Is it Feeling Like Spring 2020?

Transcript

Jake: Is it feeling like spring 2020? Some boards and management teams are saying yes. Thanks for tuning in to our inaugural episode of Pearl Meyer Unscripted. I'm Jake George, Chief Marketing Officer at Pearl Meyer, and I've been listening in to some conversations between two of our senior executive compensation consultants, Mark Rosen in our Charlotte office and Aalap Shah based in Philadelphia. Mark and Aalap are well-known within our company as having some of the most entertaining and informative discussions on a wide variety of trends and technical topics so they were natural go-tos for the podcast format.

In our first season of Unscripted, they're going to talk through a number of concerns that boards and management teams are having in real time as market uncertainty is ramping up and affecting many organizations' business-driving executive compensation plans. To kick it off, let's hear their discussion on growing client concerns about recently approved short- and long-term incentive plans.

Aalap: Mark, can I get your take on a call I just had with a client?

Mark: Sure, what's up?

Aalap: So I think what's happening right now is, and I think we'll probably get some calls from other clients on this as well, but it's feeling a little bit like the spring of 2020 again. So everything that's happening with the tariffs and the way the markets are going, there just seems to be a lot of volatility. So a client called up and had a question about

Mark: Yeah.

Aalap: What should they do about their recently approved short-and long-term plan and should they revisit it? Should they at this point implement discretion? They're trying to think that through. So do you have a few minutes to talk with me about that?

Mark: Yeah, absolutely. I've already had some of these discussions also. So I think this is really timely. I'd love to get your input also.

Aalap: Yeah, and I think first and foremost we should really be talking to our clients about this, I think, because if you're getting calls and I'm getting calls, I think we probably should put some of our clients on notice that they should be talking about this internally. So I think this is going to be something that we would really want to focus on right now.

Mark: I think the first question is, do we know what the impact is?

Aalap: I think that's an unknown, right? Similar to what was happening in the spring of 2020 with COVID, I don't really think we have a full understanding of what the impact is. So how I would think about this is first, like in order, let's take a look at the most recent incentive plan and see how much of that uncertainty was baked in to the performance goals, does that make sense to you as a first starting point?

Mark: Clearly it does, but I don't think anybody baked in tariffs. So I think that's the first thing they need to do: figure out how are they going to capture this because we get to the end of the year, we're to have to understand what the impact of the tariffs are. Some of it will be unknown. So I know some of my clients are setting up some additional accounts to try and capture. They obviously can't capture a lost business, but you can certainly capture any tariffs that you've had to pay. So the first thing to do is to figure out or make sure you're tracking it so you know what the impact is.

Aalap: Yeah, I think that's just such an important point. But what's interesting is that I actually had a few of my clients in their goal-setting process ask about including tariffs or the impact of tariffs as an adjustment item in their definition. So what do you think about that—does that pass muster as having just blanket tariff impact as part of your definition of adjusted EBITDA?

Mark: I think you have to consider it, but I think you have to determine how you did based on what you thought you'd be able to do. And it's going to be difficult to figure out, how do you determine what this adjustment for tariffs is? Because like I mentioned, I think you set up an account to see how much you paid, but you don't really know what the avoided or the costs that you incurred, nor the sales you missed because someone decided not to buy or somebody decided to buy in some other way. So I think we need to have the actual costs and what we know and then be able to think through what we don't know. Does that make sense?

Aalap: It definitely makes sense. It doesn't mean it's not super-complicated.

Mark: Yeah, it's going to be, there's no question. But to your point though, should we be prepared to, I like to call it exercising judgment rather than discretion because let's face it, that's why board members, and you have a committee, that's why they're there to exercise their judgment. They do so at the beginning of the year in establishing those targets, but things happen during the year that they're going to have to take into account. So I think it's really important to understand what has happened at the end of the year and was the payout commensurate with performance? And that's going to be very important. And I think we have to start setting expectations today that this uncertainty is real and it's going to have an impact on our business.

Aalap: I think you're absolutely right. I mean, let's dig a little bit deeper on that because one of the things that I had my clients do during COVID when we were re-looking at the performance goals, it was very uncertain as to what the impact was going to be similar to today. So there was some reluctance to go wholesale and change performance goals. And rightly so.

And so in terms of this exercising judgment concept, what we decided to do is implement a process for the committee to exercise judgment. Because as we all know, the committee always has the ability to exercise judgment. But the nuance of this is that if you don't indicate that there's a possibility of assessing judgment, then the auditors might actually push back on you when you're trying to accrue for a, say, target payout throughout the year. And so back in 2020, what we decided to do is first have a conversation with the committee: is exercising this judgment something that you want to have the ability to do? Most committees actually said yes, we do want it. We don't want to pull the trigger on it now, but we want to have the ability to pull the trigger on it.

And so we implemented a process really to exercise that discretion. So that again, we could document to the auditors that we could continue to accrue a target payout or something that was below target as a payout. But that process included some defined criteria or guardrails around exercising that judgment.

Did you do the same with your clients and do you think that that applies today as well?

Mark: Yes and I wasn't sure where you were going with that. And the answer is absolutely, the term guardrails, I think, is important. And it gets back to what I said about expectations. We've got to set some expectations over what we think is going to happen. If you recall during COVID, we all thought the world was going to end. So, frankly, looking at our incentive plans wasn't the first thing that we thought about, but eventually got to it.

And a few things we talked about was, you know, maybe if we make these adjustments, we really shouldn't pay out over target. We need to think through where we might exercise that judgment. And some of it was just how we dealt with the business and how we navigated those very turbulent times. But I agree that your comment around I call it creating expectations, but it's that process by which we would consider to exercise that judgment and adjust at the end of the year. I think COVID payouts were higher than anybody thought they were going to be at this time in the spring of 2020 because people were able to navigate things. And after that initial, wow, this is going to be really bad, it got better. I don't know if it's going to be the same this time.

I think that we are going to be navigating some very turbulent times and we're already seeing some people pull back on investments. So that's going to factor into the budgets that have been established. And while I think sometimes executives don't get paid, we have to look at what the shareholder experience is, especially around long-term plans. But as we think about short-term plans, I think that setting up that process and saying, we're going to consider this, we're going to think it through, and we're going to do the right thing. But that doesn't mean that you're always going to get paid.

Aalap: No, I think that's absolutely right. I think, you know, reinforcing that idea of you may not always get paid is something that I try to bring into the boardroom as often as I can because it sometimes is lost depending on who you're talking to. But, you know, when we think about this idea of, you know, reluctance to maybe exercise judgment, what's interesting is that when you look back at the data, the say-on pay-vote results, and how many times an ISS or Glass Lewis came out against say-on-pay didn't actually materially change during COVID and the year after COVID, which was really somewhat surprising, but I guess not really because they understood that companies were really navigating that uncertainty. 

Mark: And doesn't that get back to your original comment, which is you establish a process and properly set those expectations about what you might do and then communicate it appropriately?

Aalap: Absolutely. And having that dialogue with your shareholders earlier on, that's a possibility, it really helps with that too. So definitely one strategy is to create that process to exercise judgment at the end of the year. But obviously there are other strategies as well, one of which is just making adjustment to the goals. What are your thoughts on doing that at this particular time?

Mark: I think it's too early. I think it is a good idea if we had more certainty as to exactly what was going to happen. So if we knew that we weren't going to be exporting any of X for the next nine months, then I think it would be easy to establish some new goals. But I think because of the uncertainty, it would be difficult.

Which gets back to the kind of thing that you might think about doing at the beginning of a year, which is to set a lower threshold. Even though you might want to stick with that same target if there's a tremendous amount of uncertainty, do you set a lower threshold? So if you're wrong, you can still get some sort of payout if performance is reasonable. There are some other ideas around that curve and around the target.

Aalap: No, absolutely. going into this year, I was already talking to clients about, do we need to build in some downside, you know, more downside protection and extending that curve further down? And I think that is really something that if you were to revisit the goals, because I'm sure going back to my client and saying, you know, it's too early, I think that the next question is going to be, well, you know, when the timing is right, what do we do? And so I think your idea here about, you know, if you were to do an adjustment, extending that curve down a bit more and getting that more downside protection would be really good.

Mark: Yeah, so the other thing to think about is LTI. Are they thinking about making changes to their performance metrics on long-term incentives also?

Aalap: Yeah, well, that did come up and my initial inclinations, what I want to talk to you about it is that for the program, the LTI program that was just adopted, I think it's way too premature to adjust that. That has to be a three year run, still. So I was almost sort of giving them the reaction that I don't think you adjust that at all. And because there's a long way to go on that, I could see that happening for our clients that have one-year long-term performance periods, right? But that's not really a majority practice. But I think the more important question is the in-cycle ones. So again, borrowing from our COVID experience, we didn't really make any adjustments on those until much later in the year.

So these are the programs that the performance period ends in 2025. So I think that is definitely something that is to be thought about. If I was making any adjustments, I'd probably tackle the short-term first and then deal with the long-term at maybe a later time.

Mark: Yeah, I agree with that. I think it's way too early to be actually making any changes to the long-term incentive. I really think we need to get closer to the end of the performance period if we do anything at all, because I'm not convinced that we should do anything on the long-term incentive, because remember, that LTI is intended to align with the shareholder experience. And to the extent the shareholders are getting beat up, and we're certainly seeing a lot of turmoil in the stock market, really need to think, do we give, it'll be viewed as giving somebody a pass and I'm not so sure that that is a good look.

Aalap: Yeah, I completely agree. So Mark, this has been really helpful. Thanks for taking the time for me to bend your ear a little bit. Not to be greedy, but I do have another question for you. But maybe I can give you a call next week on that.

Mark: Yeah, that'd be great. You know, this has been helpful to me because I'm talking to my clients on the same issue. So it's good to hear that we're aligned in our thinking.

Aalap: All right, thanks. Take care.

Mark: See ya.

Jake: Hi, Jake again. That wraps up our first installment of the new Pearl Meyer Unscripted podcast. We hope you'll listen in to Mark and Aalap’s next conversation on stretch goals versus layups. You can find that and new episodes on our website at pearlmeyer.com/unscripted and on Spotify. Until next time.