Knowledge Center

Issue 17 : Performance Issue

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Discretion: How Should Boards Approach its Application within Incentive Plans?

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While creating performance-based compensation programs designed to pay bonuses only upon the achievement of pre-established objective performance goals is desirable (and clearly a market trend), ultimately, the board and compensation committee may choose to balance this with the desire to retain flexibility to react to unexpected events and even to compensate management for more “subjective” performance criteria.

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Applying discretion shouldn’t be a third-rail issue. Even with strong, structured performance and pay alignment, boards regularly use discretion to approve financials, other numeric metrics, or exclude a now-private peer from relative TSR calculations. Discretion is also used for non-quantitative goals, such as succession or organizational effectiveness. In each case, it helps determine results within the plan.

Discretion is also needed to assure appropriate payouts when the plan did not—or could not—anticipate certain events. Perhaps the strategic plan changed and the team refocused. A well-executed spinout may be right for the long term, but cause a significant miss on current-year goals. Further, while a goal may have been achieved on paper, how it was met may undermine other critical objectives. In these and similar cases, discretionary adjustments (up or down) may be needed to align pay with performance.

Boards should develop a process to assess results and determine whether adjustments are warranted. This creates a familiar approach when discretion is needed.

Boards should:

• Adopt apples-to-apples principles for financials; document treatment of accounting changes, M&A budgets, effect of foreign exchange changes, etc.

• Understand what events might break the pay and performance link.

• Monitor the plan throughout the year, and discuss potential issues with management.

• Deal with the unplanned.

• Understand facts and circumstances and how well executives addressed the situations.

• Model alternatives to best align payout with performance, including the loss of tax deductibility.

• Clearly communicate decisions and rationale to participants, other directors, and stockholders.

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Two of Vanguard’s primary principles regarding executive compensation are “pay for performance” and “pay within reason.” These joint principles reflect our expectation of reasonable consistency in compensation among companies that are comparable when considering their size, complexity, industry, and performance. We also expect that most of executive pay will be driven by objective, quantitative goals that will create long-term value for our shareholders.

We’ve also seen a number of boards apply discretion effectively. For example, we’ve spoken to a number of companies that apply limited discretion in response to a company’s risk profile or cyclicality. We’ve also communicated with boards that exercised discretion when a company is in a turnaround situation and goal-setting is more difficult. Finally, a number of compensation committees exercise negative discretion in response to litigation or regulatory matters that may be difficult to predict.

At the end of the day, it’s most important that we understand how the compensation committee approaches these decisions. We expect that pay will generally reflect a company’s performance over time, and this is more difficult to assess when a company doesn’t use quantifiable metrics. As a result, we need to understand how the board assesses performance. Specifically, what are its criteria, agreed to at the beginning of the year, that determine the final pay decision? Companies shouldn’t underestimate the importance of thorough disclosure and other shareholder communications to convey how they’ve prudently used discretion.

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In most contexts, using discretion is considered a good thing; among other things, it implies trust and the exercise of judgment. However, when used in the context of determining executive compensation, our legal and regulatory system has looked askance at the use of discretion for at least the last 20+ years. In particular, with the enactment of Section 162(m) of the Internal Revenue Code in 1993, compensation committees became increasingly locked into using quantitative metrics and discretion became permissible only when applied negatively—i.e., when the committee reduced compensation below the amount indicated by the application of the metrics in question.

However, particularly at a time when companies and investors alike are increasingly concerned with issues such as diversity, sustainability, and compliance—“softer” issues that are not easily susceptible to quantitative metrics—I would argue that positive discretion is a good thing. Negative discretion may “punish” executives for subpar performance in these softer areas, but it doesn’t incentivize executives to excel, or even to “do the right thing,” where these areas are involved. Rewarding executives for outstanding achievements in diversity, sustainability, compliance, and other areas would give them reasons to exceed expectations and outperform peer companies (i.e., competitors) and might just provide a reason to launch a race to the top.

I’ve yet to find a company that says “we aren’t going to comply with Section 162(m) because we value discretion over deductibility,” but maybe now is the time for some brave souls to go there.

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In my experience, it is difficult for a Compensation Committee to establish objective performance metrics that account for all of the variables that may occur over a long time horizon. To comply with Section 162(m) of the Internal Revenue Code, long-term incentive (LTI) grants often include a laundry list of adjustments that will be made to reflect unpredictable events, such as litigation costs, foreign exchange gains or losses, or reorganization and restructuring programs. Despite the effort to account for these events, unforeseen developments may still render an LTI grant worthless, as we all learned in 2008. For this reason, I believe that Compensation Committee discretion to adjust performance awards remains an important tool in LTI design.

To comply with Section 162(m) while giving Compensation Committees flexibility to adjust awards, I am a proponent of 162(m) “umbrella” plans. Under a common umbrella plan design, a Compensation Committee approves one or more objective performance metrics that, if achieved, will fund the bonus pool with a maximum amount that may be paid to each participant. Under the plan, the Compensation Committee establishes separate objective and/or subjective performance metrics that determine the actual amount of the bonus pool that will become payable to each participant. To the extent the actual amount that becomes payable to each participant is less than the maximum amount allocated to the bonus pool for that participant, the Compensation Committee exercises negative discretion to reduce the maximum amount.

For many companies, the flexibility in design makes this an attractive alternative to traditional 162(m) plans. A company that implements such a design must consider how to describe the arrangement in its proxy and how to socialize the arrangement with participants.

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With continued scrutiny on executive compensation and the emphasis on pay for performance, boards generally use discretion only if there are unexpected business or market events or a fundamental change in the business. Ideally, the incentive plans should have challenging but realistic goals, which should result in payouts that are reflective of the company’s performance. However, circumstances will arise that require discretionary adjustments to awards, whether positive or negative, and the board has a duty to carefully consider all of the facts to determine if an adjustment is necessary, as well as understand the ramifications of applying that discretion. Those ramifications could include tax and accounting consequences, disclosure requirements, and employee, shareholder, and public perception issues.

As boards consider making discretionary adjustments, they need to consider all elements of performance and the unique facts and circumstances that may require a discretionary adjustment to the award payout. Also, the board may wish to consider applying discretion in a manner that falls outside of the incentive plan to help mitigate the potential ramifications. Regardless, we recommend that boards proactively develop guiding principles outlining those circumstances when discretion may be considered in incentive payouts, as well as outside the incentive plans. The guiding principles should also address how much awards can vary from the calculated amounts when discretion is applied. This will help boards determine when and how to apply discretion to incentive awards in a consistent manner

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