Examining the role of board discretion in determining executive incentive payouts for Australian firms amid the COVID-19 pandemic and considerations for FY21 incentive plans.
The effects of the COVID-19 pandemic have been felt far and wide from both a business and humanitarian perspective. Several organisations have adopted measures, such as pay cuts, layoffs, furloughs and material reductions in spending to stay afloat. The current economic outlook in Australia does not look promising, indicating further business challenges in the coming months.
Financial performance for many companies has been significantly affected by the prolonged hiatus in economic activity around the world. On the other hand, we saw a surge in business for certain industries that provide in-demand services. This volatile environment will likely be reflected in the outcomes of executive incentives. Boards will have to determine, in accordance with their organisation’s own unique circumstances, if the payouts dictated by incentive plans require discretionary adjustments to smooth out short-term instability and reflect normal business performance. Discretionary adjustments are not uncommon and usually carefully scrutinised by investors and shareholders. Unsurprisingly, in years of constrained financial performance, investors are more likely to disagree with upward discretionary adjustments in the prevailing governance environment notwithstanding the actual contribution of the executive team.
In this article, we explore considerations for boards when making discretionary decisions on executive incentives in the current environment and the various forms that board discretion could take.
Applying Board Discretion to Executive Incentives
Board discretion is always a contentious topic. However, due to recent events — including the findings of the Royal Commission regarding misconduct in the banking, superannuation and financial services industries, the Australian Prudential Regulation Authority’s (APRA) review of the remuneration practices of the country’s largest financial institutions, and highly publicised scandals in some key banks — the requirement and expectation for boards to apply sensible discretion over incentive plan outcomes is even more pronounced.
To delve into this further, below we outline potential considerations for boards when applying discretion to executive remuneration:
What’s more, investors continue to push for alignment of executive pay with company performance and environmental and social goals, as well as greater levels of transparency in communication of targets and remuneration outcomes. Last year saw the highest number of remuneration strikes recorded in Australia since 2011.
Given these trends, we advise boards to view any potential discretionary actions due to the COVID-19 pandemic in the context of a larger framework of considerations. There is clearly no one-size-fits-all solution when it comes to managing the impacts of force majeure events on executive remuneration. However, there are some key considerations in determining if discretionary actions can be justified. Figure 1 highlights the various factors that need to be weighed when considering discretionary actions.
There are different ways in which board discretion can be applied when determining the outcomes of executive incentive plans, which will be tested against performance measures at the end of FY2020. One approach is to modify plan inputs and design. Boards can do this through retrospective revision in performance targets. However, this is typically highly contentious and unlikely to elicit a favourable response from most investors. Other ways to modify include:
Specific Actions for Boards to Consider Around FY20 Incentives
Another approach is modifying the overall outcome of the incentive plan. This can be done by applying an overall percent increase or decrease to the plan outcomes in an upward or downward direction contingent on the organisation’s unique situation, enhancing deferrals of incentives with additional performance conditions, or converting all or a part of a cash-based incentive to equity using a share price averaged over a relatively long period.
- Modelling the gap between actual award outcomes and hypothetical outcomes across an adjusted / pro-rata performance period that excludes the impact of the COVID-19 pandemic
- Relaxing gateway conditions
- Introducing or reinstating retesting of performance conditions across an extended performance period; for example, the LTI awards that were set for testing across a three-year performance period to FY2020 could be retested across a four-year period to the end of FY2021
Needless to say, discretion can be a hugely contentious issue and several shareholders would be squarely opposed to incentive payouts if they have not made any returns on their investments. Therefore, all discretionary incentives should be supported by a strong business rationale, in addition to being proactive and delivering cogent communication of outcomes to the market.
Looking forward to FY21
From a forward-looking perspective, firms may need to consider adjusting the terms and conditions of their incentive arrangements and equity grants. They can do this by identifying and calibrating performance criteria for incentives in fiscal year 2021 — however, given the uncertainty of recovery, determining absolute targets and setting performance required at threshold and maximum will be challenging. Similarly, determination of the number of deferred shares and LTI performance grants to be awarded amidst significant volatility and unstable share prices may result in overallocation.
The following chart outlines considerations for taking a forward-looking approach to FY21 awards.
As the 2019-20 financial year has now wrapped up for many organisations in the Australian market, boards should prepare to make decisions around incentive payouts for executives. Any incentive payments to executives will be closely scrutinised by institutional investors and other shareholders, particularly when company financials and market valuation present a sobering picture. The specific areas in which organisations choose to take discretionary action should be determined using very thoughtful consideration of each firm’s unique situation, the severity of the impact of the crisis on its business and customers, talent risks and more. Any discretionary action should be rooted in a strong rationale and supported by a proactive, clear and cogent explanation to the market. Forward-looking awards may also require some adjustments, even if only for the FY21 grant, to continue to maintain a good balance between pay and performance and avoid any perceptions of opportunism.
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For additional questions about the impact of COVID-19 on executive incentives in Australia, please contact one of the authors or write to email@example.com.
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