The Advisors' Blog

– Michael Lovette, ISS Corporate Services

The use of discretionary awards for senior executives has decreased significantly over the past few years. Shareholder attention, increasingly focused on executive compensation in the age of say-on-pay, has prompted marked compensation reform and better disclosure. As shareholders advocate for more performance-based compensation, compensation committees have increasingly turned to defined performance metrics and explicit performance goals to define compensation packages. And to be clear, that has–for the most part–been a dramatic improvement in the state of executive pay structures, and their accompanying disclosures. But have we gone too far?

Discretionary bonuses have been disappearing at a rapid rate. The prevalence of such awards at S&P 400 firms since 2007 has dropped from roughly 25 to 15 percent. But many boards feel that, by not including a discretionary component in the compensation program, they may be abdicating a key responsibility: to subjectively add context to an executive’s compensation package, or to provide judgment in extraordinary situations where the formulas fail. Compensation has become so formulaic that many boards have little room to maneuver in regards to rewarding outstanding performance. What makes up a discretionary award and how can it be incorporated into a company’s compensation program responsibly?

Discretionary awards are compensation that is granted to an executive at the judgment of the Board. Historically, discretionary awards appeared as executive bonuses; today, these discretionary awards more often show up in the Short-Term Incentive (STI) program as an individual performance component or under the Long-Term Incentive (LTI) program as a payout “modifier,” or occasionally, as a one-time grant. (A cynic might even note that some companies could also be implicitly exercising discretion–many times with the executives’ own input–by employing non-GAAP performance metrics.) Often, boards argue that company executives have performed their duties and functions in a way not captured by the executive compensation program, or that they need to motivate and retain executives by granting an additional award, as some of the most common reasons for utilizing discretionary awards. For many shareholders, such justifications, often disclosed in boilerplate format, leave a negative impression of discretionary awards.

Why are discretionary awards viewed negatively? In most cases shareholders are not able to verify that the appropriate discretion was used by the board and, in many investors’ eyes, discretion hasn’t always been used with shareholders’ best interests in mind.