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Just over a year ago at a WorldatWork gathering of senior executive compensation leaders, we were noting the relatively slow pace of change in our field at that moment. Change and challenge tend to come in waves, and we were trying to anticipate when the next wave would hit, and how we would respond.
A few months later, we were all hit with successive waves of challenge and change that have characterized 2020. As we finish this tumultuous year, what can we expect in 2021, and how do we prepare?
Let’s start with challenges we know we will face.
Annual Incentive Design and Goal Setting
For the majority of companies, 2021 will be a big reset. The events of 2020 basically set many companies back one or two years on their growth path. So, setting new targets, thresholds and performance ranges will be a more difficult exercise than in the past and may involve more questions about sharing ratios and whether to pay target incentives for performance that may be lower than in 2019.
Levels of market risk and uncertainty have increased in many industries, which may lead to the adoption of wider, flatter performance/payout curves. Others will see 2021 as a year to make bets on a fast recovery and adopt steeper, more aggressive payout formulas.
Some companies’ business models or competitive markets will have changed, causing them to rethink their key performance measures and value drivers. If product mix, supply chains, pricing, margins or likely growth trajectories have changed significantly, then a new mix of incentive performance measures may be appropriate and necessary.
Long-Term Incentive Design, Vehicle Mix and Goal Setting
If annual incentive design is challenging, long-term incentive plan (LTIP) design will be more-so. Projecting performance out three years will be more difficult for most companies. This may cause them to consider wider, flatter performance ranges, shifting to relative performance measures like relative total shareholder return (TSR), or changing the mix of LTIP vehicles to include more time-based restricted stock or RSUs. Some have also suggested introducing more stock options.
As with annual incentives, the biggest LTIP challenges will be for companies whose business model, key performance measures and value drivers have changed.
Next, let’s consider challenges we will probably face.
Incorporating Environmental, Social and other Non-Financial Factors in Pay
There is a significant push by investors and others for companies to visibly pay more attention to their impact on the environment and how they manage their human capital. These are the two aspects of ESG (environmental, social and governance issues) that are receiving the most attention and are most likely to be incorporated into incentive plans or other executive performance evaluation.
Human capital factors like diversity, equity and inclusion (DEI), employee health and safety, employee engagement, culture and succession planning are already included in executive incentives by a significant number of companies.
Major institutional investors have expressed strong interest in companies being able to demonstrate strong human capital management. Boards are asking tougher questions about human capital. The SEC has also required that all publicly traded companies disclose material information about their human capital in public filings. All these factors point toward greater inclusion of human capital measures and factors in annual and long-term incentives, as well as greater monitoring of these measures and factors by boards.
Environmental measures are much less common in executive incentive plans (than human capital measures) but are also likely to get significantly more attention in 2021. Measures of environmental impact and risk are likely to be discussed more actively by boards and may be included in more incentive plans.
Given the uncertainty of setting financial goals in 2021, we may also see companies including strategic or tactical milestones in their incentive plans. Others may increase the emphasis on factors like building market share, new product development, expansion into new markets, or exiting old markets or products. In times of significant change, factors like these often gain importance.
Lastly, let’s consider challenges that we might face.
Pay Equity: In many ways, the pandemic has exacerbated inequalities in pay and wealth. It has also caused companies and their boards to focus more on the well-being and treatment of all employees. Consequently, we are likely to see greater focus on relative pay equity within companies, between levels, and between various gender, ethnic and racial groups. CEO and executive pay, and pay ratios are always the visible face of real and perceived inequities, thus they could receive more internal and external scrutiny.
Pay Differentiation: Conversely, there has been a significant divide between those companies that have done exceptionally well during the pandemic and those that have not. And many companies in the digital world have performed remarkably well, with pay levels that are literally off the charts for critical talent. High-performing companies and those with high-skill-value talent will have to provide differentiated (and sometimes highly differentiated) pay to recognize both performance and people.
More Sophisticated Pay Models: As companies revisit their incentives and pay models, it may be time to consider behavioral economics and the psychology of pay. Companies and consultants regularly test and quantify perceived-value trade-offs between various benefits elections. Similar technology can be applied to determine the relative perceived value, motivational impact and risk-return trade-offs in alternative incentive arrangements. Similarly, more sophisticated financial and probability modeling can be used to structure incentive performance ranges and corresponding payout levels.
Resurgence of Retention: During the pandemic, it has been a little easier to keep valued employees. As we emerge from the pandemic, we are likely to see increased movement in the job market. As companies rebound, and as people become less risk averse and more active, keeping valuable talent will become more difficult and may create a greater need for creative and targeted retention strategies.
In one year, we have gone from a slow and steady pace of change in executive compensation, to a rapid and challenging pace of change, with significant unknowns in the year ahead.
We live in interesting times, and the next year will test our skill and creativity as much or more than the tumultuous year just ending.