The COVID-19 pandemic is upending business operations across the global economy and has likely ended the longest period of economic expansion in United States history. Organizations are racing to address immediate business needs while maintaining a steady cash flow, and adjustments to executive compensation can be a valuable tool to accomplish this.
Deferring or reducing cash-based compensation can free up much-needed cash flow, while allowing time to adjust the pay program to meet the emerging business objectives that quite likely have changed during performance measurement periods. Highlighted below are immediate (one to two weeks), short-term (two to three months) and long-term (within a year) opportunities for organizations to restructure their executive pay to help address cash flow concerns.
Immediate: Executive pay deferrals
The quickest and simplest way to save cash in the short-term is to encourage salary deferrals for highly compensated executives. During the financial crisis of 2008, many financial institutions adopted mandatory salary deferrals or incentive payouts at the C-suite level to help make payroll for the rest of the organization. Others simply cut salaries moderately, with the intention of reinstating market competitive salaries once the company became more confident in their cash flow position. Given the fast-moving nature of the COVID-19 pandemic, these strategies have not been fully utilized yet.
However, they are already being contemplated by numerous companies and are expected to be increasingly discussed at the compensation committee level as organizations begin to get a better handle on their new business realities. Organizations may consider whether a voluntary deferral program would have enough participation, or whether a mandatory plan is necessary to increase available cash. As with any compensation plan involving deferrals, human resources and legal departments must be sure their actions are compliant with Section 409A.
Short-term: Annual incentives paid in equity
Amending annual incentive plans to pay out in equity (or deferred cash at a later date) will help free up available cash as organization’s project their cash flows in the coming months and years. Although this option will not free up cash immediately, it can represent a significant savings opportunity for organizations whose employee population is heavily weighted towards director and vice president levels (e.g., professional services or financial institutions) or for companies whose compensation philosophies are heavily weighted toward cash compensation. To encourage or “sweeten” the deal, companies could increase initial bonus payouts by 25% to 50% to soften the blow of not having incentives paid on their normal schedule, which could optimize retention and behavioral import, particularly if salary has been deferred or reduced. As noted above, Section 409A must be addressed to ensure appropriate compliance.
Long-term: Incentives, deferred compensation
Many, if not all, Dec. 31 tax year-end companies have already determined their executive compensation levels and incentive plans for their 2020 fiscal year. To the extent that modifications can be made in 2020, or for when 2021 planning begins, companies may decide to save cash by shifting portions of cash compensation (salaries and annual incentives) to equity-based long-term incentives or deferred compensation plans. The movement of cash compensation to long-term incentives is not a new trend in the world of executive compensation: many compensation committees have adopted this philosophy to better align with the preferences of prominent proxy advisors and institutional investors.
The opportunity to save cash, align compensation plans with proxy advisor preferences and strengthen the alignment of executive pay and performance through higher equity compensation levels may be an opportunity for companies to pursue over the long-term horizon. Movement to full value equity vehicles (i.e., restricted stock, restricted stock units, phantom stock) as a meaningful portion of the shift, as opposed to simply appreciation-only vehicles (i.e., stock options, stock appreciation rights), is strongly recommended, primarily due to the volatility of the markets and the risk for unnecessary expense from vehicles that could be underwater within a short time frame.
Organizations with a heavy reliance on stock options may consider whether it is appropriate to reprice historical option awards that are well underwater (there are special Section 409A rules that apply to lowering the exercise price of underwater options). Although this strategy goes against proxy advisor preferences, it may be necessary for organizations with retention concerns where executives have little or no outstanding equity binding them to the company and certainly could be deemed favorably, to the extent that the re-pricing doesn’t include options held by senior executives.
Strategies and opportunities to maximize immediate cash flow will be at a premium as organizations get a better understanding of their COVID-19 related business challenges. Identifying forms of cash compensation that can either be deferred to a later date or transitioned to equity compensation will be the primary tools compensation committees utilize to minimize cash outlays. Companies should thoroughly review their plan documentation and consult with outside advisors to ensure they are complaint with Section 409A regulations, which can carry significant financial penalties if violated.
Over the longer horizon, companies will need to consider how COVID-19’s impact on financials will flow through to the evaluation of year-end performance. Organizations will have full authority to exercise discretion in evaluating their incentive plans, especially as a result of TCJA removing the exception in Section 162(m) for deducting performance-based compensation in excess of $1 million Another compensation tool to respond to market volatility is adopting quarterly incentives in lieu of an annual incentive plan. Quarterly goals, which can be easier to set and communicate in times of economic turmoil, were frequently used throughout the 2008 financial crisis when companies had difficulty in establishing goals on an annual basis. Regardless of the action, compensation committees should be exploring each strategy and opportunity at their disposal to make their executive pay plans responsive to the current economic climate.
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