Attorney Mike Melbinger, Partner in the Winston & Strawn Chicago office, brings perspective to this ICS/ISS illustration model of how a sample company might choose to adjust annual goals for incentivizing executives. As Mike points out this topic, “will affect nearly every company in corporate America”.
ICS/ISS Illustrates How Compensation Committees Could Consider Adjusting Annual Incentive Goals in 2020
Last week1, ICS/ISS2 announced that it will be providing “a series of potential frameworks Compensation Committees could consider for adjusting annual incentive goals or metrics in 2020 in an effort to establish a more realistic structure for properly incentivizing executives during this period of unprecedented volatility.” We have made several presentations to NASPP3 chapters around the country in which we discuss this topic, which will affect nearly every company in corporate America, so it is helpful to understand ISS’s perspective.
The announcement included “Case Study 1 of 4” (presumably there are more to come?), involving a midcap retail company with $2 billion in annual revenue which is adjusting full-year goals with a commensurate reduction to the CEO’s short-term incentive award. The company uses EBITDA4 as the sole metric under their STI5 program for the CEO’s annual incentive award. The full case study is a bit too long to include in a blog post, but it may be downloaded from ISS by request, using the link above.
The goals were developed using a quantitative Monte Carlo6 simulation that used the following inputs for growth rate and volatility assumptions, and were based on a typical probability achievement for threshold/target / maximum goals for corporate issuers:
Pre-COVID-19 Growth Rate: +2.4%
Pre-COVID-19 Volatility: 7.5%
|Probability of Achievement||90%||50%||10%|
|FY 2020 EBITDA||$204 Million||$225 Million||$246 Million|
|CEO STI Award Value||$500,000||$1,000,000||$2,000,000|
After watching the pandemic shutter all of the company’s retail locations as social distancing protocols went into effect, the Compensation Committee realizes the original goals established in February are likely unattainable, even if forecasts signal a strong rebound in consumer spending in Q4. Given the extreme shock on the full-year EBITDA results expected in Q2 due to the coronavirus shutdown, the Committee decides to revise the full-year goals to reflect a more reasonable landscape for 2020 by adjusting the growth rate and volatility assumptions for the Monte Carlo simulation and recast the EBITDA goals as follows:
Post-COVID-19 Growth Rate: -25.0%
Post-COVID-19 Volatility: 15.0%
|Probability of Achievement||90%||50%||10%|
|FY 2020 EBITDA||$123 Million||$165 Million||$207 Million|
|CEO STI Award Value||$375,000||$750,000||$1,500,000|
The recast goals using the more realistic growth rate assumption of -25.0% and higher volatility create a more reasonable range of outcomes for the EBITDA goals after experiencing the seismic shock the nationwide shutdown imposed on retailers in Q2 (with lingering effects expected to last into Q3 and possibly Q4). In addition, the revised goals should properly incentivize the executive to achieve challenging EBITDA targets despite the extraordinary headwinds the pandemic has created for the company, as opposed to simply assuming 2020 will be a lost year with no realistic chance of a payout under the annual incentive plan.
In connection with the lowered EBITDA goals, the Compensation Committee decided to apply a 25 percent reduction as a commensurate adjustment to the CEO’s STI award opportunity to maintain an appropriate pay-for-performance framework under the annual incentive plan. Given the significant financial loss experienced by shareholders via steep declines in share price during the pandemic, the Compensation Committee believed it was appropriate to reduce the CEO’s pay opportunity to align the pay outcome with shareholders’ interests, and to prevent the executive from experiencing a windfall payment should the economy rebound at a faster rate than expected.
In order to keep the CEO properly motivated to achieve meaningful performance goals for the remainder of the year, the Committee decides to recast the annual incentive goals to reflect a more reasonable operating landscape for the balance of 2020, and applies a commensurate reduction to the CEO’s STI award in order to maintain an appropriate link between pay and performance for shareholders.
ICS/ISS warns that the case studies should not “be considered as any indicator as to how the ISS Global Research Department will evaluate compensation design decisions when preparing voting recommendations for investors.”
For more insights on incentivizing executives in a post-pandemic economy, download the full report found under ISS “Topics” in the category: Governance & Executive Compensation.
#compensationcommittee #executivebenefits #incentivizingexecutives #executivepay
1 This article was published June 17, 2020
2 ISS Corporate Solutions (“ICS”)
3 National Association of Stock Plan Professionals (NASPP)
4 Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
5 Short term incentive (STI)
6 Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted due to the intervention of random variables. It is a technique used to understand the impact of risk and uncertainty in prediction and forecasting models. (https://www.investopedia.com/terms/m/montecarlosimulation.asp)
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