Top Themes for 2019 Award Design Season

My colleagues David Outlaw and Alec Katric just delivered a webcast on novel award designs to inspire you as the fall 2018 award design season approaches. I’d like to follow up with some thoughts on broader governance, design, and proxy themes to watch out for as we enter award planning season and begin preparing for the 2019 proxy season. (For even more ideas, don’t forget to check out our 2018 Executive Compensation Decision Support Survey, which reveals how compensation leaders are thinking about these very topics.)

1. Designs are getting bolder, more targeted, and even more creative.

The homogenization of long-term equity award design has concerned many of us in the industry for some time now. Too many companies are issuing simplistic, carbon-copy awards that are detached from their specific strategic priorities.

Happily, the 2018 proxy season saw a noticeable uptick in creative and bold award designs. What were the highlights? And will this trend continue? Let’s take a look.

Leveraged Performance Units (LPUs)

LPUs come in many shapes and sizes, but the basic quality is a very steep payout curve that allows recipients to earn extremely high payouts in outperformance scenarios. These are most appropriate during periods of organizational and strategic transformation.

For example, Carnival Corporation issued an LPU to four named executive officers (NEOs) other than the CEO. With this award, each NEO can earn up to five times the payout they might otherwise, based on how much the absolute total shareholder return (TSR) goes up. Carnival’s explanation in the proxy explains why this type of grant made sense in light of the organization’s then-current predicament:

Mr. Donald has made significant changes to the senior leadership team as well as the structure in which they work to jointly direct the operations and strategies of our brands across the entire corporation. The fundamental objective of this new focus is to leverage the scale of our worldwide businesses with the goal to profitably grow our cruise business and increase our return on invested capital, reaching double digit returns in the next three to four years, while maintaining a strong balance sheet. In order to incentivize and focus the NEOs during this critical transition period to achieve these broader goals beyond the individual brands or departments for which they have responsibility and strengthen the alignment between compensation opportunities and shareholder outcomes over the next three years, the Compensation Committee granted a special PBS grant to Messrs. Bernstein, Buckelew, Cahill, and Thamm with a target value of $1,000,000 each.

Carnival introduced this design back in 2014. Since then, numerous other companies have followed suit.

Performance-Based Stock Options

Although stock options have been on the decline for many years, some companies miss the way they create clean long-run incentives to grow the stock price. As our research shows, the now-normal three-year TSR performance periods are so short that payouts often may have more to do with volatility than with sustained performance.

One reason stock options fell out of favor is that ISS doesn’t consider them to be performance-based. Given the expectation to make at least 50% of long-term equity grants performance-based, for many organizations stock options were literally crowded out of the equation.

The design trend we’ve seen as of late is to add price vesting hurdles to secure “performance-based classification” for stock option grants. Since options only have meaningful value when the stock price materially rises, adding hurdles shouldn’t be a drawback to the recipient. We expect to see greater use of performance stock options to create higher leverage and cover a lengthier time horizon. Some notable examples include American Express, BlackRock, and Palo Alto Networks.

Multi-Metric Performance Awards

We’ve been writing about these for a few years now. Also known as “hybrid awards,” multi-metric awards are predicated on the idea that an effective long-term equity grant needs to balance the recipient’s need for line of sight with the shareholder’s need to link executive pay with value creation.

This is why classic TSR awards came under fire. They were criticized for not using goals that were relevant to the day-to-day obligations of the executives receiving them. Multi-metric awards begin with a financial or operational goal that relates to the core strategic priorities of the organization and then thread in a shareholder value creation goal. The shareholder value creation goal is usually relative TSR. But it could be absolute TSR or even a non-TSR goal like return on equity.

In our 2018 Executive Compensation Decision Support Survey, we found that over 75% of companies use two or more metrics in their long-term equity award design. What’s more, 66% of companies use independent metrics.

We expect to see a few trends this design season. One is for the share of companies using multiple metrics to climb further, perhaps past 80%. Another is a gradual shift away from independent metrics to modifier relationships.

A modifier structure establishes one core metric (say a three-year return on invested capital) with a payout grid, then allows another metric (like a three-year TSR) to modify the payout up or down. While there are good reasons for both modifier and independent designs, we find the modifier structure easier to explain. That’s particularly so if the primary metric is the one with highest line of sight. Then the more abstract metric (like TSR) serves as a check to make sure that final payouts are indexed to shareholder value creation. Another plus: The accounting is slightly better for modifier structures since missing the core (non-TSR) metric will allow for reversing the entire accounting cost.

Minor TSR Design Tweaks

Be aware that many firms are trying to improve their TSR programs. Some are changing the design so that it reduces the cost and/or improves the governance story without hurting their appeal to executives. An example of this is to add a negative absolute TSR cap. Another goal is to reduce the risk of unintended consequences, like a cost surprise due to unusually high or low realized performance between the performance start date and grant date (common among relative TSR awards). One fix we’re beginning to promote is to synch those two dates.

2. ESG may take many companies by surprise.

Environmental, social, and governance (ESG) topics historically have operated at the fringes of the executive compensation and corporate governance landscape—the sort of thing reserved for egregious offenders or those companies unlucky enough to be targeted by an activist investor with an ESG agenda.

Now, though, ESG issues are much more central to the proxy and executive compensation. Interestingly, the driving forces are not only a handful of activist investors, but also active fund managers and even the passive funds. Why?

Let’s start with the passive funds, focusing on the big three (Vanguard, BlackRock, and State Street). They’re desperately fighting to differentiate and justify their fees in an era of extreme fee compression. Additionally, since their holding period is basically “forever,” they’re willing to think about long-term issues. The tenor of shareholder engagement meetings has changed markedly: There are far fewer questions about the quarterly results posted and far more about big picture topics like the corporate culture, talent development, health and safety, and governance.

As for active fund managers, their higher fee schedules have put them under even greater margin pressure. So this group is looking for ways to deliver value-added investing advice. This group will still be focused on short-run matters like quarterly performance, but they can’t turn a blind eye to ESG when the passive funds are putting ESG in the spotlight.

Finally, activists have discovered that they can piggyback on ESG trends to drive their agendas. Rather than emptying their pockets to accumulate endless numbers of shares, they can try to align on issues with passive fund managers who already have large ownership interests. This increases their leverage when seeking to introduce shareholder proposals or acquire board seats. One very public case was Jana Partners teaming up with CalSTRS to push Apple to rethink how children use their devices.

Consider that:

• Of the top 10 activists, 6 emphasize ESG topics as being core to their investment hypotheses.

• Eight ESG proposals received over 50% of support during the 2018 proxy season, compared to 17 over the past 7 years combined (research by Semler Brossy).

• After publicly articulating their heightened interest in gender diversity, State Street voted against directors at over 400 companies where they believed efforts to improve in this area had been inadequate.

It’s worth learning more about the passive funds’ evolving views toward ESG, especially at State Street. But let’s move on to what to do about these headwinds.

To begin with, make sure your organization has a long-run ESG strategy and you’re able to articulate it clearly and concisely. If your organization doesn’t have such a strategy, now is a good time to begin building support for one. Think about it this way: If you suddenly found yourself in front of your top three investors, all demanding to know how you were managing a series of ESG risks pertinent to your business, how prepared would you be? In our world of ongoing shareholder dialogue and shareholder proposals materializing out of thin air, the more you can prepare in advance to explain your ESG strategy, the better.

Next, consider whether ESG metrics should make their way into the annual bonus plan or long-term equity plan. The question will inevitably arise: “If you say ESG is so important, then why don’t you compensate on it?” In fact, we’re hearing some argue that they don’t want to hear much in closed-door outreach meetings that they can’t also see in formal proxy disclosures .

We’re skeptical of rushing to disclose ESG metrics in the proxy or embed them as performance goals in the annual bonus plan or long-term equity plan. Plenty of important topics never make it into compensation plans but are clearly part and parcel of an executive’s performance evaluation. Examples include stewardship over the corporate culture, risk management, and proclivity toward innovation. In other words, we think it’s premature to add an ESG metric unless you can identify one that’s clean and straightforward to measure and explain. Nonetheless, you may be pressured to do just that, so keep careful watch of these issues.

Finally, be proactive in initiating relevant ESG initiatives. We’ve written about pay equity, but ESG is broader—encompassing health, safety, climate, and more. Bring these up in your shareholder engagement meetings and make sure investor feedback gets back to senior management. The best shareholder meetings are reciprocal, where you share information and probe to see where your investor base might have concerns.

3. Say on what? Proxy advisor evaluations are changing.

Obviously we’re referring to say on pay (SOP). However, the running joke has been that it’s really “say on performance”—the idea that SOP is more about whether a company performed well than about their specific pay decisions. ISS has fueled this criticism thanks to their habit of using a formulaic relative TSR measure for assessing performance.

All of that’s changing, and we think it’ll be a mixed bag. In the future, it will be even more challenging to forecast how ISS will rate your pay decisions vis-à-vis performance.

To understand why, consider what happened last year when ISS widened their focus from TSR by introducing the Financial Performance Assessment (FPA) test they plan to run. This is in addition to the multiple of median (MoM), relative degree of alignment (RDA), and pay-TSR alignment models. The FPA test will involve different financial metrics that are selected and weighted differently by industry. The metrics include:

• Return on invested capital (ROIC)
• Return on assets (ROA)
• Return on equity (ROE)
• Earnings before interest, taxes, depreciation, and amortization (EBITDA) growth
• Operating cash flow growth

Like TSR, companies will be assessed against their peer group.

The FPA so far has received little attention because ISS intentionally limited its reach during this first year. However, we expect to see a greater reliance on either the FPA or one or more derivatives of it. As we’ve blogged elsewhere, we think many companies will long for the old solo-TSR world. FPA’s financial metrics are as-reported GAAP results, which tend to compare very poorly across companies. Additionally, two firms in the same industry can justifiably have very different levels of the above financial metrics, making comparability dubious.

This may be just the beginning of more change in how pay and performance are modeled. Back in February, ISS bought EVA Dimensions, which specializes in creating models for gauging economic value (instead of book value). Measuring economic profit was a big thing in the 1980s and 1990s, and it seems to be making a comeback. Expect to see some flavor of it showing up in future ISS pay-for-performance tests. Glass Lewis or institutions like Fidelity that do this modeling internally may choose to follow suit and come up with their own measures.

These developments are significant because organizations go to great lengths to model pay-for-performance linkage in order to avoid misalignment situations that chip away at say on pay votes. This modeling can become considerably harder to do if proxy advisors and investors begin using models of a more black-box or proprietary nature. There are two things you can do to prepare:

• Upgrade the quality of visualization used in your proxy. The proxy is the best vehicle you have to explain and justify your pay decisions—and pristine visualization is one of the best tools for upgrading the persuasiveness and appeal of that story. We blogged earlier this year on some model proxies that do this well.

• Start modeling additional financial metrics. This way, you can rebut erroneous assertions about your firm’s performance. For example, at this year’s WorldatWork Total Rewards Conference I spoke about how easy it is for return on invested capital (ROIC) to be biased by M&A, divestitures, and R&D treatment. Be ready to unpack any numbers a third party runs so that you can tell your side of the story.

4. Goal-setting is becoming a top issue among proxy advisors and institutional investors.

Nowadays, if you open an ISS report one of the top themes you’ll see is goal-setting rigor. So far, however, assessments have been limited to comparisons with the prior year’s target or actual performance. For most companies, it’s easy to exceed the bar set last year and use that as evidence to support the rigor behind the goals.

Proving that goals are rigorous will only become more difficult. For one, if the markets cool down it may be necessary to set goals below the previous year’s actual result or target goal level. Another consideration: ISS bought a firm that does simulation modeling on goals to infer a goal level that corresponds to a probability of achievement. The process is comparable to how we assist clients in goal-setting. The difference of course is that ISS may try to use these models to grade goal threshold and target levels. Either way, plan to get more pushback on proposed goal levels, whether via proxy advisors or from your own compensation committee.

The best defense is to show your work on the proposed goal structure. For example, if your FP&A team provides a single three-year projection for earnings per share (EPS), at a minimum you’ll need some level of rigor around how you flex the target to create threshold and stretch levels. Techniques for setting performance goals include fitting probability distributions to historical data, using Monte Carlo simulation, and drawing inferences from analyst forecasts.

5. Companies are redoubling their efforts to balancing grant agreement flexibility with clean accounting.

We’ve written extensively about non-GAAP performance metrics as a way for compensation committees to maintain some discretion over metric outcomes and deal with exogenous shocks like tax reform or accounting standard changes. However, non-GAAP metrics—if used incorrectly—can create accounting grant date and modification accounting problems.

During the 2018 granting season, we expect to see a stronger focus on the use of non-GAAP metrics. Below are three risks and best practices to think about:

• Avoid overly-vague and discretionary language in your grant agreements. Remarks like “The Committee reserves the right to adjust performance goals in light of unplanned events” are too vague, and risk undercutting the presence of an upfront accounting grant date. Some auditors have taken the opposite view and argued that any adjustments by the compensation committee at payout constitute a modification, which is a similarly problematic outcome.

• On the flip side, avoid overly-specific language in your grant agreements as well. Simply by way of example, some companies failed to write into their agreements that tax law changes are a reason they can adjust reported performance. As a result, any adjustments to factor in the effects of the Tax Cuts and Jobs Act triggered modification accounting. A more likely area of risk going forward is whether you preserve enough flexibility in how you treat acquisitions and divestitures.

• Coordinate with your accounting team on how to make non-GAAP adjustments. This is an in-the-weeds problem, but incredibly important. Most companies lack immediate access to a series of parallel universes that illustrate what their performance results might be if events A, B, and C never occurred. The most salient recent example is adjusting for the effects of ASC 606, which is the new revenue recognition accounting standard. Most companies discovered that their systems did not allow them to continue tracking revenue as if they did not adopt ASC 606. That forced them to build elaborate models so they could estimate what their financials would have been had they never adopted ASC 606.

These risks are most pertinent to financial and operational metrics, such as EPS or ROIC. However, even TSR awards are susceptible since peer group entry and exit can wreak havoc on payout calculations. We’ve devoted an entire issue brief to those very risks.

As an industry we’ve had a relatively easy time calculating award payouts and factoring in unplanned events. That’s because market performance has been healthy and most companies have surfed the bull market wave. But keep in mind that these issues become much more challenging during down markets. We aren’t macroeconomists, but we are getting concerned that it’s time to think carefully about how the awards we grant and plan agreements we write will perform during a down market. After all, the last bear market was in 2008 and, historically, the markets retreat about every 10 years.

These are the topics on our mind as we get ready to help compensation leaders through the 2018 grant planning cycle. If you’d like to delve into any of them, or vet altogether different ones, we’d love to hear from you.