Now cash is the only KPI, there is an opportunity to rethink executive incentives
There is now a singular concentration on conserving corporate cash.
The Bank of England has issued a statement, falling barely short of an instruction, that banks should withhold dividend payments. Some, but not all, have complied. This is a crucial week for UK plc, as a number of the UK’s largest companies announce their results and dividends. BP and Shell are among them. Some analysts estimate that these two companies account for almost 25% of FTSE 100 dividend payments yet to be made based on last year’s performance. The boards of both companies face a difficult decision on dividend payments. The imperative of conserving cash in the company, at a time when the oil and gas sector is suffering the effects of a low commodity price, has to be balanced against the importance of their dividends to the economy, particularly pension funds. At the time of writing, BP has maintained its first quarter dividend; Shell’s announcement is due on 30 April.
Last weekend, it was reported that the total UK company pension deficit of about £136bn is expected to increase by up to £500m. Industry insiders believe that the Pension Protection Fund can withstand this increase but that company levies to the fund are predicted to rise, placing more strain on company cash flows.
In addition, there are numerous examples of directors taking salary cuts. A High Pay Centre study shows that 25 of the UK’s top 100 companies have taken a 20% pay cut in line with pay for furloughed workers. Some CEOs have taken bigger cuts. Long-term incentive awards have been scrapped or put on hold; remuneration committees have been wrestling with decisions about bonus awards for the past financial year and bonus targets for the current one. Executive pay is not significant in relation to the value of the biggest companies but cutting it shows solidarity with the cuts enforced on the, sometimes, large numbers of employees whose costs are significant to a company, however large, which has seen its business fall away as a result of the pandemic.
Cuts in CEOs’ pay increase the, already high, level of attention on executive remuneration and it is unlikely, perhaps, that executive pay will ever get out of the fire. However, the current situation provides an opportunity to re-evaluate some of the accepted norms about incentive plan design, which might help to lower the temperature.
In the run-up to the current crisis, executive pay has been criticised, including by government, for being too complex and too high, with many arguments for and against. Executive incentives (both bonuses and long-term incentives (“LTIs”), attacked for neither aligning executives’ and shareholders’ interests nor linking pay to performance, have been singled out for particular criticism.
Annual bonuses tend to be based on a range of financial measures, usually a form of profit or profit/return measure, and personal performance measures, likely (but not exclusively) to be qualitative. ESG factors are now seen (rightly) to be an essential focus for boards. Remuneration committees are strongly encouraged to introduce ESG measures into their executive incentive plans. Many bonus plans now include ESG targets but the introduction of another set of performance criteria does not help to limit complexity.
LTI design has evolved to the point where companies are now encouraged by shareholder guidance to adopt plans which their remuneration committees believe are right for the company and support its culture, remuneration philosophy and business strategy. However, relative TSR and EPS continue to feature high on the list of performance measures. Arguments in favour of replacing traditional LTIs with restricted share schemes (about which there is a separate article in this Newsletter) are gaining ground but restricted share plan proposals are still treated with suspicion by some shareholders.
On 27 April, the IA published guidance for UK listed companies on shareholder expectations regarding the operation of executive incentive plans as a result of COVID-19. Surprisingly, the IA guidance makes no reference to restricted shares. A summary of the key points in this guidance is as follows:
• Companies which have cancelled dividends are expected to consider how this should be reflected in remuneration policy; including use of discretion and malus
• Remuneration committees are not expected to amend performance conditions for annual bonuses or “in-flight” LTIs
• No adjustment to grant size for 31 December year-end companies if share price fall is wholly related to COVID-19; but remuneration committees are expected to take action to avoid windfall gains
• In relation to LTI grant size and performance criteria for new grants, remuneration committees must:
– decide whether to make or to defer awards; the guidance sets out a number of options
– explain their actions and how they will avoid windfall gains and ensure outcomes reflect executive performance and the experience of shareholders and other stakeholders, including employees
– making maximum awards after a substantial share price fall is discouraged
– performance conditions may be set up to six months after the award date; the performance measurement period should be at least three years but, if performance measurement periods are reduced, award sizes should be reduced accordingly
• Any additional capital raised or government support sought should be taken into account in outcomes for executives; the guidance warns of serious reputational ramifications if pay and conditions of the wider workforce are not taken into account
• Companies which have spent time consulting shareholders on a new remuneration policy to be put to their forthcoming AGM will not be expected to rewrite that policy; but committees should consider if any proposed increases in variable pay for 2020 are appropriate
• Committees must balance the need to incentivise executives when management are being asked to show resilience and leadership and to ensure that executive pay takes account of the interests of shareholders and other stakeholders, including employees.
LTIs and bonuses are likely to be part of executive remuneration packages throughout and after the current COVID-19 crisis. They serve a number of purposes. Bonuses increase the focus on key performance measures and actions so as to enhance business performance. They also enable companies to increase the value and competitiveness of remuneration in a way that is justified by company performance or to reduce costs when company performance is poor. Equity-settled LTIs align executives with shareholders.
The current reality is that cash is the only KPI. For the present, many companies are in survival mode and cash is fundamental to their survival. In better (normal?) times, cash (not TSR, EPS or, even, a year’s profit) is essential for sustainability and growth. A company’s ability (or its potential ability) to generate cash goes directly to its worth. Cash and cash-flows determine a company’s ability to:
• reinvest in the future of the business and fulfil its commitments to the community and the environment
• pay suppliers
• provide returns to shareholders and increase market value
• pay down debt
• pay executives and the wider workforce.
Cash, therefore, is crucial to developing and maintaining a sustainable business, not just in these unusual times but in better times, too, whatever the market or wider economy is doing.
Incentive policies based on the sources, generation, conservation and uses of cash would provide an opportunity to focus executives on a constant factor, essential to creating value and sustainability in any business. Requirements for remuneration committees to take account of ESG factors, act fairly in relation to the wider workforce and other stakeholders and engage with shareholders to explain their proposals and decisions would continue to be just as relevant and important as they are now.
For further information or to discuss this article, please contact Paul Norris.