While it is still unclear what long-lasting impacts the COVID-19 pandemic will have on compensation structures going forward, the pandemic highlighted the need for flexibility, judgment, and the ability of the Board to utilize discretion when necessary.
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recent piece from Meridian details how discretionary authority empowers compensation committees to ensure payouts are aligned with performance and strategic goals. Discretionary authority has (often unfairly) historically been perceived by proxy advisors and investors as a pathway to unjustified payouts. However, a well-structured annual incentive plan allows committee members to incorporate real-time data into their informed judgement about executive performance, including adjusting to volatile conditions and rewarding progress on goals that do not lend themselves to quantitative formulas, such as ESG milestones.
The Meridian piece highlights several methods of incorporating discretion into annual incentives:
- Full Discretion: In this model, 100% of an executive’s annual incentive is discretionary. While the plans typically have an established structure to guide decisions including performance measures and goals, the compensation committee has full discretion to determine the final payout. These plans may work best in times of high volatility or a complete strategic shift or recovery. However, they are also likely to draw the sharpest criticism.
- Weighted Component: A certain percentage of the incentive payout will be determined formulaically, and the remaining percentage is discretionary (for example, a 70% quantitative/ 30% qualitative split). Such plans remain quite common, and in general do not raise substantial criticism. However, criticism will likely rise if the qualitative results repeatedly pay at maximum while quantitative goals are missed.
- Modifier: Plans with modifiers use a formulaic plan to create an initial payout level but specify that the compensation committee may use its qualitative judgment to modify the payout based on established criteria. While less common than a weighted component, these are seen with some frequency. Critics will protest if modifiers are repeatedly used to increase payments, but never used to reduce awards.
Proxy advisors have expressed a preference for formulaic plans, but typically discretion is not an automatic reason to recommend against a company’s pay plans. If pay and performance are aligned in the quantitative analysis, the presence or use of discretion may draw criticism without an adverse vote recommendation. If quantitative screens highlight a concern, then discretionary elements are likely to be the cornerstone of a negative recommendation.
Interestingly, shareholders expressed a preference for judicial, moderate use of discretion in response to COVID-19. Compensation committees were encouraged to consider employee and shareholder experiences in award decisions, and a well disclosed rationale for discretion was often more appealing to investors than attempts to modify existing performance goals or metrics. Ultimately, we will have a better understanding of concerns regarding discretion as shareholder vote results are disclosed.
