Incentivizing CEOs with long-term rewards has become a popular practice with remuneration committees. Incentivizing executives to meet business objectives is a critical factor in designing executive compensation plans. Organizations can choose from several well-established methods to pay for the performance of executives, often with significant tax advantages to the executive and the employer. It has become increasingly more important to ensure that the public and elected officials can readily grasp the reasonableness of executive compensation plans—especially in public corporations. Over the past decade, executive compensation plans have come under significant regulatory and political scrutiny.
Seemingly, lavish executive compensation garners high-voltage attention in print, TV, and Internet media. The public often does not understand that executive compensation is a matter of the meeting, and beating, a global competition to attract the best and brightest executive talent (SHRM, 2020).
At the same time, executive compensation plans have abused both public funds and the interests of private shareholders. Directors of corporations, C-suite executives, division managers, and HR professionals struggle with how to design the right type of executive compensation plans to meet corporate goals and still appear reasonable to a public that does not understand the complexities and market challenges of the job (SHRM, 2020).
Given this legal, social, and political environment, a straightforward and well-balanced assessment of key design issues is critical for any organization that undertakes to have executive compensation. A sound executive compensation program depends on good governance and well-established compensation philosophies, policies, and practices that are closely aligned with the organization's overall goals and objectives.
Effective organizational management is about developing and optimizing the value of human capital as a business asset. The value of human capital is optimized by various factors to include:
- Attracting the right employees for the right jobs.
- Retaining employees.
- Developing and Training employees as key assets.
- Aligning employees' vision with shareholders' vision.
- Motivating employees to achieve organizational performance objectives.
- Recognizing and Rewarding human capital as a valuable asset.
- Succession Planning for management and/or employee buyout.
- Reducing business cash outflows.
- Maximizing capital investment creating more jobs.
- Sharing Surplus Value with employees.
This is best achieved by ongoing employee training and development projects and by linking through long Term Incentives (LTI’s) employees to the company by utilizing the right kind of remuneration and related equity programs. Research shows that there is a direct link between Employer Equity Programs, Human Capital Management, and Companies Financial Performance. International experience demonstrates that LTI Employer Equity Plans assist in the attraction, motivation, and retention of employees.
Long-Term Incentives - What Are They and How Do They Work?
What Is a Long-Term Incentive?
A long-term incentive (LTI) is a vehicle that has an extended time horizon (generally greater than one year) and that can be a strategic compensation vehicle to promote long-term retention and alignment with company goals (Mercer, 2019). LTI can be a win-win for all participants:
- For employers, LTI presents an opportunity to reward the achievement of long-term plans, promoting buy-in to corporate performance.
- For employees, LTI can be a reward for outstanding performance and are a vehicle for capital accumulation.
- For shareholders, LTI is a vehicle that aligns employees with the performance of shares (for market-based equity vehicles) and the long-term vision of the company. When employees become shareholders themselves, they have the incentive to increase company value as the performance of the shares directly affects their compensation.
Long-term incentives are part of an organization's long-term incentive plan (LTIP). A long-term incentive plan (LTIP) is a company policy that rewards employees for reaching specific goals that lead to increased shareholder value. In a typical LTIP, the employee, usually an executive must fulfill various conditions or requirements. In some forms of LTIPs, recipients receive special capped options in addition to stock awards (Investopedia, 2020).
Understanding the Long-Term Incentive Plan (LTIP)
A long-term incentive plan (LTIP), while geared toward employees, is a function of the business itself striving for long-term growth. When objectives in a company's growth plan match those of the company's LTIP, key employees know which performance factors to focus on for improving the business and earning more personal compensation (Investopedia, 2020).
The incentive plan helps retain top talent in a highly competitive work environment as the business continues evolving in predetermined and potentially lucrative directions.
Long-term incentives generally comprise the largest component of executive pay -- typically over 60 percent for the median S&P 500 company (Center on Executive Compensation, 2020). The purpose of the long-term incentive is to reward executives for the achievement of the company’s strategic objectives that will maximize shareholder value. These may be provided in the form of stock-based compensation, such as stock options, restricted stock, performance shares, cash, or stock-settled performance units. Usually, long-term incentives are a mix of types of equity and may include a cash component (Center on Executive Compensation, 2020). The performance period for a long-term incentive typically runs between three and five years, with the executive not receiving any pay from the incentive until the end of the performance period.
Long-term incentive goals vary by company but the most prevalent are focused on total return to shareholders, operational measures such as earnings per share, and return measures, such as return on assets (Center on Executive Compensation, 2020). Like annual incentives, long-term incentives are typically structured to include a targeted level of performance, as well as a stretch component to reward executives for achieving superior performance. According to research long-term incentives are considered an important part of a well-balanced pay plan, as they ensure alignment with the shareholder interest, especially when combined with appropriate stock ownership guidelines.
What Are The Types Of LTI?
LTI can generally be broken down into the following three types:
- Appreciation-based: Value is delivered based on the increase in the company’s underlying value, which in the case of a public company, is reflected in the share price. Per unit, employees will receive the difference between the value of the underlying unit in the future, and the underlying value when the stock options/stock appreciation rights (SARs) were granted (Mercer, 2019).
- Stock-based: Value is delivered in shares of the company stock. The payout may be tied to the achievement of performance goals, but ultimately, employees will receive a share of company stock. Note that some companies may grant “phantom shares.” Which tracks the movement of the value of the underlying shares but the payout in cash (Mercer, 2019).
- Cash-based: Value is delivered in cash and is not tied to the performance of shares; employees will receive a cash payout, based on service, the achievement of predefined performance goals, or both (Mercer, 2019).
Long-Term Incentive Plans
What Are Common LTI Vehicles?
- Stock Options
A stock option entitles the grantee the right to purchase shares of a company at a fixed price (known as the exercise price) in the future. Generally, the option’s exercise price will be the stock’s closing price on the date of the grant (Mercer, 2019). Once a stock option vests, the grantee can exercise the right to purchase stock at the exercise price. For example, if a share is trading at $10, and the exercise price is $5, the grantee can purchase a share at $5 and sell at $10 in the open market, resulting in a $5 profit per unit.
The window of time that a grantee can exercise the option is referred to as the term. Most companies grant options with 10-year terms. An option has no value if in the future the share of the company is below the exercise price (since the grantee would be paying an above-market price, and there would be no impetus to exercise the option). These options are referred to as being “underwater.”
- Stock Appreciation Rights
Stock Appreciation Rights, or SARs, function very similarly to a stock option in that a recipient of a SAR will receive the value of the increase in the stock price in cash (though sometimes it is received in stock). The major distinction between a SAR and a stock option is that a SAR does not require the actual purchase of shares (Mercer, 2019).
- Time-based Restricted Stock/Restricted Stock Units
Time-based restricted stock/units vest based on a predetermined length of time (Mercer, 2019). A company can choose to grant equity-based on a predefined value on the grant date or a predefined number of shares (the former is more popular). Unlike an appreciation-based award, the restricted stock will still have value upon vesting even if the per-stock value decreases.
- Performance Shares/Units
These are also full-value shares; however, the vesting of these types of shares is contingent upon meeting predetermined performance goals. These goals can be internal or external and can be measured on a relative basis (compared to other companies), absolute basis (compared to predefined achievement levels), or both. These have grown in popularity over recent years due to the ease of linking payout to long-term performance (Mercer, 2019). Metrics used by companies differ but are generally consistent within each industry since the metrics that define good performance tend to be similar (Mercer, 2019). One of the most popular metrics is total shareholder return (TSR), which measures the increase in share price over a predefined period (most commonly three years).
Companies will generally grant 100% of shares at a target level and give the shares both downward and upward leverage (meaning shares can vest at less than 100% for poor performance, and shares can vest at greater than 100% for outstanding performance).
- Long-term Cash Units
These are non-equity-based long-term grants that payout in cash. The grantee will receive cash payout after the vesting period (Mercer, 2019).
- Performance Cash Units
These are cash-based long-term grants that vest based on performance achievement. These are more common at private companies, due to the difficulty of share valuation (Mercer, 2019).
What are the Pros and Cons of Different Incentive Strategies?
Image Credit: Mercer LLC 2019
What is Vesting?
LTI is typically granted with what is known as a vesting period. What this means is that grantees are conditionally granted equity, but they do not own it until the vesting period expires. This is the retentive feature of LTI; unless the grantee fulfills the applicable vesting requirement (e.g., staying with the company for three years after grant or meeting a performance goal), they forfeit the grant.
There are two types of vesting: cliff and rateable (Mercer, 2019). Awards that cliff vest are paid out all at once, after a predetermined period. Awards that vest rateably vest a portion at a time (e.g., an award that vests 25% each year for four years). If an employee terminates before the end of the final vesting period, the employee still owns the portion that has vested.
Who Receives LTI?
Commonly, LTI is more prevalent for employees at higher levels of an organization because the value of the company is predominately affected by those with line-of-sight into the long-term strategic vision of the company. Let’s say a company grants performance shares that are contingent on achieving a net income target. Would the CEO be able to influence corporate profitability? Yes (at least we hope so). But an entry-level accountant? Probably not. There is less value in administering performance-based LTI to lower-level positions since these roles do not have the impact that effects that type of change. For this reason, LTI for lower-level employees typically focuses more on retention (Mercer, 2019).
LTI is more prevalent at public companies because of their liquidity and ease of valuation (i.e., a share of a public company is valued by and can be sold on the open market, whereas the value of a share at a private company can differ widely based on valuation methodology).
What are the impediments to LTIPs?
While not necessarily a deal-breaker, the implementation process, including definition and tracking of performance metrics, becomes an important consideration in how the plan operates, and ultimately on how the plan's rewards are perceived by its participants. If the relationship of pay and performance cannot be ascertained, or if the value of the reward is not commensurate with performance, then the impact of the LTIP will be diminished or lost, or the plan could become detrimental.
What are the benefits of LTIPs?
There are several significant advantages inherent in LTIPs:
- Employee retention. Regulations require that LTIPs must contain a "substantial risk of forfeiture." Along with the attainment of performance metrics, the most common requirement is continued employment. Therefore, the LTIP acts as a "golden handcuff," which subjects the participants to the loss of a portion of (or all) accumulated LTIP awards if they voluntarily terminate their employment or are fired "for a cause."
- Focus on desired results. The objective of any incentive plan is the achievement of one or more pre-defined performance goals. Establishing goals upfront allows the participants to look over the horizon and "focus on the target."
- Balance of short and long-term decision-making. A common criticism of incentive programs is that nonowner participants are only concerned with short-term (annual) results. An LTIP allows participants to share in the long-term results, and therefore almost mandates that participants consider the consequences of their short-term decisions on developments over the long term.
- Sharing in the company's growth. A very important concern of many executives is that the work and investment (sweat equity) they make in the company's long-term success will not accrue to them. The LTIP allows them to share in the company’s value proposition by tying their rewards to that success, as though they were owners. This is particularly significant when a privately owned company needs to recruit from the outside for a member on its leadership team.
- ***The long-term incentive component can serve as an attraction tool, especially in a turnaround situation. Conversely, the absence of this pay element may detract from the company's ability to hire well-qualified leaders.
Designing a Long-Term Incentive Plan (LTIP)
Designing an effective long-term incentive plan (LTIP) can be very difficult, as boards must be aware of the potentially high costs that come with an overzealous LTI design. Similarly, boards must be privy to the gains associated with an effective plan, both for shareholders and the executives themselves. Consequently, compensation committees must work diligently to determine multiple factors in an LTI plan. Committees must select the correct metric(s) on which to base performance, the weighting of that metric compared to total performance, set the targets, thresholds, and maximums for each award and lastly measure these goals to appropriate payouts.
Designing an LTIP requires several items. These include:
- Commitment by the owners (including equity shareholders).
- Acceptance of a compensation philosophy covering the what, who, why, and how of compensation.
- A strategic plan or at least an understanding of what is expected in the future.
- A well-thought-out approach.
- The willingness to communicate targets and results in incentive program participants.
Executive Long-Term Incentive Plans: EQUILAR REPORT 2019
The report focuses on the trends associated with these performance awards and how they are implemented through the LTIP design process at companies in both the Equilar 500 and the Equilar 100. Decisions made in the LTI process affect the overall outcome of pay and performance, as well as the award values for executives and the values realized by shareholders.
Relative TSR Continues to Dominate Metric Usage
Despite an emerging trend to tie executive compensation to metrics that underlie relative total shareholder return (TSR), for the most part, companies continued to rely heavily on it as a performance metric in their long-term incentive plans. Approximately 54.7% of Equilar 500 companies included TSR as a metric in their CEO’s long-term incentive plan in 2017, while the second-most commonly used metric, return on capital (ROC), saw usage from 37.1% of companies. While a majority of the most frequently used metrics remained largely stagnant in usage from 2013 to 2017, the percentage of companies implementing relative TSR targets rose by 9.8 percentage points for CEO LTIP awards, 8.8 percentage points for CFO LTIP awards, and 9.6 percentage points for other officers’ awards. At the CFO award level, cash flow has risen slowly in usage over the last five years. While only 11.8% of Equilar 500 companies used this metric in 2013, 14.9% were using it in 2017, a 26.3% increase over the period.
Similarly, the number of Equilar 100 companies using relative TSR in CEO LTIP awards mirrored that of the Equilar 500, with half of the companies doing so. Additionally, there seems to be evidence that compensation committees believe relative TSR functions well in tandem with another metric. 42.5% of Equilar 100 awards to CEOs that used relative TSR as a metric used it as 50% of the total performance weighting. Metric weighting in incentive plan awards varies greatly, depending on a multitude of things—for example, a given company’s current financial standing or the objectives it sets for itself. In 2017, CEO performance awards at companies in the Equilar 100 saw EPS emerge as the metric most likely to stand alone, with 31% of awards using it alone. This is in contrast to 2016 when the most common standalone metric in performance awards to CEOs was relative TSR at 33.3% of all awards using that metric.
Three-Year Performance Periods Reign Supreme
The performance period of choice for LTIP awards in 2017 was three years, and, though it was the most popular throughout every year in the study, the prevalence has increased over each of the last five years. Between 2013 and 2017, the percentage of Equilar 500 companies that used three-year performance periods in their LTIPs increased by 12.9 percentage points among chief executive officers, topping out at 86.9% in 2017. All other performance period usage has dropped over the same period, except for the five-year performance period, where the user has hovered around a mere 2% of Equilar 500 companies.
While one-year awards have remained the second-most prominent choice for performance periods, they have also seen usage decline most significantly of any category. In 2013, approximately one of out every five companies used one- year performance periods. Yet, by 2017, that number was 7.6 percentage points lower among all chief executive officers.
Performance and Payout Ranges Maintain Consistency
Performance equity grants to CEOs have consistently required award recipients to achieve within 10% of metric targets to earn the threshold payout. This was even more so the case in 2017: 32 metrics in Equilar 100 long-term incentive plans specified that CEOs must reach at least 91% to 99% of target performance to achieve only the threshold of the metric. On the flip side, the most common maximum, again specified by 32 metrics, was between 101% and 110% of target performance. Unsurprisingly, maximum payouts associated with Equilar 100 CEO LTIP awards tended to be double that of target performance, as specified for 88 total metrics. A less frequent—though still heavily used—the possibility was a maximum payout being 150% of the target payout, as it was for 38 performance metrics. The most frequent threshold payout was 50% of the target payout, with 74 metrics. However, it was more common for threshold payouts to range from 0 to 49% of target payout, as was the case with 79 performance metrics in 2017.
For 2019, executive long-term incentive plan design will continue to be a challenge for compensation committees. At the very least, companies can remain pressured by activist shareholders, or need strategies in place for the aftermath of the Tax Cut and Jobs Act of 2017. The repercussions of this Act can be far-reaching beyond simply corporate taxation, to potential brand reputation from the increased visibility of CEO pay in proxy statements. What’s more, the increased focus on executive gender pay will most certainly be at the forefront of most companies’ strategies. Notably, the Paycheck Fairness Act is a bill that is a proposed labor law that would require companies to report compensation amounts and promotion activities by gender, geography, and race. While this level of transparency is a welcomed solution to a serious problem, it will certainly have an impact on plan sponsors and plan design.
Executive Long-Term Incentive Plans, an Equilar publication (2019), examines the performance metrics and periods associated with long-term incentive awards granted to CEOs, CFOs, and other NEOs at companies in the Equilar 500. Year one was defined as all companies that filed a proxy statement between January 1, 2018, and December 31, 2018, and previous years were defined similarly. Long-term incentive awards are defined as the summation of all equity awards, as well as any cash awards with a performance period contingent upon metrics that are measured over more than one year. The performance metric return on capital (ROC) includes all of the return on capital, return on invested capital, return on capital employed, return on investment and return on equity, while cash flow includes free cash flows and cash from operations.
Also, the study includes a more in-depth examination of the most recent long-term incentive awards granted to CEOs at Equilar 100 companies—a subset of the Equilar 500. For this analysis, data includes performance metrics, weightings, performance ranges as a percentage of target performance, and as a percentage of target payout.
The narrative portion of the complete publication delves into the trends revolving around the design and specific awards in incentive compensation for c-suite executives. E*TRADE Financial Corporate Services, Inc. added independent color and commentary to provide more detail into the structure of incentives and awards associated with performance.
- Relative TSR continues to be the most prominent long-term incentive plan (LTIP) performance metric among all executive officers. In 2017, 7% of companies utilized it in their equity grants to CEOs, and a total of 54 individual equity awards to Equilar 100 CEOs included relative TSR as a metric.
- Return on capital and earnings per share (EPS) were the second- and third-most common LTIP performance metrics, respectively. A total of 1% of companies used return on capital in LTIP awards granted to CEOs, while 29.7% used EPS in their 2017 equity grants.
- EPS was the most common, standalone performance metric with 31% of usage weighted at 100%, while revenue was most likely to be used in conjunction with other metrics.
- By far, the most prevalent performance thresholds for LTIP awards granted to CEOs were between 90% to 100% of the total award, while the most common maximums for those same awards fell between 100% and 110% of the target.
- Approximately 87% of performance awards granted to named executive officers in 2017 had three-year performance periods.
There are over 100 decisions needed in putting together an effective long-term incentive plan for a private company. The methodology for making these decisions is almost as important as the decisions themselves. These plans bond the individual and the company for the long-term and are based on creating value for both. So long term incentive planning is fundamentally a win-win opportunity but needs to be carefully planned and executed to realize desired LTI benefits.
The appropriateness of an LTI vehicle ultimately varies from company to company. No one LTI vehicle is superior to another, and it typically requires an overall assessment of culture, company strategy, and goals to select the right mix, amounts, and vesting mechanics. Industrial Psychology Consultant (IPC) consultants have experience in every industry and can help you determine the right approach when it comes to utilizing long-term incentives as part of the total rewards package for your employees.
Milton Jack is a Business Consultant at Industrial Psychology Consultants (Pvt) Ltd, a business management and human resources consulting firm.
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