Why Does Having a Good Severance Plan Matter?

January 18, 2018 Chris Kelley


Thinking about severance plans can be depressing.  Severance is paid out when an employment relationship ends, so it’s not as bright and uplifting as designing an variable pay plan or equity program that you’re using to incentivize high performance. But regardless of whether the employment relationship is ending because of

  • Downsizing,
  • Merger or acquisition,
  • Individual performance, or
  • A host of other reasons

Having a competitive severance plan can help you maintain an engaged and productive workforce as you move through whatever transition your organization faces.

Individual companies and even certain industries can be facing downturns right now, but overall, the economic climate currently is positive for most organizations.  So why does it make sense to think about severance when things are going well? First, if you take the time to assess the competitiveness of you retention programs at the top of the market, you are doing it from a position of strength. You don’t want to wait until you’re company’s situation takes a turn for the worse and try to design plan features when your company has a weaker position. The second reason it makes sense to think about severance in a favorable climate like we’re in now is that we are seeing a sustained high levels of merger and acquisition (M&A) activity. As Jack Grange pointed out in a Pay Insights blog last summer, a severance plan can be a relatively inexpensive first defense for retaining talent during a corporate transaction since it only becomes an actual cost in the event of job loss.

To help you assess whether or not your severance plan is competitive, we recently conducted the Severance and Change in Control Survey.  Here are some of the highlights we’ve gleaned about the characteristics of competitive severance programs.

Severance Plan Eligibility

It’s common practice to have severance and change-in-control plans in place for the Chief Executive Officer and their direct report leadership team.  It’s also common practice for severance programs to cover the extended leadership team (other executives) as well as other critical employees and key contributors.  However, broader utilization of severance programs is one of the key findings our colleagues in the Strategic Advisory team found for their study titled, Addressing Human Capital Challenges in M&A.  They report that companies that characterize their M&A activities as ‘very successful’ utilize severance & retention programs more often and deeper within their organization compared to other companies.

Because of this, our Severance and Change in Control survey analyzes eligibility prevalence for both executive levels as well as broad-based employee populations.

Competitive Severance Formulas

The amount of severance benefit provided varies considerably by job level.  The competitive severance formulas for executives is typically expressed as a multiple their compensation.  We also see the value of the severance being higher if the reason for the severance is a change-in-control (CIC). The stakes are higher for a company to keep executives and critical employees productively engaged throughout the corporate transaction.

 For broad-based employees covered by severance plans, the benefits will usually vary based on the length of service of the employee. The other main difference in the severance formula at this level is there is typically no premium in the severance benefit for CIC transactions.

Trigger Mechanisms

The circumstances for when severance benefits are provided will usually be well documented for executives in their employment agreements. Severance is usually not provided to executives who voluntarily reason or if they are involuntarily terminated for cause (i.e., criminal activity or gross misconduct). Some voluntary terminations may still qualify for severance benefits in cases of ‘for good cause’, (i.e., material changes to the scope of the executive’s job). Involuntary terminations for other reasons (i.e., downsizing, redundancy, or even performance) are usually triggers for payment of severance benefits.

For CIC transactions, good governance practice is to use a ‘double-trigger’. This means that severance benefits are only payable when two things happen; the actual change in control of the company and the loss of employment for the executive.

Treatment of Compensation Elements

Since a large portion of the total compensation package for executives goes far beyond their base salary, it is imperative to define how you will treat all the different elements of compensation as part of the severance plan.

For short-term incentives for executive severance plans not related to a CIC, we see a range of options that companies use. The most common is to pro-rate the bonus payment based on actual performance.

Long-term incentives (LTI) for executive severance plans not related to a CIC can be a bit more complicated.  It’s not just the dollars at stake, but the various types of LTI plans, the time periods they cover and rules in place regarding vesting.

Performance-based LTI plans can get even trickier when defining their treatment in the severance plan.

What’s clear from our analysis of severance plans is that it is good practice for companies to evaluate the competitiveness of their severance plans periodically. Ensuring your plans are market competitive can help you retain and engage your talent at all levels. The four main characteristics described here just begin to scratch the surface on helping you understand the competitive landscape, but you can learn more by checking out our recent Severance and Change in Control Survey

Or, you can contact us for more information or speak to one of our executive compensation consultants for help with designing your severance programs.

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