As more uncertainties about the economic outlook for 2008 emerge, management, boards and shareholders should be bracing themselves as companies edge towards “softer” performance targets in pay plans.  But take a hard look before making decisions on executive pay plans.  Differentiate between the genuine, and the “others”.

The trend is already evident in the UK, where most companies have a financial year end in April.   Some proxy firms have already seen evidence of companies “tinkering” with their pay plans, and have warned that these companies are unlikely to be the last. They predict that a trend towards “softer” performance targets for pay will emerge in 2008.

The same will happen in Australia.

In a still tight labour market there are pressures to maintain the same level of bonus actually paid, to retain executives who are facing lower payouts from existing incentive arrangements as the economy slows. Boards will be keen to ensure performance targets are achievable, which may require a reduction of performance and vesting targets for future awards.

We expect there will be several cases where the bonus opportunities for executives will remain unchanged (or in some cases will be increased), but potential rewards for shareholders, measured by dividends paid and share prices, may be limited. 

Investors may question whether this represents a proper alignment of interests.  However, a counter argument is that lower targets during economic downturns may be just as challenging as higher hurdles are during more benign market conditions.

New arrangements may be a better reflection of lower growth rates expected by shareholders amid less robust economic conditions.  The proof of this will be in the company’s share price.  This may be a clear signal that the market expects lower future earnings.  But this is not necessarily a signal that performance targets should be adjusted to suit as well.  Boards need to exercise judgment on the extent to which a reduced share price is a function of general market sentiment (i.e. the beta component of share price), or management competence (i.e. the alpha of share price movements).  In Australia the current expectation is that some market sectors will hold up well (e.g. mining), while a few may suffer from the credit squeeze and poorer consumer confidence (e.g. the banking and consumer discretionary sectors). 

Therefore, boards should consider the validity of the overall sector’s outlook before broaching amended management performance targets with investors.

This can be more easily assessed for annual bonus plans.  But there should be some sympathy for directors given the difficulties of setting robust long-term performance targets in turbulent markets.

Investors need to be realistic about what is achievable.  In some cases, performance targets that might have previously been realistic have ceased to be. You can expect these to change.

There is no point in having an incentive scheme that does not motivate executives. But that does not mean that targets should be soft or that investors will always sanction amendments to targets.

Unfortunately, there is little sign yet that boards are wary of remuneration plans without adequate risk control. As a matter of course, boards should ask how the plan ameliorates the tendency of some management to take an excessive punt to boost their annual remuneration.

This should not take away from the board’s primary concern.  Investors have become hawkish about rewards for lacklustre or mediocre performance.

The Australian government’s election platform promises action on this (see our article HERE).  While it will not come about this next reporting season, boards should expect that at some time during the government’s first term there will be a focus on better reporting of pay for mediocrity rather than pay for performance.

Given the pressures, boards may want to consider the following checklist:

• Is there a justification for assessing a change to performance targets based on management’s financial outlook?
• Is the revised outlook validated by external measures of customer demand and share market sentiment for peer companies?
• If the revised outlook is valid, and not a function of management’s relative competence, are incentive targets still appropriate?
• Do revised targets, if achieved, at least meet and preferably exceed market expectations, reflected in the company’s current share price?
• On achievement of the revised targets, is the quantum of reward fair, given what is known of competitor pay and performance levels?
• What is the extent of knowledge (or ignorance) of the investor community on the way you measure your own performance? Do they consider it valid?  Can they be educated?
• What would be the reaction of the proxy advisory firms? 
• Is there enough time to consult with the proxy firms and investor community?
• What fall back positions are there to retain management if there is a negative reaction to the proposed revisions?
• In the end, what is in the best long term, fiduciary interests of shareholders for ensuring management are adequately incentivised and rewarded for valuable outcomes?

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