Dancing with Discretion: the Promised Land?
If there is one thing that most people seek in times of disruption it is: certainty. Knowing what is coming helps us set our expectations and prepare for the situation at hand. We also know that the only certain things in life are death and taxes, so has target setting become the ties that bind in executive incentive frameworks?
Executives, Boards and shareholders all want to see ‘fair’ outcomes delivered. Each tends to have differing views on the level of certainty appropriate for incentive frameworks. While executives want clear targets to aim for, they also want reason to believe they will be rewarded for achievements. Proxy advisors (and some investors) want to be able to place remuneration decisions under the microscope and subject Boards to the long walk home. Shareholders want alignment between rewards and their outcomes. But Boards know that a good system needs room to adapt, because business strategy, now more than ever, is not something you set-and-forget and management teams need to be encouraged to be agile and adapt to an ever shifting operating, social and regulatory environment.
The case for flexibility
The 2020 pandemic has taught us that, without flexibility, STIs and even more so multiple series of LTIs can be rendered ineffective, as in all or nothing at all, where the original assumptions against which performance measures and targets were set turn out to be wrong, or dramatically change due to external forces.
Critics say “so what?”. Incentives should just not vest. You didn’t hit the targets you set. Potentially for multiple years. This is the price you pay.
However, are they just blinded by the light? It costs time and money to recruit talent. It takes time for strategies to gain traction. Having senior executives vulnerable to approaches from other companies, particularly those in buoyant industries with strong track records of incentives vesting, would appear to be poor risk management.
Though frameworks often come with some level of in-built flexibility (eg by normalising for FX rates, or incorporating a cross-section of financial and non-financial metrics to counterbalance one another), the desire for more certainty both from executives (who do not want to see the goalposts shifted) and investors/proxy advisers (the latter tend to assume flexibility always means discretion in favour of executives) means Boards have, at least historically, tilted more towards rigidity than flexibility.
A shock to the system
The past 12 months have forced Boards to assess achievements more broadly rather than within the confines of scorecards and articulated performance metrics and then apply discretion.
Examples include:
zeroing out the financial component of the STI scorecard where the Board formed the view outcomes did not align with shareholder experience;
reducing awards where the Board sought to remove the ‘tail-winds’ provided by the pandemic;
granting one-off retention/recovery awards where there was no motivational or retention value in existing incentives; and
exercising discretion to reward in equity only.
While Board discretion remains essential to retaining flexibility in incentive frameworks and ensuring the framework is operating as intended – it tends to be applied looking over your shoulder at the end of the performance period, limiting the motivational and retention impact during the performance period. It is also howled down by proxy advisers (and some investors) when it favours management. However an incentive framework that does not drive behaviour, or is in fact a disincentive, is just a wreck on the highway.
Where to from here?
So what other options to traverse these badlands and bring back the glory days of incentive effectiveness could be considered?
If it remains tougher than the rest to set meaningful FY22 STI and LTI performance hurdles in the context of ongoing market disruptions, should Boards consider setting targets with an eye to revisiting them at key times during the performance period and communicating this to executives and, at least in relation to LTIs, to the market in the company’s remuneration report? Dexus, Dominos and BlueScope adopted this approach last year, which provides the opportunity to recalibrate targets (both up or down) in-flight.
If the Board anticipates exercising discretion in relation to LTIs for FY22, should Boards consider communicating this intent in advance to stakeholders rather than further on up the road? Both Woolworths and Cochlear noted that as economic conditions continue to be uncertain, the Board would consider applying discretion for the coming year. Bringing stakeholders on the journey can help remove the perception of Board’s 'changing the goal posts’ at the last minute as both the intent, and rationale, have been clearly communicated up-front. In some cases it may also be possible to provide an indication of how that discretion could be exercised by highlighting the key assumptions underpinning targets (eg FX rates, market growth expectations, interest rates, etc) and noting that if actuals vary from forecasts by more than a set percentage, the Board would exercise discretion.
Could better days be had, instead of hard-wired targets, if the Board sets key areas of focus (not necessarily tied to specific performance measures or targets) with a look-back assessment as to whether the Board believes that the outcomes delivered warrant a reward (a bit like the discretionary bonuses of years gone by)? While possibly a hard-sell to both executives (some management teams will be more receptive to this than others) and external stakeholders, it does not place a ceiling on success and may free management to think beyond the hard edges of their incentives to what really drives shareholder value creation.
Alternatively, is it time to take a wrecking ball to STI and/or LTI and pursue US-style annual grants of restricted equity (potentially at a discount to current STI/LTI levels). May this better suit some companies with high volatility and remove the rocky ground of measure/target-setting and discretion altogether?
The shared experience of the pandemic provides an immediate example to everyone that we must, at times, shy away from our need for certainty and embrace that change is inevitable – and build processes and frameworks that can reflect this. Fortunately, the one thing that the pandemic has not changed is that the ‘best’ executive remuneration decision for any Board is and remains the one it is most willing to stand behind, strike or no strike. No surrender!