Executive compensation has become increasingly sensitive and is under heightened scrutiny. During the past two years the environment in which businesses operate has changed dramatically. The COVID-19 pandemic, rise of stakeholder capitalism, intensified talent mobility, regulatory changes and other external factors will continue to impact the governance of executive pay and performance programs.
So what should boards, remuneration/compensation committees and senior executives be thinking about to address these complexities? Willis Towers Watson’s research and consulting experience working with leading clients globally points to five themes that will likely impact executive compensation programs in 2022 and beyond.
Environmental, social and governance (ESG) issues are top of mind for boards and management teams. Increased expectations from investors, customers, employees, regulators and other constituents have prompted companies to better align management’s interests with those of all stakeholders.
Companies have started incorporating diversity, equity and inclusion (DEI) measures such as gender and racial representation, as well as climate measures such as greenhouse gas emission reductions and de-carbonization targets into their incentive plans. Based on Willis Towers Watson’s latest research, more than half the S&P 500 companies in the United States and more than two-thirds of the top 400 companies in Europe have at least one ESG measure/factor in their incentive plans.
Currently, ESG metrics are more common in short-term incentive (STI) plans compared to long-term incentives (LTI). Even though measures like CO2 emission reduction involve longer-term transitions for most companies, only 13% of European companies and just 2% of U.S. companies have climate-related measures in their LTI plans. We expect more companies to start incorporating ESG and climate measures in STI and particularly LTI plans.
Companies are pursuing various corporate actions, such as carve outs, in an attempt to create and unlock value. We will likely see continued focus on mergers and acquisitions reverse special asset acquisition companies (SPAC) mergers, public offerings and other transactions. Several companies have implemented value creation incentives, whereby management is rewarded for generating sustainable (and at times risk-adjusted) returns in excess of relevant hurdle rates. Executive pay models will have to align with these corporate actions.
Additionally, we are witnessing the digital evolution of traditional industries, requiring significantly different pay models. Companies are setting up digital ventures to compete with disruptions brought about by start-up ecosystems. For these sponsor-backed ventures, companies will need different incentives arrangements compared to the parent organization, and with higher risk-reward profiles.
Companies are beginning to question what drives and motivates their executive teams. For example, conventional models of highly-leveraged incentives may not always drive the desired behaviors or outcomes. Companies are increasingly applying behavioral economics concepts to assess tradeoffs that executives would make related to upside opportunities, loss aversion and incentive time horizons. This could impact line-of-sight, performance orientation, motivation and retention elements of incentive plans.
Some companies have started to offer executives the flexibility to choose between different pay-mixes or different incentive arrangements, while maintaining equivalent expected value (i.e., grant values may differ, but when adjusted for probability of achievement and time-value discounts the expected values are comparable). This allows executives to make relevant tradeoffs, choose models best aligned to their personal needs and take more accountability for their own compensation.
Companies are applying innovative pay models relevant for different stages of their business lifecycles — hyper-growth, profit-share, value creation, transformation and capital-recycling incentive plans. We are also seeing incentives delivered through cryptocurrencies, tokens, co-investments and other instruments.
Another important lens to consider is the complexity of incentive plans. Companies are trying to simplify models through fewer instruments and stronger line of sight. Some have opted to deleverage pay and have converted high risk-high reward instruments to lower value plans with lower risk and lower rewards. There is also a growing school of thought regarding instilling an ownership mindset among executives through lifetime shares and larger shareholding requirements.
Committees will need to continue applying sound judgement in dealing with executive pay programs impacted by COVID-19. For example, addressing potential windfall gains or losses (depending on the industry), determining appropriate bonus outcomes if companies outperform targets that were considerably lower compared to prior years, dealing with in-flight LTI awards, determining appropriate basis for LTI grants in cases of significantly depressed share prices and so on. Additionally, depending on jurisdictions, they may also need to consider enhanced disclosure requirements, changes to compensation governance standards and more involved investor engagement.
In addition, we are witnessing the broadening remits of compensation committees to cover talent management, succession planning, employee engagement, corporate culture, diversity, equity and inclusion, and sustainability issues. Committees are putting in place explicit linkages between executive pay and broader human capital governance — incentives for collaboration, leadership bench strength, employee well-being and ESG goals, for example. Several leading companies globally have even broadened the names of compensation committees to include leadership, people, culture, organization development and other priorities.
It is important to note that not all these trends are new. But they will likely gain prominence in 2022 and beyond. As companies navigate through some of these complexities, they will benefit from drawing on Willis Towers Watson’s executive compensation guiding principles of purpose, alignment, accountability and engagement. Starting with the appreciation of why the organization exists, ensuring management is aligned with interests of all stakeholders, having clarity regarding pay and performance linkages, and understanding human behaviors, retention and engagement will help companies design more meaningful pay programs and effect positive outcomes.
Governance of executive compensation programs will continue to be a complex undertaking.
The five themes listed above might help boards and management teams keep their plans relevant and future-proof. Companies would do well to start planning for some of these changes over the coming months.
A version of this article appeared in Workspan Daily on October 14, 2021. All rights reserved, reprinted with permission.