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Secular Shocks and Executive Compensation—Lessons from COVID-19

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July 27, 2020 | Equity Methods

Thanks to Takis Makridis and Therese Sebastian

Introduction

Secular shocks are more frequent than many of us care to imagine. We had the energy crisis in the 1970s, soaring interest rates in the ‘80s, and geopolitical instability in the ‘90s. The 2000s kicked off with the dot-com bust and the September 11 attacks—and then, after a slight reprieve, the global financial crisis set in.

Coronavirus Disease 2019 (COVID-19) is but the latest in a series of unplanned secular shocks. Many of our friends and colleagues have written about the impact of COVID-19 on performance goal setting and goal achievement in a long-term incentive plan (LTIP).

We’d like to take a different angle: How does COVID-19 make the case for relative performance metrics? By that, we mean not just relative total shareholder return (rTSR) but other relative awards such as those based on financial metrics (like EBITDA growth). Relative TSR is generally a preferred approach, but it’s hardly the only option on the table. Here’s what total rewards leaders and compensation committees can learn, using late February 2020 market volatility from COVID-19 as a case study.

Dealing with Secular Economic Shocks in Compensation

COVID-19 is a pristine example of a wholly unexpected and uncontrollable shock. From the perspective of achieving performance goals, compensation committees have different views on how to respond to secular shocks:

Do nothing and live with the setbacks (it’s just part of business)
Make targeted adjustments to cushion the impact of the unexpected shock
Design awards to insulate payouts from such shocks

The problem with the “do nothing” strategy is that an exogenous shock decimates the realizable value of outstanding equity awards, making it easier for competitors to buy out executives’ compensation packages in a talent poaching blitz. At the same time, a precipitous drop in realizable pay linked to uncontrollable factors stokes executive cynicism in a way that primes them to take a buyout package more seriously.

As for the second approach, it’s appropriate to adjust incentive metrics in the context of secular shocks. For example, adjustments to existing performance goals were necessary in the wake of the 2017 tax reform because goals failed to reflect the updated code. But this solution is deeply imperfect, and for many compensation committees it’s simply a non-starter. Even when on the table, goal adjustments can set a troubling precedent and introduce undesirable accounting and proxy ramifications. In the extreme, such adjustments are just stock option repricings under a different name.

That leaves approach number three: Design awards that are more naturally insulated from secular shocks. As it turns out, the best insulation comes in the form of relative performance awards.

Secular Shocks Devastate Incentive Goals

In the last two weeks of February 2020, COVID-19 made headlines as a global problem. Finance theory tells us that markets are highly efficient in incorporating new information into asset prices. As the business impact of this global virus came to light, security prices plunged. Between February 14 and February 28, the average decline among the S&P 100 was -13%. Only one firm, Gilead Sciences, had a positive return (2.7%).

These near-instantaneous and drastic share price declines represented the market’s expectation of lost value. The erosion of value is not an abstract concept. It’s a measure of widgets that don’t get sold, inventory that becomes obsolete, human capital productivity that atrophies, capital expenditures that get deferred, non-essential business meetings that get canceled, and so on. In other words, it’s an effort to predict what financial statements will look like in the future.

While fortune-telling isn’t one of our services, it’s very plausible that most organizations will see the impact of COVID-19 in their financials later in 2020 if not lingering into 2021. This means that both LTIPs and annual bonus plans ending in December 2020 will likely face a problem. Goal setting on newly launched 2020 LTIPs and annual bonus plans is equally spurious; some companies are deferring when they lock down goals until April or May, but we doubt the full ramifications of COVID-19 will be understood so quickly.

Although erosions in market value can be a loose proxy for the financial statement impact of COVID-19, another angle to explore is the actual guidance that companies issued. We studied dozens of analyst reports and earnings transcripts. Some companies rescinded previously shared guidance. Others offered new guidance on the anticipated short-run impact, noting that the long run is unclear. Then some said they expected an impact but weren’t able to quantify it.

But even the companies giving the most amount of guidance focused on the short-term Q1 and Q2 impact. In the cases we studied, just the Q1 (and Q2) impact of COVID-19 could lower incentive plan results from target to threshold.

In short, both outstanding incentive plans and newly designed ones are materially affected by external shocks. Again, we’re using COVID-19 as just a case study—a flavor of the month—as to why any material external shock can wreak havoc on compensation plan effectiveness. We don’t yet know whether 2020 will come to be defined by COVID-19 or whether it will soon pass. But we do know that history is full of unplanned shocks. And we also know that except during uneventful bull markets, absolute performance goals are too easily hijacked by exogenous economic shocks.

Relative Performance Equity Dampens the Impact of Secular Shocks

There are many forms of performance equity, but we’ll use rTSR to frame the benefits of relative performance equity during periods of intense market volatility. Let’s start with the S&P 100, which consists of the country’s largest companies across the main industries.

To mimic a performance cycle that is affected by a secular shock, we assume a hypothetical performance period that begins on March 1, 2017 and ends on February 14, 2020 (prior to the COVID-19 shock) or February 28, 2020 (after the first shock waves rippled through the markets). In reality, the shock could occur anytime during a performance period and have a comparable impact, so there is nothing essential about modeling the shock at the very end.

Compensation theory would suggest that sudden, exogenous, and secular shocks should not radically reshape how executives are paid. Therefore, we start by looking at changes in absolute TSRs and percentile rankings based on shifting the performance period end date by a mere two weeks—from February 14, 2020 to February 28, 2020. We hope to see limited movements in payouts under the premise that erratic payout swings will shatter executive line of sight, thereby introducing cynicism and lowering the perceived value of the award. Table 1 shows the results:

These results are tolerable because the presence of a relative metric dampens the sensitivity of the payout to the shock. Executives are not wholly immune, of course, because the shares they are receiving are now depressed in value—but the clarity of the incentive signal hasn’t been unraveled.

Table 1 describes an award whose payout is coming due. But what about a brand-new award just being designed? Realized performance during the window leading up to the date of the grant can have a drastic impact on the fair value and therefore the disclosed value in the proxy summary compensation table and/or the number of units granted to an executive. We’ve discussed this broadly, including in this summary blog post, this issue brief on all the rTSR design levers, and this issue brief offering some creative solutions.

Table 2 offers another angle by focusing on performance changes for an S&P 100 company that grants an rTSR award on either February 14, 2020 or two weeks later on February 28, but in either event, sets the performance start date to be January 2, 2020. We’re interested in seeing how much realized performance changes during those two weeks since this change will drastically impact the fair value. In reality, averaging windows are used to set the TSR prices, but to accentuate the point, we use spot prices on January 2, February 14, and February 28:

These results are a little less comforting. Morgan Stanley’s decline from the 72nd percentile to the 39th percentile or Gilead’s ascent from the 60th percentile to the 97th percentile spell considerable fair value volatility given the impact that realized returns has on ASC 718 valuation. Drops in realized volatility allow far more units to be granted for the same total proxy cost, but spikes deflate the number of units granted. Most firms in the sample didn’t experience such drastic swings, but we’re nonetheless concerned with those that did.

These sharp results can be substantially avoided by using an averaging window instead of spot prices. Changing the model to base the beginning and ending prices off the trailing 30 calendar day average causes the percentile ranking changes to virtually disappear. That solves the problem in this example, but not necessarily in cases where the secular shock is protracted or occurs at a different time outside the window when awards are granted.

The results in Tables 1 and 2 remind us just how important the peer group is when designing a relative performance equity award. Most secular shocks are industry specific.

Industry-Specific Peer Groups Dampen the Impact of Secular Shocks

In the prior section, we showed that relative performance schemes insulate payouts from secular shocks. Yet even in Table 1, Gilead’s percentile ranking jumped by a full 12% based on the events of two weeks at the end of the hypothetical performance period. That seems like a rather large jump for such a short amount of time. Gilead is in a unique situation because it’s one of the few firms on track to produce a vaccine to COVID-19, but the broader point remains that major payout swings over extremely brief periods can be jarring.

We saw similar swings among companies outside the life sciences sector, especially within financial services and technology. Large financial services firms like Citigroup, BlackRock, Morgan Stanley, and Metlife would have experienced payout drops approaching 10% simply due to the market volatility during the last two weeks of February. Alternatively, consumer staples firms like Walmart and Procter and Gamble would have benefited from similarly large payout increases in the other direction. These swings are much more tolerable than whatever would happen on an absolute performance metric, but they still give us some concern.

A critical design component in any relative performance equity award is the comparison group. We devote an entire step in the rTSR design process to this key decision. Let’s see whether the payout swings referenced above change if we make one minor alteration: using industry peer groups instead of the pan-industry S&P 100.

Since Gilead and life sciences companies have a direct market opportunity from COVID-19, we’ll base this next analysis off the financial services sector where the 15 firms in the S&P 100 experienced an average TSR decline of 20% between February 14 and 28. The average change in their percentile ranking was -3.7%.

Therefore, we explored how these statistics would change if we used the S&P 500 Financials Sector Index as the comparison group. To do so, we recreated Table 1 where we again simulate a hypothetical rTSR award that was granted on March 1, 2017 and ends on either February 14, 2020 or February 28, 2020. To crystallize the analysis, we dropped E*Trade since they were acquired by Morgan Stanley and realized an instantaneous 25% price spike. Table 3 shows the results:

These results are much more in line with expectations. Even though financial services firms were severely hit by COVID-19 and their absolute share prices tumbled, the impact on rTSR payout multiples is subdued when using a sector index as the comparison group. We saw similar trends hold up in the technology sector and even within healthcare where some firms like Gilead had a direct path toward monetizing the COVID-19 outbreak. Quite simply, relative performance equity dampens the impact of secular shocks.

Implications for Making Design Decisions in FY 2021

COVID-19 may define market realities in 2020 or it may be gone by summer. Either way, history suggests that shocks come and go as they please. With a greater reliance than ever on absolute three-year performance metrics and investors frowning on pure repricings, we worry that such shocks will undermine the incentive plan line of sight in an unprecedented way.

There’s been surprisingly little market volatility between 2010 and the present, and asset prices have appreciated with very few hiccups. To this end, it seems naïve to assume that markets and the economy will not experience recessionary pressures or that there will not be other exogenous shocks in the years ahead. Markets have never stayed calm for decades on end. We think the summer and fall of 2020 are important times to reassess whether your equity awards are resistant to economic shocks.

Here are some key questions to address:

1) How susceptible are your performance goals to economic shocks?

Take an inventory of how sensitive your LTIP is to an economic shock—i.e., what would it take to torpedo realizable pay levels on some or all of your outstanding performance cycles?

In general, absolute three-year financial metrics are most affected by secular shocks, such as a three-year cumulative EPS goal. In contrast, one-year goals allow more frequent resetting and recalibration. Another consideration is how widely dispersed threshold, target, and stretch goal markers are. And, of course, does any component of the LTIP depend on relative performance? If the answers suggest the award is not well insulated from economic uncertainty, consider adding a relative component or increasing the weighting of an existing one.

2) How should a relative component be introduced?

Gone are the days of basing the entire LTIP on relative performance. This was arguably an overcorrection from the last recession. As effective as relative components are in buffering secular shocks, they too have their drawbacks and usually shouldn’t comprise the entire LTIP (notable exceptions do exist, especially in REITS).

The two main choices are to introduce a stand-alone independent relative metric or a relative modifier. We call this type of combinatory design the hybrid award, and each approach has its pros and cons. We’re seeing a gradual shift toward modifier designs because they’re more versatile and allow the award to be framed in fundamentally operational terms for better line of sight outcomes.

Regardless of whether an independent or modifier metric approach is adopted, you have the choice of what weighting to assign. The relative component can play a very small role overall or be 50% of the entire pay opportunity.

3) Should the relative performance metric be TSR or a financial metric like EBITDA growth?

We based the examples in this article on rTSR, but relative financial metrics such as relative revenue, relative EBITDA growth, and relative ROIC are valid alternatives. The main critique of relative financial metrics is that they are not normalized—the peers have different fiscal years and different accounting conventions in terms of how they treat and record like events. M&A activity also creates stark wedges in reported financial results.

Notwithstanding these limitations, relative financial metrics are gaining traction. Target, for instance, rolled out a few relative metrics in the last recession and has successfully maintained this award design ever since. Still, we expect rTSR to remain the most common solution. When we work with clients, we typically engage in a series of back-testing to explore the competing pros and cons of these different approaches.

4) Which comparison group is appropriate?

We showed cases using the S&P 100, a broad market index, and sector-specific indexes. The rule of thumb is that when secular economic shocks do impact industries differently, sector indices will neutralize the effect of such shocks more effectively.

However, this is only true if your organization’s stock price movements correlate with those of other industry players. Tesla, for example, doesn’t correlate well with firms like Ford and General Motors. For startups and organizations pursuing disruptive strategies, a broad market index is typically more appropriate than a sector-specific one. Ultimately, these decisions should be based on correlation and beta modeling, backtesting, and qualitative considerations about what participants will understand.

Wrap-Up

The US economy saw a protracted and relatively unprecedented bull market for nearly a decade following the 2008 financial crisis. There were unusually few interruptions during that time. When it came, COVID-19 introduced a small but globally noticeable pause not only in daily life but in the equity markets as well. As we write this in mid-March, we wait with anticipation to see how COVID-19 continues to unfold.

Regardless of the road COVID-19 takes, it’s a reminder of why performance equity plans need built-in resilience to handle secular economic shocks. Relative performance metrics are a way to achieve that goal. Over 60% of companies do use relative metrics—and, if our discussions are any indication, most have held up in the face of COVID-19.

Veritas Executive Compensation Consultants, ("Veritas") is a truly independent executive compensation consulting firm.

We are independently owned, and have no entangling relationships that may create potential conflict of interest scenarios, or may attract the unwanted scrutiny of regulators, shareholders, the media, or create public outcry. Veritas goes above and beyond to provide unbiased executive compensation counsel. Since we are independently owned, we do our job with utmost objectivity - without any entangling business relationships.

Following stringent best practice guidelines, Veritas works directly with boards and compensation committees, while maintaining outstanding levels of appropriate communication with senior management. Veritas promises no compromises in presenting the innovative solutions at your command in the complicated arena of executive compensation.

We deliver the advice that you need to hear, with unprecedented levels of responsive client service and attention.

Visit us online at www.veritasecc.com, or contact our CEO Frank Glassner personally via phone at (415) 618-6060, or via email at fglassner@veritasecc.com. He'll gladly answer any questions you might have.

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