When stock market declines impact executive compensation

    By Shai Ganu

    The Business Times, 16 December 2016

    Since January 2015, the Straits Times Index has dropped by approximately 15 per cent. The depressed share prices and low corporate earnings have affected Singapore companies in various ways. Some have cut jobs, some have frozen or reduced executive salaries, whilst others are awarding lower bonuses. The biggest impact, however, will likely be on the companies’ long-term incentive (LTI) plans.

    LTI plans are recommended by Principle 8.2 of the Code of Corporate Governance. They should be designed to align the interests of management and shareholders, and reward forward-looking performance. In Singapore, the most prevalent plans revolve around restricted shares (which reward the achievement of operational targets and enable retention of executives) and performance shares (which reward the creation and preservation of shareholder value over the long-term).

    Typically, performance shares incorporate total shareholder returns (TSR) as a performance hurdle. TSR combines share price appreciation and dividends to measure total returns to the shareholder. Management is rewarded for generating TSR in excess of a certain hurdle rate, or for generating a higher TSR relative to peer companies.

    However, the depressed share prices may mean that many LTI plans might not meet the required performance thresholds, and executives’ pay may end up being lower than the amounts previously granted by the board and disclosed in the annual reports. This in itself is not an issue, but concerns arise when the company’s share price drop is caused by the overall market sentiment, rather than its own operating performance, which could actually be improving.

    In such cases, the non-vesting of LTI plans could lead to declining motivation levels. Consequently, what can boards and remuneration committees (RCs) do to retain top talent??

    Existing LTI awards

    Where existing LTI awards do meet required performance thresholds, boards may exercise the discretion provided in the plan rules and allow for partial vesting. Boards may do so if they feel the share price drop does not do justice to management’s efforts and underlying operating performance. In such cases, it is important to explain to shareholders the rationale for exercising such discretion.

    Another, albeit unpopular, approach is to allow performance conditions to be re-tested. If management does not achieve the performance thresholds over the nominated period, the board could extend the plan by another couple of years, allowing management the opportunity to make up lost ground. However, in the west, such re-testing is strongly discouraged on the basis that shareholders may not have a similar opportunity to wait for a turnaround.

    Future LTI awards

    For future LTI awards, at a tactical level, companies can increase the size of the awards. A bigger award, with a lower share price, could result in the granting of a much higher number of shares. This could help keep executives motivated. However, it can also exhaust approved share pool levels, and cause high dilution.

    For companies going through a business transformation, another approach is to implement a special transformation incentive. Usually, these are in addition to existing LTI plans, and have non-overlapping objectives.

    A more sustainable alternative is to review the performance measures of the LTI plans. Today, TSR is one of the most prevalent measures used. However, there is a growing view that it may not be the only way to achieve pay for performance alignment. Indeed, several companies have analysed the underlying drivers of shareholder value, and introduced measures such as return on equity, earnings per share, and economic profit.

    Even if companies adopt TSR, it is important to analyse what drives the share price. Mercer’s Performance Sensitivity Analysis suggests that a company’s share price volatility is attributable to three factors: the overall market (i.e. company moves up or down with the overall market); the industry peer-group; and the company’s actions. Such categorisation allows each company to tailor the TSR hurdle that best suits its share price characteristics. For example, if a company has a very high proportion of firm-specific volatility, it might make sense to set an absolute TSR target, rather than comparing it with peers or the overall market.

    Reviewing LTIs

    To drive the desired behaviours, it is important to understand executives’ perceptions about incentive plans. RCs should periodically assess the effectiveness of LTI plans to ensure alignment with evolving business priorities. Specifically RCs should:

    • Review the mix between base pay, annual bonuses, and LTI. Within LTI, review the mix between restricted shares and performance shares.
    • Review the performance measures for LTI plans, particularly whether to supplement TSR by other measures.
    • Analyse the drivers of share price volatility, and assess whether to use absolute or relative TSR or both.
    • Analyse the grant value versus the realised pay (i.e. the take-home pay) to understand the materiality of low vesting of past share grants.
    • Ensure that there is detailed communication to executives, and enhanced disclosures to shareholders around LTIs.

    Non-vesting of LTI should not be the sole reason for making any changes. Any compensation model is likely to result in years of high payouts and low payouts. Boards and management teams should expect the ups and downs. However, Boards should assess the underlying causes, and determine whether any adjustments are warranted.

    Shai Ganu is a member of the Professional Development Committee of the Singapore Institute of Directors.