Bonus Plans: Scratch Whatever You Had

Compensation committees face a daunting challenge—putting together 2021 incentive and bonus plans for a year that’s likely to be as uncertain as 2020.

If CEOs and other leaders are wondering about their year-end bonus, they should know at least they aren’t the only ones: so are some compensation committees.

Now, well into the fourth quarter, experts say boards are still trying to figure out how to account for the financial fallout from COVID-19 in this year’s bonus and incentive awards. And that’s only part of the challenge—they need to simultaneously design next year’s too. In fact, with the pace and timing of a recovery still uncertain, compensation experts anticipate boards will face similar issues in deciding bonus and long-term incentives in 2021 as they did this year.

“The more uncertain the environment, the more boards have to build flexibility into plans to allow for a rebalancing of priorities,” says Michael Weisbach, chair of finance at Ohio State University’s Fisher College of Business.

Providing levers for flexibility is expected to be a key feature of 2021 plans, mainly because experts expect bonuses for a large majority of executives across industries will be down significantly this year, if they get or take one at all. For example, Irv Becker, vice chairman of Korn Ferry’s Executive Pay and Governance practice, says many boards are considering widening the minimum and maximum performance levels on financial goals such as revenue or operating earnings to counter the uncertainty and volatility in 2021.

Under a traditional structure, for instance, CEOs would get a portion of their bonus (maybe 50%) upon reaching 90% of the revenue goal, the full payout at achieving the goal, and maximum payout at 110% of the goal. Instead, next year could see boards move to a scenario in which smaller portions of the bonus would be paid out at lower performance levels, such as 25% of the bonus potential after hitting 80% of the revenue target, 50% after reaching 90% performance, and so on. “Widening the range makes it easier for management to get some payment but harder to get above target payouts,” says Becker. “That’s the trade-off.”

The biggest challenge boards face in designing new bonus and incentive plans amid the pandemic is that performance has been so abysmal that it has to be taken off the table. As such, compensation committees are reevaluating everything from whether stock options still make sense to moving from three-year cumulative to annualized goals. Not unlike widening financial targets, Becker says, that approach provides an avenue to temper some of the volatility caused by the pandemic this year and likely well into 2021.

If there is a silver lining to the pandemic’s financial devastation, it’s that it could potentially compel boards to decrease their reliance on total shareholder return in determining bonus and incentive awards, says Don Lowman, a Korn Ferry senior client partner and global leader of the firm’s Rewards and Benefits practice. He says the focus on total shareholder return has helped drive up executive compensation and possibly hurt companies by distracting boards from evaluating management on other nonfinancial but equally important areas of performance, such as safety, sustainability, diversity and inclusion, and talent retention.

“Many compensation committees have satisfied themselves that higher incentive awards are well justified in light of strong TSR performance,” says Lowman. “But that comes at the expense of broader organizational health and could be the reason many organizations find themselves at the strategic disadvantage they are in today.”

Boards already appear to be giving more weight to nonfinancial objectives in bonus and incentive plans for 2021 and beyond, because of the pandemic as well as the advocacy of powerful institutional shareholders and other stakeholders. Becker says some boards are carving out as much as 20% of the annual bonus pool and allotting it toward environmental, social impact, and governance goals in next year’s plans.

Still, Becker says the key challenge for compensation committees is to design incentive plans in a way that is realistic but still motivates performance—especially after a 2020 in which many CEOs and other executives took cuts in salary and likely will be disappointed in their bonus. “You don’t want to stretch plans so far that they turn into disincentives,” he says.