The Advisors' Blog

It continues to look likely that many compensation committees are going to have to grapple with what to do if annual incentives don’t meet thresholds this year. Sometimes that result is appropriate and warranted, but other times it doesn’t sit well with compensation committees that may feel that management — all things considered — navigated a challenging environment comparatively well. Plan language may give the committee the option of making discretionary adjustments, but this approach can make investors uneasy and result in say-on-pay and even director support issues. This Semler Brossy alert says there are broadly two situations where discretion may be appropriate to adjust outcomes in management’s favor:

When management makes a qualitative, but objectively measured, improvement to the company’s long-term outlook. This may include launching a new product earlier than planned, reconfiguring a product’s design, sourcing, or distribution to be more cost-effective, achieving a key customer win, or improving product quality or service offerings.

When the company outperforms its peers. Improvements in relative market share, brand reputation, margin growth, etc., are still useful benchmarks, as everyone is “going through this together.” Outperforming the field still indicates outsized performance.

Together with these circumstances, discretionary adjustments are better received when they reward good future positioning (versus solely addressing short-term problems), are reciprocal (adjustments in response to an external factor are both upward and downward), and they’re appropriately sized (aka, get executives closer to threshold, not over target).

The alert encourages compensation committees to consider developing a discretionary scorecard, “a non-binding, unweighted set of strategic metrics that the board deems indicative of success during turbulent times,” which “allows boards to approach the topic of discretionary adjustments with flexibility and confidence” and offers these three advantages:

1. They offer hope. An incentive program that won’t pay out, through no fault of the employees, can be demoralizing.

2. They give people direction. A well-designed scorecard says, “We know we can’t control the tariffs, but here is a list of variables we can control.”

3. They provide rationale in advance. Shareholders are justifiably skeptical of claims that the board “can evaluate performance at the end.” Establishing the parameters of success in advance will bolster the company’s case with shareholders if/when adjustments are disclosed in the proxy.

I have always focused on number 3, but of course, 1 and 2 are potentially even more important! And here’s the key to really getting the benefit there: time is of the essence!

The sooner this scorecard is developed, the more effective it will be. Since yearly goals have already been set, a discretionary scorecard will run in parallel with the current incentive plan, and crucially, it comes with no weightings among measures or a promise of payment. Because it is non-binding, the scorecard gives the board time and flexibility to determine any adjustments later in the year. If the board feels like relief is warranted based on discretionary factors, they already have a strong, quantifiable foundation from which to base their decision.

Semler Brossy has some tips for developing these scorecards as well! (More on that to come!)

– Meredith Ervine