When Should Companies Consider an Adjustment to Executive Incentive Payouts?

As we approach the end of the year, companies with December fiscal year-ends will begin evaluating the performance of their executives and discussing incentive payouts. Some will consider whether any adjustments should be made to their formulaic incentive plan results. This can be a complicated decision, as compensation committees must balance wanting to reward executives for adding value to ongoing operations despite external setbacks, with maintaining alignment to the shareholder experience and the integrity of the incentive program.

Guidelines for Adjustments

In general, only items outside of management’s control should be considered for adjustment. Even then, only a subset of these items warrant adjustment. Adjustments serve the purpose of excluding the impact of any unusual or extraordinary results that do not reflect on-going business operations (e.g., changes in accounting rules). This helps avoid unintended incentives for management to make decisions solely based on achieving incentive results (e.g., avoiding write-offs associated with investments because of the potential impact on bonus pools).

Adjustments should also consider the impact of prior-period actions to ensure consistency in decisions and identify if they are truly infrequent.

Care should be taken to avoid adjustments that forgive management for making “bad bets.” For example, management should not receive incentive relief for an impairment charge on an acquisition they advocated for that doesn’t pan out. Forgiveness for such actions may skew management’s incentives towards greater risk-taking and introduce a misalignment between pay outcomes and shareholder interests.  

Evaluating Executive Incentive Adjustments in Fortune 100 Companies

To help shed light on how companies approach adjustments, Semler Brossy analyzed the 2023 proxies of 92 Fortune 100 companies for incentive payout changes. Our analysis focused on discretionary adjustments outside of a pre-defined adjusted metric. For instance, Adjusted EBITDA with built-in GAAP adjustments would only apply if there were further adjustments during the year in addition to the reported Adjusted EBITDA metric definition.

We found that 22 companies (approximately 24 percent) adjusted incentive payouts or targets. Of those companies, 10 made changes only to Annual Incentive Plans (AIP), 10 adjusted only Long-Term Incentive (LTI) plans, and 2 made changes to both AIP and LTI plans. Of these, the majority (14) were downward adjustments, which tend to receive minimal scrutiny from investors.

Of the eight companies (approximately 9 percent) that made upward adjustments to incentives (six of 12 LTI adjustments, two of 12 AIP adjustments), all displayed a positive total shareholder return (TSR) in the year of adjustment. This is an important distinction: upward adjustments are received more positively when they align with the shareholder experience (e.g., positive TSR) and business outcomes. Additionally, upward adjustments typically were made due to factors outside management’s control such as macroeconomic factors (COVID-19, Ukraine conflict) or tax and accounting regulatory changes. Commentary from ISS on these upward adjustments was generally minimal in most cases (none received “Against” recommendations).

However, adjustments that aren’t aligned with the shareholder experience and without a strong rationale are generally received negatively by shareholders. For instance, multiple large healthcare companies faced investor pushback due to disclosure issues in recent years. A major distributor received an “Against” recommendation from ISS and a below 60 percent say-on-pay vote when it adjusted the financial metrics in its bonus plan to exclude large litigation-related payments. Adjustments related to these litigation-related expenses and the lack of disclosure were cited as the driving factor for ISS’ “Against” recommendation, although pay vs. performance misalignment was also noted as an issue within the company’s incentive program.

A Pre-Established Adjustment Framework is Helpful

It is helpful for companies to define specific adjustment frameworks prior to the start of the performance cycle. This ensures that all stakeholders understand the pre-established guidelines for adjustment.

In our review of the Fortune 100, the main factors driving incentive adjustments included macroeconomic factors, M&A activity, pay vs. performance misalignment, changes to company long-term strategy, and tax-related regulatory changes.

Conversely, companies generally do not adjust incentives based on changes in market supply and demand or competitive landscape, non-tax and accounting regulatory changes, or changes in interest rates.

There are also several scenarios where adjustments are sometimes made depending on the circumstances. These include restructuring costs, renegotiation of contract terms, foreign currency fluctuations, asset impairments or write-offs, litigation costs, accelerated items, and impacts from natural disasters. Such factors do not always drive incentive adjustments but require a case-by-case review to determine if an adjustment is appropriate. For instance, a large industrials company made an upward adjustment to its AIP financial metrics due to its inability to fulfill foreign contractual obligations outside of management’s control. However, had this situation occurred due to executive decision making, an adjustment would not be warranted.

While the establishment of a framework is essential, it is also important to have consistent and symmetrical application of the pre-defined guidelines. Adjustments should not inherently favor executives, and there should be fair judgment in both directions.

Concluding Thoughts

Adjustments to incentives may be appropriate in limited circumstances but should occur infrequently and require robust discussion at the committee level. Any adjustments made should include enhanced disclosure detailing the rationale for the adjustment and the process for making the determination. It is also critical to have consistency both up and down over time. Resulting changes should align with management’s true performance during the cycle and consider the overall shareholder experience and reactions.

Semler Brossy is a NACD partner, providing directors with critical and timely information, and perspectives. Semler Brossy is a financial supporter of the NACD. 

Deborah Beckmann is a managing director at Semler Brossy.

Kristofer O’Toole is a senior consultant at Semler Brossy.

Matthew Mazzoni is a consultant at Semler Brossy.

Jason Li is an associate consultant at Semler Brossy.