Establishing Long-Term Incentives Amidst Uncertainty

May 21, 2021

Dan Marcec

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The past year cast a wide shadow on how companies should approach long-term compensation planning. COVID-19 played a big role, reminding us that the great unknown is always potentially around the corner.

Meanwhile, a bright light shined on public companies’ role in addressing perpetual racial and income inequality, as well as the persistent impacts of climate change. As stakeholders look to Corporate America to wield its power and make a difference, boards of directors are thinking critically about how to incentivize strategic planning that will drive change.

Equilar recently hosted a webinar with Aaron Oberg, Senior Manager at Morgan Stanley at Work, Shelly Carlin, Executive Vice President of the Center On Executive Compensation, and Drew Hambly, Executive Director for Morgan Stanley Investment Management, to cover these topics and more. The panel sought to help companies think through critical issues on the table as they go into annual executive compensation planning cycles. This article shares key highlights from the discussion.

Predicting the Future With a Foggy Crystal Ball 

Recent trends in pay for performance mean executives are heavily invested in sharing value creation with multiple stakeholders, which is widely agreed upon as a good thing. 

“In executive compensation, the big story is performance awards and what the metrics are,” said Oberg. “We do see more and more performance metrics coming in with pressure release valves in case something happens in the macro environment that affects the ability to achieve those metrics. Incentive plans have to have teeth, but also flexibility so you don’t end up in a situation where they are demotivating.” 

COVID-19 laid bare the reality that like any investment portfolio, compensation packages need balance. Incentive plans have to be structured in a way so that when some things are doing poorly, other things may do better. 

“One of the key lessons [from 2020] is that you have to make sure all your eggs are not in one basket, and it is important for the compensation committee to have the proper amount of flexibility, or informed judgment, to exercise in a circumstance no one could have predicted,” said Carlin. “But it can’t go too far. The companies that have done best through this, and the ones that have not had to tweak anything, are the ones that have had balance.” 

“There are all kinds of reasons to build in flexibility, but the main reason is the reason you can’t think of,” added Oberg. “We still can’t anticipate every future event.” 

Ultimately, investors would like to see companies avoid making modifications to their pay plans if possible. It’s not realistic to expect everything to work neatly as a formula, and it’s understandable that some companies may need to move the goalpost a little bit, especially during an unexpected, market-wide event such as a pandemic. That said, the plan should build in the ability to be patient and allow for a “wait-and-see” approach without having to make hurried changes. 

“We want boards to be measured and patient, but if you do have to make that step, you can’t do it in a way where the new award is more valuable than the original one,” said Hambly. “That’s not in alignment with shareholders. We don’t get to reset our price. We want to make sure it’s not a ‘heads they win, tails we lose’ situation. And I don’t think that’s unreasonable.” 

Incorporating ESG Into Compensation

Stakeholders across Corporate America — not only investors, but also employees, customers, and the public at large — have made clear that part of a company’s value comes from its dedication to environmental, social and governance (ESG) issues. 

Generally, non-financial metrics surrounding environmental goals and diversity, equity and inclusion (DE&I) are not yet common as part of executive compensation packages. According to an Equilar analysis on executive long-term incentive plans, only about 3% of the Equilar 500 disclosed such metrics as a determinant for awarding executive equity.

However, some sectors with high environmental impact have seen related performance metrics start to crop up in executive compensation plans, and a lot of companies are setting net zero carbon targets. On the DE&I front, there is a lot of talk, but hesitancy on taking action so far, even though boards widely agree on the importance of the issue and the need for incentivization to drive change. 

“2020 was a tumultuous year, and [ESG] was very visible,” said Oberg. “Companies are being cautious because they don’t want to be haphazard or do something that backfires. But they don’t want to be caught doing nothing.”

The question is not about desire, it’s about practicability. Targets can vary from company to company, and there’s widespread uncertainty around diversity metrics as a whole.

“Representation is like the TSR [total shareholder return] of diversity,” said Carlin. “It’s the ultimate measure of what you’re trying to achieve, and like TSR, it needs to be done on a sustainable basis. I think that’s why people are being so cautious.”

For example, she added, boards could easily put in an incentive to increase the number of women or people of color employed at a company in any given year, but if management meets the goal in a way that’s unsustainable, they’re not serving the ultimate outcome. 

“You have to consider what actions drive those outcomes, just like with TSR,” Carlin noted. “This is where people get stuck, because they are not clear on what is going to drive truly sustained representation.”

While there’s not an easy formula today, establishing sustainable diversity metrics provides a huge opportunity for compensation and benefits professionals to partner with their talent acquisition and retention colleagues. It’s an opportunity for the board to shine a light on HR and CEOs to work with these departments to identify process metrics that will drive the outcome metric. The challenge is understanding, and satisfying, the multi-stakeholder environment.

“Most people would agree that the effects of climate change are a key systemic issue across the global economy, and diversity and inclusion, which is having its day in the sun, rightfully so and long overdue, is a systemic issue,” said Hambly. “Companies won’t solve it alone, but they have to put a chip in the pot. If they are going to be serious, some compensation needs to be tied to this.”

View the full panel discussion on demand.

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