Salary Reductions and Their Unintended Consequences
In times of crisis, companies are desperate to reduce expenses
As the weeks go by, the effects of COVID-19 have entered nearly all aspects of life and business. The month of February marked the first death from the virus on American soil which soon began the series of events that led the country to shut down as a whole. As citizens nationwide adapt to the changes of everyday life during the pandemic, American businesses have seen some of the worst financial times since the recession of 2008. As markets retract and businesses strain to acclimate to the changing landscape; massive layoffs, furloughing, and pay cuts have been the measures taken to reduce G&A expenses and increase cash flow to keep businesses afloat.
Reducing executive compensation is the first reaction
While this is intended to be a temporary solution, long-term consequences could potentially cause some ill-effects to employers and employees.
Although COVID-19 has generated a newfound desire by many to reduce compensation values and restructure programs, these reactions are certainly not confined to times of pandemic. Similar reactions have been taken throughout the years when markets turn unexpectedly or when previously strong industries face headwinds, much like the 2008 financial depression or the 2014 energy crash. Often, when looking for savings, the initial reaction is to reduce base salaries of CEOs and NEOs, as well as board member retainers. However, whether a noble voluntary action or forced act of necessity, the chain reaction created by this simple decision must be fully comprehended.
Many compensation components are tied to base salaries, mainly incentive plans
Base salaries are the foundational components of compensation programs. While base salaries for executives typically account for the smallest percentage of their overall compensation package, many other components of compensation and benefits are directly tied to this value and will be impacted by fluctuations – up or down. As with any decision, there are unforeseen and unintended consequences, both short and long-term. This furthers the importance of executives and directors alike in understanding the full impact of their decisions, not simply focusing on optical implications or the myopic value diminishment of salary dollars.
Incentives are prevalently tied to the salary levels of executives and employees. In quantitative bonus programs, annual bonus targets are typically expressed as percentages of salary. Similarly, long-term incentive values are often guided by or determined by salary level. As such, when base salaries are reduced in reaction to poor markets, without proper mitigating actions, the bonus potential and long-term incentive award values are also possibly negatively impacted. In some cases, significantly so.
Scenario: A CEO who has a base salary of $500,000, a bonus target of 100% and an LTI target of 500% has a typical targeted total compensation opportunity of $3,500,000. In reaction to a significant event, the company experienced significant reductions in earnings and has to make layoffs in order to manage expenses. As a means of “sharing in the pain” the CEO voluntarily reduced his salary to $100,000. This created a greater external optic in the media and among shareholders, but the Board failed to take action on other aspects of the compensation program. Since the CEO’s bonus and equity award was tied to this reduced salary level, the bonus opportunity and LTI award values could potentially be reduced by up to $2.4M, resulting in a total reduction of $2.9M.
This scenario may be over-blown a bit, but regardless shows the possible impact a simple salary reduction may have if not considered from all angles.
Other considerations: life insurance, employee agreement laws and employee benefit plans
Yet another possible impact that is rarely considered is life insurance. Many executives carry personal life insurance which is likely not impacted, however, company-paid plans often function as multiples of salary. In these cases, the death benefit during the period of the reduction would be reduced to align with the then current salary. While this does not impact the take home pay of an executive, should an executive perish while in the temporary reduction window, the family’s death benefit could be severely diminished.
Further concern is centered around employee agreement law and employee benefit plans. This is a case-by-case problem. A reduction in base salary could be viewed legally as a for-good reason voluntary termination, providing an executive with the ability to terminate employment and activate a generous cash severance package. “Each arrangement that includes a ‘good reason’ construct should be analyzed to determine whether the contemplated reduction in base salary could trigger an argument of constructive termination.” Although this circumstance triggering will be rare, mitigation of the risk is important.
Tips to navigate compensation decisions
Understanding the possible implications, how should boards approach this delicate topic? There are multiple approaches which can be taken to ensure the integrity of the overall compensation program is maintained or that ultimately result in better outcomes:
- Ensure bonus targets and long-term incentives remain tied to pre-reduction base salaries. This will maintain incentive program integrity by allowing for the continuation of incentive opportunity. This mitigates an over-reduction scenario caused by reducing salary and all program tied to it.
- Use another compensation vehicle to reduce compensation levels. Eliminating or capping a bonus opportunity sends a stronger message…one of recognition that performance is an issue. Long-term incentives are also a better reduction mechanism as the value impact will be minimal and it also reduces accounting costs and conserves cash and/or shares. But be careful here also…too much reduction could impact timing with share ownership guideline compliance.
- Consider deferrals in lieu of reductions. Non-qualified deferred compensation arrangements and Supplemental Executive Retirement Programs (SERPs) are great tools for deferring value opportunity to future dates. This is both tax advantageous to the recipient and reduces compensation received in what may be a poor market.
- Redesign life insurance programs to function as set dollar amounts or ensure plan language does not account for temporary salary reductions.
- Consider potential termination triggers and get legal opinions related to temporary reductions.
- Consider potential FLSA exempt status impacts, as reducing too low could affect this status.
While further prevalence of these actions may develop over the coming months, by this time the majority of public companies, mostly in the travel, hospitality and energy industries, have already made many decisions related to potential temporary reductions. The Board needs to seek guidance on their exposure and determine whether steps should be taken mitigate any perceived risks. There is no doubt, actions related to compensation are very often necessary in reaction to crisis, but making the right adjustments is key. If salary is the chosen direction, enter that decision fully educated on all impacts and all manners in which to protect the company and employees.
If your organization needs further assistance with its compensation programs, don’t hesitate to contact Longnecker & Associates below, we are here to help.