To Pay or Not to Pay Short-Term Incentives in the Year of the Pandemic
Updated: Jul 27, 2022
The COVID-19 pandemic has had a substantial impact on revenue and earnings for businesses across the country. While the first two quarters of 2020 are complete and results are known, the final two quarters of the year will most likely continue to be heavily influenced by volatile economic conditions.
As the end of the year approaches, companies should consider the impact of the pandemic on short-term incentive plan payouts, and whether is appropriate to apply discretion in order to adjust bonus amounts. We feel it is best to discuss alternatives and determine the relevant factors now to manage expectations and effectively communicate rather than waiting until the end of the year.
Incentive Plan Objectives
There are four primary objectives of incentive compensation which should be kept in mind when considering measurement alternatives or using discretion:
Provide a competitive, market-based opportunity;
Link variable pay opportunity to relevant performance metrics;
Provide motivation to participants by providing them an opportunity for additional compensation;
Provide a degree of retention through the payment of the incentive.
Short-Term Incentive Treatment Alternatives
As many companies set the goals for their short-term incentive plans early in the first quarter of the year before the impact of the pandemic was understood, the current goals in place are not likely to be indicative of how the business will actually perform in 2020. In the event that halfway through the year it is clear that goals previously set are no longer grounded in reality and payouts cannot be achieved, companies should consider their options.
The first option is to utilize previously set goals, even if it is clear that no payout will occur. This may be appropriate if the business cannot afford to provide short-term incentive payouts due to their financial condition or employees were negatively affected through layoffs, furloughs, or pay reductions. While this option has negative implications as it does not support employee motivation and retention, it may be necessary when considering adverse impacts on other stakeholders.
The second alternative is to adjust goals based on updated financial forecasts and works best if new goals can be set with some degree of confidence in their probability of achievement. Participant motivation and retention are supported by this alternative; however, it may be difficult to accomplish considering the uncertainty of the severity and duration of the virus’ impact on the economy and businesses.
Lastly, a company may decide to apply positive (upward) discretion to short-term payouts calculated on its original goals, in order to provide a payout for eligible employees.
This would be appropriate if there are positive aspects to the company’s performance during the pandemic, there is not significant adverse impact to other shareholders, and modifying goals is not possible.
Many companies are taking a wait and see approach to fully understand the impact on results for the year and not setting new goals. We advise that some communication to participants should occur to manage expectations.
Application of Discretion Alternatives to Short-Term Incentive Payouts
There are a number of ways that discretion could be applied to incentive plan payouts, including:
Excluding certain line items that are due to the pandemic from overall financial results, such as the expense associated with employee testing, facility cleaning, or the loss of a major client due to their financial situation;
Considering results before COVID-19, how successful the company has been in navigating the challenges posed by COVID-19, and how well positioned they are for future growth, and use these factors to determine some level of incentive payouts – even though these criteria were not part of the goals set early in the year;
Reducing the threshold level of performance results required to achieve a partial payment related to actual performance;
Analyzing how the company performed in each of the four quarters of 2020, rather than using the annual financial goals, to determine if one or more quarters’ performance met or exceeded the amount of the annual goal for the respective quarter; this could allow for some level of short-term incentive plan payout, even if the annual goals did not meet threshold performance;
Providing some level of payouts due to strong individual performance, even if overall company results would not otherwise warrant a payout on the individual performance metric.
The decision to provide discretion to incentive payouts must be weighed against the impact on other stakeholders and the company’s past incentive pay practices.
Considerations for Public Companies
Public companies will need to disclose if discretionary adjustments were made to their short-term plan payouts and should consider how these adjustments will be viewed by shareholders and proxy advisors. In conducting its qualitative pay-for-performance analysis, Institutional Shareholder Services (ISS) will likely consider the following factors related to discretion employed in 2020:
The rationale for adjustments made to incentive plan payouts;
The overall ratio of performance-based compensation to fixed or discretionary pay; and
The degree of discretion exercised by the compensation committee.
Another proxy advisor, Glass Lewis, indicated that “effective disclosure and rationales provided by companies will be particularly critical to our exercise of discretion in making judgments about whether changes made as a result of this crisis are justified and address material shareholder concerns.”
Considerations for Private Companies
While private companies won’t need to be concerned about disclosing how their board or compensation committee used discretion, they should still base their decisions on pay for performance principles. In addition, the optics of using positive discretion for senior leadership incentive plans should be considered, especially if the general employee population will not receive a bonus or if the company had to lay off workers in 2020.
Discretion should only be used when there were areas of strong performance (even if the initial financial or operational goals for the year were not met), and we do not recommend that discretion be used to pay incentives at target if no payouts would have been achieved but for the discretionary adjustments. Further, when determining the level of discretion, consideration should be given to the general rule of thumb on the design of short-term incentive plans where the probability of achieving threshold should be 80-85%, probability of achieving target should be about 50%, and the probability reaching maximum levels should approximate 15%-20%. Given that incentives should not be viewed as guaranteed, it may be appropriate for payouts in 2020 to be near threshold (if any payouts occur at all) if business results are significantly below typical years.
This is the second in a series of articles by the POE Group that will address the main components of pay and how they might be considered for updates or adjustments as the pandemic continues to impact the business environment.
- Joe Kager, Managing Consultant at The POE Group. Joe is a Certified Compensation Professional with over twenty-five years of experience in compensation and human resources. Call him at 813-546-8628, or email him directly at firstname.lastname@example.org