Whether it’s rewarding executives or employees more broadly, incentives don’t always go to plan, resulting in outcomes that weren’t in the design play book. To combat those unexpected events, most incentives almost always allow for discretion – a catch all clause in the rules allowing for the powers that be to amend or cancel the scheme at any time. Typically, ‘discretion’ is not described beyond an overarching statement (for obvious reasons) signalling to participants and stakeholders the incentive is at risk and may change if the board so determines. Sounds like a reasonable and prudent approach for governing what is often a large quantum of remuneration particularly for executives? Perhaps in normal times, however these recent events from the pandemic have certainly stress tested board approaches to discretion, especially when things don’t go according to plan.
Challenges when exercising discretion
An ASX release from TechnologyOne (ASX:TNE) this week serves to remind us of the challenges faced when exercising discretion in a public company context.
The Board at TechnologyOne chose to exercise positive discretion pertaining to the executive’s long term incentives (LTIs), citing that the targets were set years ago, hence there was no consideration given to the effects of a global pandemic. Some proxy advisors didn’t buy into the rationale, recommending shareholders vote against the Company’s Remuneration Report. The outcome was a first ‘strike’ on the Remuneration Report as greater than 25% of eligible shareholders voted against the resolution.
Booking outcomes from a volatile period of business performance combined with an uncertain outlook is creating great difficulty when forecasting and budgeting, key factors that underpin incentive plans. Boards are now faced with the ultimate balancing act when planning for the next few years; catering to the best interests of the business, shareholders, executives and other key talent, while bracing for what could easily be another tumultuous financial period in time.
How should discretion be exercised?
As we move into 2021 equipped with some past learnings, it is interesting to observe the various views being formed on the topic of discretion. Some guidance is now available on how companies may think about discretion, including policy makers and shareholder groups.
ASIC has published information sheet 245 (INFO 245) to provide high-level guidance to assist boards when navigating decisions on executive variable pay in the context of the COVID-19 pandemic. There are also updated guidelines by which Proxy Advisors are basing their recommendations e.g., ISS Australian Proxy Voting Guidelines.
Our research tells us that we should expect to see the increasing application of discretion during these uncertain times. Data analysis from our December 2020 Remuneration Pulse Survey shows that more than 50% of respondents (with STI plans) indicated discretion was exercised by the Board over STI outcomes in 2020 – a 7% increase compared to 2019. Where disclosed, the majority applied a downward discretion in response to COVID-19 (reasons included performance impact of pandemic, government grants such as job-keeper received or the need to preserve cash). Comparably, LTI discretion was applied by 16% of respondents which may be due to a number of factors such as the types measures (e.g., relative measures which may not require adjustment for market volatility).
Fig. 1 – Discretion exercised for incentive outcomes last year – percentage of respondents
Time to get ahead of the game
In anticipation of the new financial year, companies should be ahead of the game by stress testing their incentive schemes to understand how they may respond in various scenarios, measure the hypothetical outcomes and then determine if they pass the ‘pub test’.
To enable greater understanding across all stakeholders, companies should also look to provide more direction when describing ‘board discretion’ in policy documents and if applicable public disclosure including remuneration reports. There is a balance to be found between being too prescriptive, but rather a thematic approach to provide enough insight on principles that may be used when considering discretion. Here are some areas that may help to determine themes under which board discretion may apply:
- Are there matters not known or not relevant at the beginning of the financial year? which may impact under- or over-performance of the CEO and Group Executives during the financial year?
- What is the context under which our targets have been set and what degree of stretch is implicit in the scoreboard measures and targets themselves?
- Has the operating environment during the financial year been materially better or worse than forecast?
- How have we fared against our principal competitors?
- Is there any relevant positive or negative risk management or reputational issue that could significantly impact us?
- Has there been any major positive or negative aspects regarding the quality of leadership and/or behaviours consistent with our values?
Ultimately, boards need to assess whether there is a policy framework that defines under what possible circumstances discretion may be applied as an incontestable course of action. The policy should equally deal with circumstances where a decision is taken not to exercise discretion.
Where to from here with incentive schemes
2021 will require a concerted effort to ensure remuneration programs are fit for a volatile new world. Companies should test whether incentives schemes can respond appropriately to potentially unforeseen circumstances. To ensure greater clarity of how discretion may apply, companies should also review the broad array of discretionary approaches to optimise outcomes for stakeholders.
We are here to help!