Incentive pay is an important element within the board’s overall compensation structure; it also happens to be a hot button for failed say-on-pay votes, which is why compensation committees must be sure that their incentive pay structure is both current and aligned with the company’s long-term strategy. Year to year, what guidelines should boards use to gauge whether their incentive plan needs to be tweaked or restructured?
It’s important to make a distinction between ‘rethink’ and ‘tweak.’ Many companies will tweak their plans maybe every year—certainly every couple of years. Priorities change. Business environments change. [The compensation committee] may switch a weighting or add a metric… That’s actually a healthy place to be—where you have an incentive structure that allows you to move things around based on priorities. ‘Rethinking’ [your incentive plan] is a different animal altogether.
Why Would a Board Need to Rethink its Incentive Structure?
Shareholder pushback is the most common reason for rethinking the incentive plan. Even companies that passed their say on pay vote may engage their shareholders to understand how they can achieve higher levels of support—and the feedback they receive may motivate a plan restructure.
Companies that undergo a change to their business model may also need to rethink their plan design to ensure strategy and incentives remain aligned. Even more common, says Ullman, are those incentive plans that evolve into an “unwieldy beast” over several years of added metrics, bells, and whistles.
Anyone who’s been through a restructure of the incentive plan knows that the process can quickly become over-complicated by the vast range of potential metrics, precedents, and options for plan design. In his episode, Ullman condenses his advice into eight high-level Dos and Don’ts, which we’ve briefly summarized below. Be sure to catch the full episode for more information.
The Dos & Don’ts of Incentive Plan Restructure
1. DON’T ‘tweak’ if you really need to rethink. Many companies that need to rethink their incentive plan make the mistake of just “nibbling around the edges,” says Ullman. Compensation committees tasked with restructuring incentives need to make sure that they’re making significant changes and isolating the metrics most indicative of the company’s whole performance.
2. DON’T over-engineer. While it’s important for compensation committees to demonstrate changes to the incentive plan, it’s just as easy to over-engineer. You can’t measure every single thing, says Ullman. Boards must select and hone in on the metrics that make the most sense for their company.
3. DO record your rationale throughout the process. When the compensation committee is going through the design process, it’s critically thinking about the business economics and developing the rationale for alignment. Record that thought process in the moment, says Ullman. That rationale will be crucial for the CD&A and future shareholder communications.
4. DO involve all the right people. To make the best decisions, compensation committees should involve all the right people: finance, HR, business unit leadership, corporate leadership, and investor relations. The more perspectives you can gather, the better, says Ullman. Business unit heads and corporate leadership are particularly important, as boards will need their buy-in to successfully roll out any new incentive targets down the road.
5. DO think about year one. After a shiny new incentive plan is introduced, all eyes will be on the compensation committee. Spend extra time on the targets and ranges to ensure that the performance you’re incentivizing is rewarded. The credibility of the compensation committee will be particularly malleable in year one.
6. DO consider the feedback of shareholders during the restructure. More companies are conducting regular shareholder outreach; it’s wise for boards to take this feedback into consideration, says Ullman. Investor relations may have some great insights for the compensation committee.
7. DON’T blindly follow the proxy advisor guidelines. ISS and Glass Lewis both outline pay guidelines that can be very helpful during the restructuring process; however, the compensation committee needs to make sure they do what’s right for the company. If the new incentive plan deviates from these guidelines, boards should be prepared to support any digressions in the CD&A with solid business rationale.
8. DO communicate the new incentive plan rationale to all stakeholders. Internal and external communication are both important, says Ullman. Internally, there are multiple audiences that need to understand how the new plan design will impact their jobs and their business units. Externally, of course, shareholders will need to understand how plan design aligns with the company’s strategy for long-term growth—just another reason why it’s important to record your rationale in the moment.