The Loss of Performance-Based Compensation Tax Deductions Will Lead to Greater Consideration of Non-Financial Incentive Plan Measures

The Tax Cuts and Jobs Act of 2017 eliminated the performance-based exception under Section 162(m) of the tax code, making all compensation to the CEO, CFO, and next three highest paid officers at publicly traded companies non-deductible. Many commentators suggested that companies would now have greater freedom to use performance criteria beyond the objective, financial results-based formulae that have become standard practice for executive compensation. The thinking was that since focusing incentives on more strategic and/or line-of-sight objectives no longer carries a tax penalty, these alternative measures would grow in popularity.

However, investors have neither abandoned their focus on aligning pay with performance, nor signaled that they are eager to abandon financial statements in favor of alternative scorecards when assessing performance. In a nutshell: those companies that base their incentives on something other than performance demonstrated in financial statements may find it more difficult to convince shareholders they indeed link pay with performance.

In this climate, we are curious to understand whether compensation committees will in fact seriously entertain alternatives to financial statement-based performance measures.

Survey Says…

Fortunately, our Quick Poll series "Setting the Compensation Committee Agenda" is designed to challenge and explore whether items that appear to be capturing public attention—for good or ill—translate into actual time spent in review and discussion at compensation committee meetings. This fall we asked participants a simple question: Do you anticipate restructuring incentive plans in 2019 to place less emphasis on financial results-based formulae?

We received 138 responses, detailed below:

We find it interesting that:

• A sizeable minority (35% of board respondents and 25% of management respondents) affirm that they either anticipate or have already determined they will place greater emphasis on non-financial criteria in 2019…we suspect that very few of these respondents will use such non-financial measures as the cornerstone of their incentive plans. Instead, they are likely to incorporate individual or strategic goals as a modifier (e.g., increase or decrease calculated payout by 10%) to financial result-driven formulae, or as stand-alone goals that account for less than 25% of total incentive plan opportunity.
• There is a stark contrast between the percentage of management respondents (40%) vs. board respondents (19%) who simply indicate they are not considering this approach. This echoes earlier polls we have conducted which indicated that boards are more open to consideration of ESG (Environmental, Social, and Governance) measures than management teams, possibly because they feel they are under pressure from the investor community to at least explore the topic.

Yes, There is a Place for Non-Financial Measures

We believe that non-financial measures can play a powerful role in aligning annual incentive plans with business strategy. For example, a company fostering innovation and expansion into new markets may combine “lagging” financial measures that hold management accountable for continued success in existing markets with “leading” non-financial measures that focus on execution against growth strategies. A scorecard of such leading measures may include:

• Success in industry vertical penetration
• Success adding new markets/geographies
• Successful integration of acquisitions

Our experience is that the investor community is receptive of such plans if and when companies make the effort to (a) clearly articulate why these measures are their performance priorities, (b) how efforts against these goals will translate into shareholder value creation, and (c) how they go about ensuring there is rigor in performance assessment. This requires a good deal of investment in shareholder outreach—but we often find there is a very strong return on that investment!

What Your Committee Should Also Consider in Q4

For December fiscal year-end companies, Q4 is an excellent time to discuss the broader topic of incentive plan design for the coming year. Companies that are contemplating a shift in the mix of measures included in their incentive plans would be well served to stress-test these designs (modeling various performance and “what if” scenarios) before the end of the year. Where non-financial statement measures are part of the mix, we encourage companies to game plan for pay disclosures. How might the new plan design be described in the CD&A section of next year’s proxy statement? Would the board support above target payouts on such measures even if the pay trend ran counter to income statement and/or shareholder return trends? How would such a result be explained to the investor community?

We have also found that Q4 meetings work well for reviewing how compensation opportunities compare to external benchmarks. We encourage boards to review such materials in a separate session from when pay actions (base salary changes, incentive plan payouts, next cycle of equity grants) will be approved. Boards should have an opportunity to digest benchmark information before acting on it in a subsequent meeting.

The end of the fiscal year is a whirlwind with respect to executive compensation plan decision-making. If contemplating changes for 2019, the clock is ticking—begin your modeling now!