- On September 27, 2016
The WSJ published an article last week penned by Bruce Nolop (former CFO of Pitney Bowes and E*Trade Financial) entitled Why Basing Executive Compensation on a Formula Doesn’t Work. In the article, Nolop discusses some of the trends related to the use of discretion in incentive compensation and risks of formulaic compensation.
Trends in Incentive Design and Use of Discretion
Nolop suggests that:
We may now be seeing an emerging trend toward less adherence to a strictly formulaic approach and more room for boards to make discretionary judgments, which used to be more the norm.
The pendulum is definitely swinging more toward the reintroduction of Board and Committee discretion in adjusting incentive plan payouts. Most Fortune 500 companies have by now adopted some sort of 162(m) “umbrella” plan to design their way around the restrictions of the tax code, so they can continue to deduct compensation even when the compensation formulas do not in practice allow for Committee discretion. 162(m) umbrella plans offer Committees the ability to use both negative and positive discretion to adjust incentive plan payouts. For context, let’s take a quick look at the history of formulaic incentives and the role of discretion and how we got here.
In the 1970s and 1980s, variable pay programs were common, but many of the plans of the time were discretionary in nature. Pay was indeed related to performance, as the amount of pay available for bonuses increased when performance was strong and declined when performance was weaker. However, the formulas that generated such bonus pools were usually either not disclosed, or if they were, they were not transparent. Except for perhaps the most senior executives, the plans represented “bonuses”, not incentives. (Bonus: Pay that varies according to performance, but participants typically do not know either the performance measure or perforamnce goal. Incentive: Both performance measure(s) and goal(s) are communicated, so participants can calculate how pay varies according to performance.)
Beginning in the 1990s and 2000s, shareholder activists began encouraging companies to disclose how bonuses for top executives were calculated. And for broader employee variable pay, companies began to realize the difference between bonuses and incentives. Most importantly, the introduction of section 162(m) of the Internal Revenue Code via the 1993 Tax Act pushed most public companies to adopt a formulaic approach to their incentive compensation programs, at least for their very top executives. (An Excellent Overview of 162(m) from Skadden Arps can be found here.) No longer would discretionary bonuses be tax-deductible if they pushed executive compensation over the $1 million ceiling.
The Great Recession of 2008-09 shook the world of executive pay and had lasting effects on how incentive programs are administered. Many companies continued to post solid financial results through 2008, yet saw their stock prices fall dramatically by the end of the year. Compensation Committees struggled with approving large bonus payouts at the same time as shareholders suffered significant losses. Boards discussed whether management teams should have taken more precautions to protect or hedge market positions to prvent larger losses.
In 2009, most companies suffered from perforamnce that fell far short of goals established in late 2008 or early 2009, so most companies’ incentive plans paid out minimal amounts or even zero. However, by 2010 and 2011, performance goals were adjusted and companies across many industries had incentive plans that paid out well above target and many even maxed out their plans.
In the years following the recession, Compensation Committees struggled trying to reconcile the volatility of payouts in 2008, 2009, 2010, and 2011 with the financial performance results, shareholder experiences, and external factors arguably beyond the control of management. What emerged from these discusssions and thinking is a new approach to how discretion fits in with heavily formulaic incentive approaches. The emerging best practice allows the Compensation Committee to retain discretion to adjust payouts and awards, but most companies have adopted principles that guide Committee adjustments, so that actions taken are not viewed as arbitrary.
The Risks of Formulaic Compensation
In the WSJ article, Nolop argues that formualic compensation has several problems:
They are impacted by events outside management’s control (e.g. the Brexit vote). Formulas can exclude certain factors such as currency translation but it’s hard to anticipate all the contingencies, and they should not deviate too much from the metrics valued by investors.
They may incentivize short-term thinking and undue risk-taking(e.g. the impact of EpiPen’s price increase on Mylan’s reputation), often favoring actions that have immediate impact, such as share repurchases, over longer-term investments with less certain paybacks.
They often undervalue qualitative factors (e.g. customer experience, employee relations or brand image).
All of these drawbacks are true, but none are sufficient to avoid consideration of formulaic incentive compensation. And more importantly, all these risks are either easily addressed by good management teams, or are easily mitigated through compensation design. For example, events outside of management’s control can — and should — be addressed by various risk management strategies: hedging, insurance, resource allocation tactics, etc. Short-term thinking and undue risk-taking can be easily addressed by changes to a company’s pay mix: less emphasis on short-term pay and more emphasis on long-term compensation. And if compensation programs undervalue qualitative factors, then the solution is to quantify those factors, measure them, and set goals for maintaining or improving performance across those dimensions. Today, qualitative factors such as customer satisfaction, employee relations, and brand image can all be measured. Many leading companies already incorporate these types of measures in their incentive programs.
Most importantly, attempting to identify the key financial and non-financial measures that drive value for your enterprise is a tremendously valuable exercise in and of itself. Identification of those measures should engage your management and Board in a meaningful discussion of the drivers of enterprise value; the importance, leverage and sensitivity of each driver; and what the near-term and long-term priorities for the company ought to be.
Risks of TSR
Nolop closes by articulating several risks of using TSR: absolute TSR is dominated by overall stock market moves, so relative TSR is better [we agree]; TSR relative to a broad market index is influenced both by industry performance and company performance and strategy; TSR relative to industry peers is best, but is subject to difficulties of constructing an approrpriate peer group; finally, TSR formulas can be distorted by external actions such as shareholder activists or cross-company ownership.
Again, while these criticisms of TSR are fair, they can be overcome — or at least sufficiently mitigated — in almost every situtation. The keys:
- TSR must be defined over a sufficiently long enough period (at the beginning and end) to eliminate unusual stock price volatility — external activities such as shareholder activism or cross-company ownership are both resulting activities of management teams that have not done enough to address shareholder value.
- TSR ought to be measured relative to a reasonable peer group, and if an appropriate peer group is unable to be constructed, then the TSR component ought to be balanced by using other financial measures
Nolop’s “Bottom Line”: “We should heartily embrace a trend toward more discretion in executive compensation.”
Sheffield Barry Perspective: Discretion has a role and Compensation Committees should retain some measure of discretion to adjust performance or calculated payouts, but we would not advise giving up on a formulaic incentive approach just because it isn’t 100% without risk. The process of designing a formulaic incentive approach and reviewing the design annually, can have significant value to Boards and management teams.
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