Adapting Executive Rewards for COVID-19

Authored by: 

Arvind Laddha | CEO | Mercer India, Arjun Prakash | Executive Remuneration Practice Leader | Mercer India

By any measure, COVID-19 is an unprecedented crisis affecting almost every individual and organization – albeit at varying levels. From a business standpoint, companies’ annual operating plans, near-term strategies and (in some cases) even business models have been all but upended by the sweeping halt in global economic activity. While many companies are protecting their employees, customers and vendors to prevent disproportionate fallout for any one group, there is growing urgency to also ensure business sustainability. In our view, this underlying trade-off between empathy and economics will determine how organizations balance their talent, performance and rewards decisions.

As companies scramble to deal with this rapidly evolving phenomenon on numerous fronts, it is crucial that leadership teams diligently firefight the current situation while staying motivated to quickly ramp up as markets return to normalcy. Executive compensation can be a vital tool to help drive both these objectives. Below are the key actionable items that companies should review to align executive compensation with their business continuity plans, long-term objectives and future sustainability. As is true during business-as-usual conditions, there is no one-size-fits-all solution and every company should assess and implement measures that help drive its strategic priorities. 

  • Executive Pay Cuts

    Rationale
    • Cost cutting to offset projected loss of business
    • Executives have the highest accountability for organization performance and hence experience the greatest impact on personal rewards in both economic booms and downturns 
    • Exhibit “lead from the front” mentality 

     

    Key Considerations

    • Magnitude of pay cuts should take into account the projected business loss for the financial year, i.e., commensurate with severity of the pandemic’s impact on the P&L
    • Pay cuts should be applied to fixed pay, which in turn may also lower the annual incentive and long-term incentive (LTI) opportunities as those are typically set as a percentage of fixed pay
    • Most appropriate for worst-hit industries – travel, hospitality, retail, auto, real estate, etc.
    • Several companies like Oyo, SpiceJet, Apollo Tyres, Kotak Mahindra Bank, Zomato, Indiabulls Housing, etc. have announced fixed pay cuts ranging from 15%-75%. Most organizations have applied higher pay cuts for senior management than for mid-to-junior level roles
  • Executive Pay / Increment Deferrals

    Rationale
    • Temporary cost containment to offset immediate business loss 
    • Postpone incremental expenses until there is better visibility into future performance  
    • Exhibit “lead from the front” mentality

     

    Key Considerations

    • Deferrals may apply to FY 2020-2021 increments, ongoing salary payments, or new incentive awards
    • Application and length of deferral should reflect the expected timing of performance recovery
    • Appropriate for companies trying to conserve cash and manage operational liquidity 
    • Several companies like TVS Motors, PwC India, Zoomcar and Wipro have undertaken salary / increment deferral
    • Companies undertaking pay cuts or deferrals could consider equity incentives, a non-cash expense, in lieu of fixed pay and annual bonus that are cash expenses
  • Adjustment of Outstanding Annual Incentives and LTI Awards

    Rationale 

    • Annual incentive for FY 2019-20 performance and in-cycle LTI grants are likely adversely impacted in terms of the payout value due to the steep business downturn
    • Balancing ‘pay-for-performance’ philosophy with the fact that COVID-19 is an exogenous occurrence beyond employees’ control is important to ensure that the rewards system is deemed fair and continues to attract, retain and motivate top talent 

     

    Key Considerations

    • Most companies will refrain from any discretionary adjustments and let actual performance results dictate the incentive payouts to uphold the integrity of plans 
    • Some companies may consider adjusting the performance results to mitigate COVID-19’s impact on incentive payouts. This may be relevant when the alternative of not taking such action would wipe out substantial rewards for otherwise strong performance 
    • Some companies may consider repricing/exchanging underwater stock options (i.e., options with zero intrinsic value due to precipitous decline in share price). However, this approach is considered a poor pay practice since it creates misalignment between shareholder and employee experience
    • Board NRC should carefully study the facts and circumstances to determine the need for adjustments to prior plans. If a modification is deemed appropriate, then the NRC would be well-advised to consider the potential legal and accounting implications before finalizing its decision
  • Consider NonFinancial Performance Measures in Incentive Plan

    Rationale

    • Financial performance metrics (revenue, profit, return on capital, cash flow, etc.) measure the performance outcome and hence may lag the non-financial metrics (key value drivers) during COVID-19 
    • While financial performance recovery is critical, it will be achieved through effective execution of a well-planned strategy

     

    Key Considerations

    • Inclusion of non-financial measures – such as employee safety/productivity, customer satisfaction, efficient supply chain and inventory management, innovation – could help weather the storm better through emphasis on current strategic imperatives
    • Other measures that promote CSR initiatives to support  the broader community may also be considered
    • Non-financial measures should still be measurable / quantifiable to enable objective assessment
  • Revisit LTI Instruments

    Rationale

    • LTI instrument(s) selected based on earlier business conditions may not be effective in a prolonged economic downturn
    • Continued alignment of LTI plan structure with the company’s evolving strategy and overall economic environment is critical 

     

    Key Considerations

    • Companies may consider granting more than one LTI award type to achieve multiple objectives including retention and performance motivation
    • E.g., a portion of LTI in restricted stock units (RSUs) or long-term cash would boost employee morale and promote retention of key employees while a portion in stock options would incentivize long-term value creation / restoration
    • Performance shares would help drive recovery in the company’s financial and operational performance
  • Prudent Performance Goal-Setting for Incentive Plans

    Rationale

    • Challenging to set goals in times of high uncertainty due to low visibility into future performance
    • Traditional goal-setting approach could lead to high volatility in incentive payouts (i.e., all or nothing) and hence may not be relevant in the current context

     

    Key Consideration

    • Target goals, which are generally aligned with budget, should account for the pandemic’s impact and hence will generally be lower than the earlier projections
    • Wider performance goal ranges could be considered for target payout as well as the full payout range (i.e., threshold to maximum) to mitigate high pay volatility
    • Relative goals, such as relative total shareholder return (rTSR), versus industry peers can help obviate the need to set absolute goals while appropriately aligning pay with relative performance
    • Another bespoke approach is to set goals for shorter, truncated periods – e.g., 2 half-year goals for annual incentive and 3 one-year goals for LTI 
  • ESOP Share Pool Requirements with Shareholder Dilution

    Rationale

    • Precipitous decline in a company’s share price will require significantly more ESOP shares for value-denominated LTI opportunities. This will raise the aggregate shareholder dilution from ESOPs
    • E.g., if a CEO’s annual target ESOP opportunity is INR 1 Cr. and the share price declines from INR 100 to INR 65, the number of ESOPs required to deliver the same grant value would increase by ~54%

     

    Key Considerations

    • To balance the competitiveness of ESOP grants with shareholder dilution, companies can use 30-day to 90-day historical share price average to determine the number of ESOPs, rather than a single day’s share price
    • Alternatively, a temporary shift from value-denominated (e.g., INR 1 Cr) to share-denominated (e.g., 0.05% of total share capital) LTI opportunities may help with capping dilution at a level that is amenable to shareholders  
  • Establish a Leadership Succession Plan

    Rationale

    • Given the nature of the pandemic, it is important that companies’ Boards establish a robust succession plan for key leadership roles to ensure business continuity 
    • Conducive time for large well-funded companies to pursue aggressive recruitment strategy by luring top talent with large sign-on bonus and/or LTI awards

     

    Key Consideration

    • Developing bench strength requires an in-depth review of the current and required pipeline for future talent 
    • Once the potential successors are identified, their compensation package may need to be revisited to close the deficit versus competitive pay levels appropriate for their future role 
  • Review Executive Share Pledging Policy

    Rationale

    • As the value of executives’ pledged shares is negatively impacted in a market downturn, it can trigger a margin call (i.e., shares pledged as loan collateral can be sold by the lenders). This can lead the company’s share price to spiral downwards 

     

    Key  Considerations

    • Companies may want to consider adopting a partial or full prohibition on share pledging by executives to avoid the potential decline resulting from margin calls
    • Especially relevant for companies where executives hold a substantial amount of company shares
  • Explore Gift Matching Programs

    Rationale

    • Gift/donation matching programs are relevant in today’s times as companies can match donations made by employees to a third-party charitable organization to help advance a social cause

     

    Key Considerations

    • Positively impacts the broader community while amplifying brand goodwill
    • Since this would have incremental cost implications, it may be viable only for companies that are able to withstand the adverse economic impact of COVID-19  

 

Extraordinary times need extraordinary solutions. As organizations grapple with the widespread effect of the pandemic, tailoring the executive rewards strategy to the current situation can help drive the mindset and behavioral shift required among leadership teams to successfully overcome this crisis.