company. Many leadership teams were desperate as they watched their businesses decline for reasons beyond their control. They sought solutions to motivate employees in this chaotic environment, and their boards did the same. And then George Floyd’s death in May sparked an intensified corporate commitment toward diversity, equity, and inclusion. Investors upped the ante, asking for more visible responsiveness on these issues.

In setting or adjusting executive compensation for 2020, boards employed a variety of reactions and solutions. All of these were well intended, and some look to hold up well over time. Other compensation arrangements, by contrast, will look incongruous given what we know now. As of March 26 in the 2021 proxy season, 3.5% of the Russell 3000 companies had had a “no” vote in “say-on-pay” resolutions, a jump from last year’s rate of 1.4%. [1] Say on Pay failures are even higher to date among the larger S&P 500 companies including Starbucks, Walgreens Boots Alliance, and Acuity Brands.

It is still early days, but proxy advisors and investors seem to be questioning the pay-performance connection at a higher number of companies. They must decide whether each company’s compensation actions, in their unique context including the experience of employees and other stakeholders, were fair and well-constructed to ensure sustained overall performance over time.

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Given growing stakeholder focus on Human Capital Management (HCM), we sought to understand how companies would approach the HCM disclosure within proxy statements this year. Our study of a sample of proxies filed in December 2020 and January 2021 offers an early proxy season preview of HCM disclosure practices.

Background

In 2020 the Securities and Exchange Commission (SEC) amended certain Regulation S-K rules as part of its ongoing initiative to modernize non-financial disclosure. The rules include a new principles-based requirement that companies address HCM details within the 10-K’s description of the business, to the extent such details are material to understanding the business. The new 10-K disclosure has pushed companies to develop and refine their strategy for communicating HCM actions, processes, and metrics. The requirement arrives when companies are engaging with stakeholders on social topics like HCM more than ever before, with Covid-19 accelerating the trend. Such engagement typically relies on a range of communications channels to deliver a holistic and harmonic narrative, especially given the conservative approach to disclosure that is appropriate for the 10-K. We speculate that 2021 will be an inflection point for the communication of HCM details, including in filings beyond the 10-K such as the proxy statement.

Key Findings

Given the tailwinds behind HCM disclosure, we were not surprised to find that recent proxy statements reflect a surge in the degree and prevalence of HCM details relative to prior years. Specifically, we found:

1. 62% of recent proxy statements we analyzed included specific HCM-related details that extend beyond “boilerplate” claims; more than 2x the rate of prior-year proxies
2. The companies that provided HCM details in prior proxies materially expanded such disclosures this year
3. HCM disclosures covered a range of topics and degrees of detail, and appeared in a variety of locations within the proxy; no one-size-fits-all approach

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Sample Overview

N = 234 Russell 3000 Companies

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Boards have a lot on their plate right now. Even before Covid-19, institutional investors were challenging directors to consider stakeholders beyond investors. Now, even as directors are busy with the pandemic, investors want boards to promote a more agile, mission-driven executive team. They want leaders ready to handle the expanding complexities of corporate life with distributed decision-making, to respond to a rapidly changing business environment.

Of course, companies have always been complex entities requiring talented leadership. But success in the past depended first and foremost on financial metrics—and boosting total shareholder returns. Corporate governance reflected this priority, shown most clearly in the performance-based compensation programs for executives. Now success increasingly involves multiple dimensions.

Three Trends Shaking Up Corporate Leadership

First, more and more industries are threatened with disruption through digital technology, a challenge to be met only with strategic investments over several years. In most industries, especially with digital technology, the pandemic has now intensified the disruption. Traditional three-year planning horizons aren’t enough to meet this challenge.

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The COVID-19 crisis significantly altered operational priorities and financial results for companies in nearly all sectors. In recent months, to address some of these issues, many compensation committees have been disclosing executive base salary reductions as well as changes to in-flight and go-forward incentive plans.

The Conference Board, in collaboration with Semler Brossy’s research team and ESG data analytics firm ESGAUGE, is keeping track of SEC filings (Forms 8-Ks, 10-Qs, and proxy statements) by Russell 3000 companies announcing these changes. For the live database and some helpful visualizations of key trends across business sectors and company size groups, click here.

The following are some key observations from disclosures made since March 1, 2020 and update previously disseminated findings on a smaller sample of companies. The Russell 3000 index was chosen because it represents more than 98 percent of the total capitalization of the US publicly traded equity market. (Note: The commentary below refers to disclosures as of October 9, 2020, but the database is updated bi-weekly; please review the database and visualizations for the most current information).

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Thanks to emerging digital technologies, many industries are now facing a new wave of disruption. Artificial intelligence is powering autonomous vehicles, while data analytics are reshaping financial services and other consumer industries. AI-powered advances by themselves, according to a 2019 McKinsey study, could boost annual global GDP by $13 trillion, or an additional percentage point. And the coronavirus pandemic, by promoting remote work and commerce, has accelerated this process.

Companies in many industries now face serious threats to their business models. Yet executive compensation as a whole has been surprisingly slow to adapt to the challenge. Most programs still emphasize the same basic financial metrics on growth and profitability—which tend to focus executives on current programs rather than creative projects to meet the looming disruption.

Metrics that promote innovation and transformation are still relatively weak. Many companies rely on three-year performance periods that are too long or too short to capture the strategies they are implementing—and may thereby be contributing to the steady decline in corporate investment over the past decade. Also, boards frown on using discretion and qualitative measures in pay packages, even as they want their companies to be more agile and adjust strategies frequently. A clash is inevitable.

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Corporate boards have a fiduciary responsibility to manage risk, especially against major events that could overwhelm an organization and devastate shareholders’ investments. The Covid-19 pandemic has forced new attention on board’s responsibilities.

It’s tempting to call this pandemic a black swan, a calamity so unexpected that companies could not have prepared for it. But experts have been predicting global pandemics for years, and in January 2020, the World Economic Forum’s Global Risks Report cited infectious diseases as a potential threat. And few companies included a global pandemic in their high risk categories.

Indeed, it’s better to see the pandemic as a “black elephant”—a term derived from a cross between a black swan and the “elephant in the room.” Coined by the investor and environmentalist Adam Sweidan, it describes a looming disaster that’s clearly visible, yet no one wants to address it.

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When the Covid-19 pandemic began in March 2020, its economic impact significantly affected the annual incentive plans at many companies. In those early days, thinking the pandemic’s impact would be short-lived, directors discussed several ways to respond. Ideas included resetting goals in light of the macroeconomic impact, calculating bonuses on a ten-month basis (excluding the worst of March and April), or setting a new six-month plan for the second half of the year.

Now, with more than half of the year already past, the level of uncertainty remains extraordinarily high for many companies and industries. A ‘reset’ or other adjustment to incentive plans under ‘business as usual’ is fraught with challenges; for most companies, it is practically impossible for management and Boards to adjust existing plan goals or establish new goals for the second half of the year. That said, Boards can still work to ensure they position their companies as well as possible to enter FY2021. Some companies, facing financial constraints, will decide they just can’t pay bonuses this year, but others want to recognize management’s herculean efforts to preserve the company’s ability to thrive in the future. How can the Board best keep management motivated in these circumstances?
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Observations

• From June 1st to August 7th, 25 Russell 1000 companies announced changes to their current or go-forward incentive programs to address Covid-19’s impact:
  • Ten companies made changes to current, in-process incentive plans
  • Annual incentive plan: Schlumberger, Adobe, Newell Brands, Darden Restaurants, Hess, Lamb Weston, Lions Gate Entertainment, Sabre, and WEX
  • PSUs: NIKE, Lamb Weston, Sabre, and WEX
  • Consumer Discretionary (28%) and Information Technology (24%) companies make up roughly half the sample
  • Announcements have been made more often in 8-K filings (primarily 12/31 FYE companies with an in-process FY) than proxy filings (primarily 3/31 FYE companies with a recently started FY)
  • About half the sample announced changes to their annual incentive plan only and about one-third announced changes to both the annual and long-term incentive plans
• 40% of companies in the sample previously announced temporary reductions to executive base salaries as an immediate response to Covid-19

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The final link in the chain of improving corporate accountability for sustainability is to tie improvements to pay. In a November 2018 article, we explained that companies should use incentives to motivate executives to tap big strategic opportunities related to environmental, social, and governance (ESG) goals.

Now we want to describe how these incentives should be designed. What implementation steps do you take? And how can you overcome the challenges that deter executives and directors from changing how company incentives have traditionally been designed?

The challenges are easy enough to identify. For one, the number of possible sustainability improvement goals grows by the day, which makes it increasingly hard to know which to pursue: sourcing resources more wisely, managing waste and CO2 emissions responsibly, acting as a good citizen, celebrating diversity among workers, and so on. For another, the years-long efforts to realize payoffs from most ESG initiatives rarely fit typical annual or three-year incentive timeframes. That’s particularly true when you’re working to achieve indirect or intangible payoffs such as burnishing your brand and reputation. Results can build over decades.

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