The Advisors' Blog

As investors seek to rein in “pay for non-performance”, change in severance benefits payable after involuntary termination has become more commonplace. A review of the Fortune 250 found that one in ten changed their severance benefits in the past 12 months.

One creative tool for change in severance is a “sunset provision”. As the name implies, sunset provisions are designed to reduce benefits from a potentially high level and have them settle at a lower level at a set time in the future.

I have found sunset provisions in executive severance programs useful, not as a severance policy in and of themselves, but rather as an effective way to deal with special cases, while preserving the integrity of the existing, or planned, severance guidelines.

There is potentially a sound logic to this approach which recognizes that an individual executive’s greatest income risk from involuntary termination is during the early period as an executive, before he/she has an opportunity to accumulate wealth and/or build saleable skills in the executive role. That risk is presumed to go down over time.

However, in my experience, if applied as a policy to a large group of executives, a sunset provision will over time create a sense of inequity and confusion. Few, if any, can remember the different circumstances that created the different levels of individual severance benefits, and with a significant number of similarly-leveled executives covered at more than one level of severance there is a mixed signal on what is the intended level of severance benefit.

Two examples I have experienced where a sunset provision has worked well for a client include:

– A large employer, who had an assortment of individual severance agreements, was targeting to establish a guideline of 1 times salary for its executive leadership team, while retaining a benefit of 2 times salary for the CEO. At the same time, a COO was being recruited from outside the organization and sought a 2 times salary severance benefit, similar to his contract with his current employer. The organization offered the candidate a sunset severance program, with 2 times salary as his severance benefit during his first two years of employment, followed by a decline to a 1 times severance after that time. The sunset provision helped in resolving the potential conflict between the candidate’s requested severance protection and the Company’s planned severance guidelines.

– The Compensation Committee of a public company that had been criticized by institutional investors for providing generous severance payments during a time of poor stock price performance, decided to move forward with a reduction in its executive severance guidelines from 2 times salary and bonus to 1 times salary and bonus. However, in light of its difficult business climate and risk of unwanted turnover, they used a sunset approach and stepped the benefit down over two years, first to 1.5 times and then to 1 times salary and bonus. This sunset approach allowed them to establish the longer term standard for severance of 1 times cash pay, but not increase the risk of voluntary turnover while the company improved its business performance.

The level of executive severance benefits for involuntary performance will likely remain under pressure to decline. A sunset provision may be one tool for companies to use in attracting or retaining talent during a period of transition.

What have your experiences been? Let me know.

– Eric Marquardt, Towers Perrin