Company boards are increasingly cautious about creating executive compensation plans that stray too far from traditional norms. The growing expectations of shareholder advisory firms — and more recently, large shareholders — as well as the looming potential for a failed say-on-pay vote, are curbing innovation when these plans are developed or updated. With so much at stake, it’s important that boards are confident that innovative compensation approaches are right for their organizations. This is particularly true for long-term incentive plans (LTIPs). Institutional Shareholder Services (ISS) and Glass Lewis & Co. LLC both exert influence over say-on pay and other corporate governance issues, and institutional shareholders, including BlackRock and State Street Global Advisors (SSGA), are advocating for environmental, social and governance (ESG) criteria. ESG is an effective way to measure the strides management is making to advance human capital management (HCM) issues such as gender pay equity and inclusion and diversity policies.
There’s Room for Flexibility
Organizations that are creating or reviewing LTIPs need to be confident enough to explore plan features that are flexible, innovative and satisfy a number of objectives including the achievement of long-term performance goals and strategies, as well as retention and pay competitiveness. This creative step can exemplify and enhance the great strides in executive compensation principles developed over the past decade. Effectively aligning pay and performance may include the use of nontraditional performance if a business struggles to execute strategy. Key strategic milestones may be a core performance outcome that not only aligns incentives with a company’s strategy, but also resolves an important operational issue. However, there is a caveat. As companies face mounting pressures to increase disclosure, and employees pay more attention to the mix and design of incentives, being different may also require more resolve.
Clear Expectations are Needed
As board compensation committees seek to ensure that compensation designs are appropriate and defensible, there is an increasing tendency to interpret common practice as expected practice. Recently, for example, ISS clarified that it uses relative total shareholder return (RTSR) when it assesses compensation programs, but doesn’t require that the measure be incorporated in plan design. Similar misunderstandings may exist over the use of discretion in performance assessment.
Compensation committees also need to understand that institutional investors’ growing interest in ESG and HCM can align with their organization’s strategy and profitability goals, and that these practices may be best measured and rewarded in LTIPs. For example, the limited year-over-year change of some ESG measures, such as emissions reductions and community relations, might make them better suited as an LTIP metric. In fact, BlackRock has expressed support for compensation that promotes a long-term focus.
Rise to the Challenge
The special circumstances of an industry can create variations in plan design, but common design challenges that affect all LTIPs leave boards to:
- Cope with RTSR’s volatility;
- Reward management for strategic change;
- Align realized compensation with realized performance; and
- Establish long-term goals in highly volatile industries.
These challenges require solutions that fall outside of mainstream practices, while also balancing fair and reasonable compensation with long-term value creation.
Cope With RTSR’s Volatility
RTSR is a pretty straightforward theory, but in practice there are pitfalls. Peers are often difficult to select, and the way they are selected can vary. For instance, a Willis Towers Watson survey of clients found that 52.3% chose peer indexes and 47.7% use custom peer selection. And the largest share (47.7%) of those surveyed had between 10 and 25 peers, but there was a range of between 1 and 500 or more, as the figure above illustrates. Those surveyed (16.6%) that used peer companies with a main listing outside of the United States faced issues about how to measure TSR.
Additionally, results can be highly volatile, particularly when the sample size is small, and relative performance can generate significant awards even when absolute performance is poor. Relative performance does matter, but some organizations would argue that RTSR places too much emphasis on the context of performance and not enough on the absolute result. Even so, RTSR might account for as much as 50% of LTIPs’ total rewards. We also found that slightly less than 10% of participants in our survey use TSR as a modifier for vesting.
RTSR’s inherent volatility was reduced when used as a modifier rather than an independent weighted performance measure. Achievement of predetermined performance objectives that determined the base LTIP reward were then modified by RTSR of +/- 20% of the basic award. Limiting RTSR’s impact focused management on the business’ meaningful absolute results while also acknowledging the relevance of relative performance.
Reward Management for Strategic Change
Long-term incentives typically focus on financial performance measures, but for businesses that are going through significant transformation, key milestone objectives essential to long-term profitability may determine success. Often these strategic goals are shared by the leadership team and are achieved over a number of years.
Introduce key strategic milestone achievements into the long-term incentive (LTI) design. Key milestone objectives that advance an organization’s strategy ensure that the entire leadership team shares accountability for success. Depending on the objective, there are different ways to measure these milestones including pass/fail, quantitative goals and qualitative judgment informed by the underlying transformation plan. Discretion should be used when it helps identify the best way to assess performance without diminishing clear expectations that drive the transformation. Quantitative measurement is a valuable tool to assess performance but may not be the most meaningful approach in all cases.
The absence of key strategic measures means that the drivers of strategic change are secondary to the outcomes that success brings. Performance is the ultimate goal, so the outcomes of transformation need to be included in plan design to align pay with achievement.
Align Realized Compensation with Realized Performance
Typically, stock options are granted at the expected value of the grant, and generally at the Black-Scholes value (BSV), which accounts for price variation over time. Often this value differs from a board’s expectations for share price growth. This may be particularly true for companies implementing new strategies with an expected share value growth not reflected in the BSV. Therefore, a typical option grant can result in a realized award to the executive that differs significantly from the expected performance of the company.
Instead of granting the targeted compensation value based on the stock’s BSV, reverse-engineer the grant. First, determine the appropriate realized compensation for an expected outcome. For example, if the business strategy is to create a $5 increase in the share price over the next five years, then the expected realized compensation would be divided by the $5 expected gain to determine the number of options granted. Using this approach, the realized compensation is fully aligned with expected performance. This nontraditional approach may not be suited to ongoing annual option grants, but it can work well when options are part of a periodic (LTI) mix.
We would also suggest that traditional time-based annual and shorter-term vesting distracts companies from the long-term focus of traditional option grants. This long-term horizon can be restored by extending the term and moving to either a cliff vest or a fixed period before vesting begins. Gains on options are no longer a random windfall, but rather a targeted award for achieving expected results.
Establish LongTerm Goals in Highly Volatile Industries
Performance share units (PSU) — restricted stock awards granted in units that represent shares — and performance cash plans often measure financial results as a three-year average or endpoint goals. But for highly volatile industries, a three-year goal can become unattainable because of one bad year or because business circumstances make it difficult to predict three-year outcomes.
When missed targets are the result of unpredictable markets or other unforeseen circumstances, it’s in shareholders’ interests to keep management incentivized to drive growth through the balance of the performance cycle. A “these are the breaks, you missed target” approach will probably not advance your strategy or produce the desired results if the performance setting challenge is market based rather than just poor performance.
Change the performance measurement to focus on the consistent achievement of the annual goals that drive the three-year outcomes. There are a number of ways to do this, but the objective is to give management the opportunity to be in the money for meeting the annual goals that form the basis of the three-year plan.
For example, the final three-year award might be based on the achievement of the three-year end point goal and on the achievement of the three annual objectives of that plan, each weighted equally. So if the goal was to grow earnings per share (EPS) by 3% per year and that target was only achieved in two of the three years of the three year plan, there is still an opportunity for a partial award. However, a full award is only possible if the three-year EPS end point is achieved.
Some may argue that this is shifting the focus of the incentive to the short term, when it really places a premium on the discipline for setting the three-year goals. Management is held accountable not only for the ultimate achievement, but also for the plan to get there. Most importantly, it encourages management to continue to drive performance improvement even when the three year goal seems unattainable.
A New Perspective
The four innovations just described are examples of the type of change we’re seeing more and more. There are many more that encourage real share ownership, address the unpredictability of longer-term performance, enhance retention and balance risk and reward.
New incentive plan features will continue to surface and existing plans will evolve as shareholder expectations for executive performance expand beyond the purely financial to include ESG and other approaches to sustainable, long-term growth.
Ultimately, the way we view compensation needs to change. The full compensation mix needs to be viewed as a portfolio of awards that identifies both the right performance outcomes and time horizons. Currently, long-term is identified as a three-year period, and given market circumstances, perhaps it is. But different needs and goals may warrant consideration of different incentives and longer time horizons.
Market perceptions and best practices offered as guidance by advisory firms and institutional investors can provide value to organizations that are developing or reviewing executive compensation plans. But these observations should be used to inform — and not prescribe — plan features. And what’s right for your peers may not be right for your organization’s sustainable success. Your company’s unique long-term strategy and goals need to frame your executive compensation plan. The right incentives help rally management to achieve targets, not fall in line with traditional norms.
Michael Thompson is a senior director in Willis Towers Watson’s Executive Compensation practice in Toronto.