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Discretion Advised: Build the Framework to Make Better Executive Pay Decisions

Editor’s Note: This is the second of a six-part, monthly series in Workspan Daily produced by Korn Ferry for the benefit of our readers and to encourage further discourse on topics vital to compensation professionals. Each article will address Korn Ferry’s “Top 10 Questions for Compensation Committees in 2021,” a publication produced at the beginning of the year.  

Many compensation committees were stuck in an unenviable position this proxy season. COVID-19 blew up many incentive programs and the committees were left balancing the interests of management with those of external groups. While executives wanted fair compensation for weathering a storm not of their own making, the media, proxy advisors and shareholders were ready to pounce on any questionable use of committee discretion on pay.  

Going into the 2021 proxy season, we knew that there would be an unprecedented level of committee discretion to modify incentive programs. And while compensation committees always knew they had this power, they often felt restrained to exercise it due to a variety of reasons, including pressure from proxy advisors. The COVID-19 outbreak changed this perception and required compensation committees to reexamine the tools in their governance toolbox.

Even as the pandemic began, some compensation committees wrestled with basic questions over how to modify incentive programs. Should the performance period change? Should the metrics change? Will payouts be adjusted through discretionary action? Which incentive program should be modified?

These questions were understandable given that proxy advisors and shareholders were eventually going to inspect these decisions closely. To their credit, Institutional Shareholder Services (ISS) published a short list of dos and don’ts that proved helpful. But ultimately, compensation committees were left with a difficult decision as to what “fair” looked like during these unprecedented times. And fairness was more important than ever given the massive number of layoffs and human suffering as a result of the pandemic.

According to one study of 300 companies in the S&P 1500, 50% of incentive programs were modified in some way to account for COVID-19. In 24% of these cases, the committee exercised discretion to adjust the final payout. In other cases, committees added or changed metrics, reset goals, revised payout scales, or excluded COVID-related expenses from performance results. Regardless of method, the committees intervened to adjust payout levels.   

In our experience, every compensation committee approached the decision to modify incentive programs in a rational and sober manner, but internal frameworks for the decision-making process were largely lacking. In other words, each committee went through a “blue sky” exercise with its decision and wondered aloud what other companies had already done.

With proxy season now in the rearview mirror, we need to get more comfortable with the application of discretion in determining executive compensation. COVID-19 has not disappeared, and it is entirely likely that some boards will go through similar program adjustments in early 2022. As such, compensation committees’ consideration and use of discretion needs to evolve. This is even more apparent given the increasing inclusion of ESG and nonfinancial metrics that often require a qualitative assessment.  

When exercising discretion, committees generally have two levers they can pull. The first lever allows for adjusting out the financial impact of an extraordinary event. This is similar to the adjustments often made to non-GAAP metrics. The committee’s second lever is the ability to adjust final payouts up or down based on factors outside of targeted performance outcomes. These are two important and powerful tools available to the compensation committee. But knowing what tools you have is different from knowing when and how to use them.

Before exercising any discretion, the committee needs to know the material factors that may push and pull on an incentive payout when the pre-established metrics are no longer useful. These factors form a framework we call “informed discretion.”

In a normal operating environment, compensation committees should be provided with quarterly, or more frequent, reports on performance against established incentive goals. The informed discretion approach is similar, but with additional attention on internal and external factors.

When performance goals are no longer realistic due to unforeseen events, the committee must still reach a logical and fair outcome with regards to incentive programs. Doing so still requires information from management, but it typically goes beyond standard presentations of financial metrics. Instead, the committee requires context about its corporate response to the event, peer actions, shareholder impacts, the effect on suppliers, and other macro-economic factors. In other words, the committee needs more information, not less.

Importantly, informed discretion is an ongoing process and it starts as soon as trouble arises. The board and management need to be on the same page throughout the year as they monitor internal and external data. In this way, both parties can avoid different expectations on what performance outcomes and payouts may look like at the end of the year.

Informed discretion is about providing more context to the committee to enable better decision making. Solely relying on the committee’s ability to modify a payout at the end of the year is not sufficient or wise. Rather, the company must widen the net of information before making any compensation decisions.

As 2022 approaches with COVID still lingering, many committees should now consider building this information framework just in case a discretionary lever needs pulling.

About the Author

 Irv Becker is the vice chairman of executive pay & governance at Korn Ferry.

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