Executive remuneration frameworks are under sustained pressure as inflation, higher interest rates, elevated WACC, and geopolitical volatility distort performance outcomes, compress margins, and force boards to rethink how TSR, earnings measures, and capital efficiency are reflected in incentive design.

Key Takeaways:

• While TSR-based vesting is unreliable in down markets, there are ways to align with performance.
• Rising WACC and tighter funding conditions are increasing the hurdle for return-based incentives (ROIC, ROE), while weak demand limits the ability to pass through costs, compressing achievable performance ranges.
• Asset rationalisation and disposal losses are heightening earnings volatility, pushing boards toward “underlying earnings” adjustments that may face scrutiny from proxy advisers if definitions lack transparency or consistency.
• Boards can shift toward capital efficiency metrics, wider performance ranges, and more diversified scorecards, while reconsidering TSR and equity instruments to maintain incentive relevance under volatility.

It is likely that share markets will remain under pressure as the impact of stubborn inflation, productivity constraints, higher interest rates and geo-political instability pressures margins, depresses consumption, and dampens investor sentiment.

If the oil supply and price shock lingers, this presents a multitude of problems in setting appropriate executive incentive measures and targets over prolonged periods.

Here are some of the more common problems followed by a Check List of What to Do.

TSR gateways

There is a real prospect that over a 3-year period, a company may perform well relative to other companies, but have a total shareholder return that is negative.

Under pressure from a proxy adviser and shareholders whose conflicted portfolio managers have bonuses tied to short term index return benchmarks, companies now require TSR to be positive before an LTI grant can vest. Even if companies do not have similar policies, it is likely they will receive less investor and proxy adviser support if a grant vests and TSR is negative.

WACC

As interest rates and stock volatility increase, the weighted average cost of capital (WACC) will also increase. Incentives that vest based on returns assessed against WACC will require higher absolute return performance for a reward to be realised. The risk of stagflation limits the extent that revenue can realistically recover these higher funding costs, as consumer demand will likely remain too fragile to absorb further price hikes.

Asset rationalisation and losses

Businesses may look to “cash up” to be more resilient in the face of economic headwinds expected down the track, or take advantage of competitors more distressed at a future date. Any losses on asset disposals necessary to provide this cash will hit earnings, and incentives may not vest unless companies rely on an “underlying earnings” figure. However, scepticism about such measures among investors and proxy advisers mean they may take issue with the measure. There may be other unintended consequences from excluding gains or losses on asset disposals from an earnings figure. Also, take care your measures are suitably refined such that resulting incentives comply with s200C of the Corporations Act as you try and sell your way out of trouble.

Lower incentive target re-sets

Depending on the nature of the company, the downside risk and uncertainty will impact earnings in different ways. Companies vulnerable to energy price spikes will see profit margins compressed while organisations that depend on offshore funding, such as Australia’s smaller retail banks, or equity asset management returns, such as wealth managers and life insurers, will have to navigate higher funding costs. Management incentives based on realistic budgets may see incentive payments for poorer profit performance and lower TSR. This will not be well received by proxy advisers and investors. Usually there is a 12 month lag between the reality reflected in incentive targets and proxy adviser expectations.

The purpose of incentives is to focus management on outcomes prioritised by the board in the interests of the company. This may not be the same as the interests of many of the company’s investors. In fact, as we have observed over the years, investors with a short term focus tend to be the difference between a remuneration strike or not. Long term strategy, company sustainability and longer term shareholder returns count for little.

So, what to do – a check list

Rely more on relative TSR but with caveats. While relative TSR is much maligned (See some of our grumpier articles from 20 years ago HERE and HERE), shifting towards relative TSR aligns with the preference of the many investors who have their own incentives benchmarked against an index. But the main benefit is that when absolute financial targets are difficult to forecast, relative TSR can filter out some market noise. It still measures performance relative to peers who will also be experiencing the same macroeconomic headwinds.

However this only works if the peer group is well defined. A broad index will include companies that experience market turbulence in very different ways. This can lead to vesting outcomes reflecting luck rather than performance. Take the time to test your peer group – can it withstand these sorts of moves?

Boards should reconsider positive TSR gateways. They are counter-intuitive in a falling market. If management outperforms the market but absolute returns remain negative due to systemic factors, the gateway blocks all rewards. This disconnect creates retention risks during volatility. Now may be an opportunity to reflect and remove.

Introduce another measure. More measures reduce risk for the company in that management does not overly focus on one outcome at the expense of others. It also reduces risk of management turnover in that there is a higher probability that something will vest. In addition, more measures probably represent a fuller and more valid picture of management performance than a single measure. However, keep in mind that incentives weighted at less than 20% rarely provide sufficient motivation to impact executive decision making.

Respond by shifting emphasis from growth to capital efficiency. Pressures on demand favour capital discipline over pure growth. Yields on equities are less attractive as sustained high interest rates offer better risk adjusted returns. Hence, boards should consider more emphasis on efficiency measures, such as ROIC or ROE. This does not mean growth measures should be ignored. However, as economic cooling persists and margins are squeezed, the priority must be capital efficiency until global volatility subsides and interest rates decline again.

Set wider ranges. In times of uncertainty and difficulty forecasting, narrow target ranges can lead to binary outcomes not reflective of performance. By widening the gap between threshold and stretch targets, boards can ensure that incentives remain functional across a broader range of situations. This helps avoid the risk of a not hitting target due to minor budget misses, while still requiring significant outperformance to achieve a maximum award.

Consider changes to the reward vehicle. Persistent market volatility and declining share prices do not favour options or share appreciation rights, which risk losing retention value if they remain underwater. While these vehicles fell into disfavour after each major recession (you may not remember the dot-com bust, but were likely around for the GFC), companies with them in place may need to reconsider. Executive equity delivered in share rights and RSUs better ensures incentives remain relevant through the end of a 3-year performance period.

Consider changes to the reward framework. Higher levels of volatility make it very difficult to forecast beyond 12 months. Setting financial targets to be achieved over a 3 year performance period becomes fraught. There are alternatives to the traditional STI and LTI combinations. But be aware that although there has been some more movement towards alternative plans such as RSUs, investors and proxy advisers are comfortable voicing their dissent against alternative frameworks.

The bottom line 

Companies struggling with performance are likely to face much more scrutiny when changing plans or bedding down recent plans.

Boards must ensure that any adjustment to the remuneration framework is rooted in a clear strategic rationale that prioritises company resilience over short term payout protection. Success in the current climate requires that these changes are not seen as a retreat from performance, but as a deliberate pivot toward sustainable value creation, supported by early and candid engagement with investors.

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