Webinar: Tue, 2/23 10:38AM • 1:05:25
Michael Sherry, Managing Director, Steven Hall & Partners
Sandra Pace, Managing Directors, Steven Hall & Partners
Leslie O’Connell, Decusoft
Thank you very much, Leslie. First off, we would like to thank all the attendees. We know everyone’s busy. We appreciate you taking the time to listen to us talk about long-term incentives. We’d like to thank Leslie very much and the whole team at Decusoft. You’ve been a great partner to us, and we really appreciate the opportunity to do the webinar series with you. As Leslie mentioned, this is part two of the series a couple of our colleagues presented last month about annual incentives. This session will focus on long-term incentives and the plans, vehicles, some associated changes, some external constituents and outside policies, design considerations, and certainly, pitfalls to look for.
We also have a study we did recently of the top 200 companies in the US, and we’re going to be integrating data from the study throughout the presentation.
I’m going to hand the ball off to my colleague here, Sandra. Sandra and I together have over 40 years of experience advising public and private companies in the exec comp space. And as Leslie mentioned, also related to governance, director compensation. Sandra and I’ve worked together for 17 years. So, without further ado, here’s Sandra to kick us off and to look at some design considerations and talk about plans, in general.
Thank you, Michael. And thank you again to Leslie and Decusoft for hosting this webinar. And I hate when you mentioned the 40 years, Mike, because it makes me feel so very, very old. But anyway, onwards.
So, just moving on to this first slide here. For those of you that tuned into the annual incentive webinar, this slide might look or sound familiar to you. And really, whenever you’re considering designing a new incentive plan or changing an already existing incentive plan, there are a couple of design considerations you want to think about. Whenever you’re looking at your incentive program, whether it’s annual or long-term, you want to make sure you know what your business plan and strategy is. And that should really be how any design changes begin. Knowing what’s important and knowing what performance metrics are going to be driving those particular goals and behaviors. You want to make sure that you have pay opportunities that are aligned correctly with responsible performance. And hopefully by doing that you’re mitigating risk as well.
Making sure you have a balanced approach to delivering compensation is also important. Whether that be short or long-term, cash versus equity, the types of vehicles that you might be using, etc. These are all important design considerations. And I often make this kind of comparison that I think of this as the
body, right? So, the incentive program is the head and you’ve got the middle there, that’s really the heart and if the heart is healthy, then it makes everything else work well. All the other pieces are kind of the arms and the legs. You want to make sure you’re operating from a position of strength, and that should be your focus.
Just moving over to the left side of the page, the internal environment. When you’re thinking about a long-term incentive program, consider what vehicles will attract, motivate and retain executives. What can you use so that they will drive corporate performance and achieve the strategic objectives that are important to the organization? Both by delivering wealth, but also creating value for shareholders and other stakeholders and investors.
The external environment plays an important role as well, because those folks continue to influence executive compensation. When we think about the media, they’re always focused on executive pay and perceived pay issues or disparities. So, we want to know, what’s going to tick them off or make people angry. It’s important to consider that. While it shouldn’t drive how you establish a program, it should definitely be a consideration.
And then, of course, the government played an important role with the regulations that it’s put into place in the past couple of years. An example is Say on Pay or regulations that have been proposed, and may or may not come about, like pay for performance rules, etc. It’s important to know what’s happening there and to keep that in mind.
Also, in terms of your competitors and other companies, what are they doing? We see this move towards refining equity plans, so that they’re more focused on pay for performance. Because that’s what shareholders and other investors want to be focused on. Knowing what your competitors do is an important consideration. And sometimes knowledge is power. So, it’s important to keep that in mind.
External environment is key. And it’s becoming even more important as we go on. Like Sandra mentioned, the media is such a big player these days. If someone gives you a call in the morning and says, your comp program is on the cover of the journal, it’s probably not going to be a great day for you. They don’t usually have cover stories that say how great your pay programs are.
Absolutely. And it takes a strong backbone when something like that happens because you don’t want to let the tail wag the dog. You need to consider those types of potential issues when it comes to what you’re disclosing in your pay program, and what your numbers are in terms of your executive pay. You’re going to keep in mind directors are going to care what other people think. So, what we’re talking about today are long-term incentives. And you’ll hear us talk about it abbreviated and say, LTI and LTIPs. Long-term incentives are rewards that are earned and paid based upon achievement of goals over a longer period of time or a period exceeding one year. And those goals might be based on either stock price or business performance.
Full-value awards are awards that vest based on time, and the employee needs to stay with the company over a period of time. That works to retain those executives over a period of time. So, they have different purposes and objectives. For the most part, today, we’re talking about equity-based awards. This is the most typical type of long-term award in a public company. But there are a small number of firms that use cash, as well. You see on the right there, there are different purposes, different objectives that LTI can achieve. We talked a little bit about creating wealth and making sure that executive and shareholder interests are aligned properly, and an opportunity to provide compensation that’s based on performance, and hopefully provide competitive pay opportunities. So again, focus participants on critical performance criteria and align shareholder interest.
Why is it important? So, on this page, hopefully this illustrates why long-term incentives are an important part of the whole compensation package. We did a study on the top 200 US public companies. When we look at CEO pay, we see them set the mix is predominantly paid in long-term incentives. 62% of CEO executive pay is in long-term incentives. These are base salary at 16% and annual incentives at 22%. And of course, given the relative size of long-term incentives, it’s only natural that there’ll be increased scrutiny on this particular component.
So, let’s take a look at the different types of long-term incentive vehicles. As we look at this page, we’ve got it kind of bucketed into three different areas: we look at appreciation vehicles, and I’m sure you all know stock options and stock appreciation rights. Mike’s going to go into a little bit more detail later on in the presentation about some of the pros and cons.
Stock appreciation rights, or SARS, are the right to receive shares of stock where the value received is based on the appreciation or rise in the stock price. So, if the stock price does not rise, there’s no value, you get zero.
When we talk about time vested full-value vehicles, it’s the right to receive shares of stock where the value received is based on the stock price on the date the stock vests. These vehicles are always perceived as having value unless the stock price is zero. And then there’s no value.
Performance-vested options are similar to full-value awards, but instead of realizing the value after a certain time period, such as the time vested full-value vehicles, the value is realized when certain performance criteria are met. Typically, you’ll see those called performance shares or performance share units.
In this particular study, among the top 200 companies that we looked at, about 54% of companies do stock options and 48% use service-based restricted stock. So, it’s split in half there, in many respects, in terms of what people are doing. And before I go into a little bit more detail here and talk about that kind of move towards performance-based stock, we do have a poll for people to participate in. And the question is, Mike, if you want to put that poll out there, how many vehicles are used in your company’s long-term incentive plan? And the potential answer is one, two, or three or more. So how many vehicles do you use in your long-term incentive program? I hope that you will participate in the poll.
We will give everybody a second to answer. And I think, over time, what we’ve seen here is a huge focus on growth and performance-based LTI awards. While trends for the other vehicles such as stock options are trending down, I think the data suggests that they are not completely gone. You can see that one or two companies are basically using options. But the trend of using options over the last 5 to 10 years has been down and service-based restricted stock has been increasing over time.
We’re seeing a lot of that movement because of the focus on performance-based pay by investors, shareholders, and advisory firms as well. And the fact that stock options and restricted stock are not viewed as performance-based by many of the advisory services firms.
So, let’s close the poll. So, it looks pretty widespread. Thank you very much for participating. It looks like 41% of participants out there have one long-term vehicle, 35% have two and 24% have three. Very interesting, pretty varied responses. You have good distribution there. So now let’s see how that stacks up versus our top 200 study. So, it looks like one, two, and three were descending.
When we looked at this particular study, we see that most companies use a portfolio approach to granting LTI. The predominant number, 55%, use two vehicles. And then it’s pretty even between one vehicle and three-plus vehicles. Our poll indicated that most people use one vehicle, but two vehicles with a close second. We’re not surprised by that.
I think when you go up in company size, and these are the top 200 companies in America, you’re going to see a certain complexity in the programs. A higher number of vehicles, etc., so not surprising to have these results at all.
Then towards the bottom of the page, you’ll see that performance-based long term represents the largest award type, in terms of what the LTI value mixes. Which again is not surprising, and just in terms of that same movement and that same growth on one of these stocks. As many of you know, if you have had an issue or a low Say on Pay vote results, one of the quick changes or quick things to look at is, are you using announcements, performance-based pay? That is something that companies will quickly make a change on and incorporate some type of performance-based pay into their long-term program.
Absolutely, and we’re going to touch on that a little bit later, too. But I think that 62% should not be surprising. There sort of is a 50% threshold a lot of times, and that’s been due to pressure from shareholder advisor groups and other, sort of that external environment that Sandra referenced on the first slide today. But we’ll get into that a little bit more later.
Mike, you’re going to take us through the next couple of slides.
Okay, so now we’re going to look at the LTI approaches. As Sandra mentioned, the dominant approach, at least in the top 200 was two vehicles. You can see that in the center, it was 55% total. But when we break down the data, you can see that it breaks out that the majority grant options in LTIP, at least of this subset, and then 23% grant restricted stock and LTIP. And there’s a small contingent that grant options and restricted stock. And looking at the other groups, the most common approach here seems to be options at some performance-based awards. But if you look to the right using three vehicles, of all three, restricted stock, options, and performance-based awards, is pretty closely tied to second along with restricted stock and LTIP. Here, we trisected the chart and put lines in to show the one-vehicle section, two-vehicle section, the three-vehicle section. And then we made the bars red that are the most dominant practice within each subset of the data. So, what the great takeaway here is, if you look at each red bar, what’s included: performance-based LTI. Sandra had the number before that 93% of companies grant performance-based LTI. It’s nearly universal. This just reinforces it because no matter what portfolio approach companies are taking, performance-based LTI is the one commonality in all three. So that’s really the takeaway here.
Now I’m going to walk through each individual vehicle, quickly define them, talk about them a little bit, and then go into the pros and cons of each one. First is stock options. And this is also stock SARS, which we’ll get into in a second. These are often called appreciation vehicles. So, these are appreciation vehicles versus time-vested restricted stock and performance-based awards. Those are often deemed full-value awards. And we’ll get into the difference, as we go along. As Sandra mentioned, an option is the right to purchase shares of company stock at a specified price over a specified period of time. That’s why it’s called an appreciation vehicle. So, if your stock is at $10, you grant someone an option, then five years later at that $20, then they have the right to exercise this option and kind of go back in time to when it was $10, buy the stock then, and they could exercise in the market today at $20. So, they would profit in that appreciation from 10 to $20, for a value of $10 per option. But just that appreciation, they don’t get anything below the strike price as deemed as the price at which you grant the option. They only get the appreciation above that point.
Okay, so that leads right into the pros, wiser alignment with shareholders, because to have any value, you have to make the stock price go up. If the stock stays flat, or decreases over time, these are worthless. So, there’s pretty easy alignment with shareholders, because shareholders like most of all, the stock price going up.
Another pro is they’re very easy to communicate. The example I just laid out, you tell everybody on your team, you know that we’re at $10, anything above $10, we’re all going to share it together. Let’s focus on 10 and getting the stock up from 10. It’s a very easy thing. It’s sort of easy to rally the troops around, and you can put a number on the board. Say, let’s get to 20 in seven years, or something like that. It just gets everybody excited and just drives towards that. It’s very easy for them to see the difference in value from 10 to 20 and understand how they’re going to share in that.
Another pro is leverage. So, there’s something called a Black Scholes percentage, and when people are granted options, you would take that $10 strike price, but then it would have a Black Scholes percentage applied to it. A rough kind of back of the napkin calculation is one-third of the stock price. So, on $10 as a strike price, the option is worth about three and a third dollars. Which means, to give someone $10 worth of LTI, you’re going to have to give them three options. And that’s where the leverage comes into play. So, for every dollar the stock price increases, they’re getting $3 because they got three options instead of one full-value share.
Another thing is that for accounting, it’s a fixed expense. Often, with other vehicles it can vary. Specifically, performance-based LTI because you have to account for the difference in earnings. You can earn above target, you can earn below target, and you have to account for what really happens.
Now the cons, because there are some cons with each vehicle. Options are not viewed as performance-based by many people. The big one here is ISS. Unfortunately, you won’t see any incentive series or compensation speech without mentioning ISS or Glass Lewis. ISS stands for institutional shareholder services. And for people that don’t know, if your company has institutional shareholders, like a BlackRock or J. P. Morgan, or TA, often they don’t necessarily have all the research capabilities and time to look into, individually, your company’s programs and policies. So, they subscribe to a service called ISS. And ISS issues a report on your company that basically advises them how they would vote based on your program. So, if you do something ISS doesn’t like, they might recommend voting against you on Say on Pay and things like that. So, they do have a lot of weight in the community and exec comp world. It’s important to know their policies and their methodology. Often, we have clients that say that they don’t listen to ISS or don’t really care about it. But when ISS issues a negative vote recommendation on them, then they want to talk about it. So, it is important to keep in mind.
Another con of options is they’re not tied exclusively to company financial performance. You might ask: Why is that? I thought stock prices equated with financial performance. A lot of people have used stock price and TSR and things of that nature as an outcome, as a result. And there’s usually something behind that. It’s a stock market-based metric. It’s not a financial operational metric, like a cash flow, like an EPS growth, like EBITDA, return on investment, return on assets, etc. So, it’s not explicitly tied to company performance. It’s tied to how shareholders view your performance.
Another thing is dilution. As I mentioned before, with leverage, you have to grant three options to someone to get them the compensation value of one full share, but you have to account for that stock. Most people have a pool they grant LTI from and three shares is going to count more than one share. So, dilution is increased, but through the use of options. Now, of course, there are SARS which can be settled in cash or stock. If you settle SARS in stock, it’s a way to minimize the dilution because basically, you’re using a full share of stock to settle the spread. It’s an advanced concept to some degree. I don’t think we need to go into too much, but just know via dilution, it can be managed somewhat via stock-settled SARS.
It’s a fixed expense, which is a pro, but the con is the expense is recognized even if the option expires worthless. Ever since the accounting standards of FAS 123 came out, you’re required to account for options. Before they were basically a free grant, you didn’t have to account for them on your income statement. So, companies are counting the expenses, the Black Scholes value, and that is not reversible. So, you take it, that grant, you usually spread it over the vesting period. But if the options end up worthless, you’re expensing for something that really didn’t deliver any value to your executives or your company in any way. It’s a con.
Now in terms of what options look like in the market out there for top 200 companies, first we’re going to look at the term schedule. How long do people have to exercise the option? You can see here, there’s a pretty dominant practice 10 years is sort of the standard, 92% of the top 200 companies do it. Over time, you can see that there’s 5%, that is the light gray on the chart; that’s seven years. Over time, companies have been cutting down the term of options. This helps manage the expense. The lower the term, the less time people have the exercise, the less the value is, the less the option is deemed to be worth, at least by accounting standards and via the Black Scholes formula. So, over time, we expect this to even increase more with companies to be using seven-year terms.
In terms of vesting, just a quick step back, there are two types of vesting you’ll see out there. A one-step or incremental will vest in tranches or equal slices. It doesn’t even have to be equal slices, just in bits. The other is a cliff. You think about it like you’re walking along, you fall off a cliff. It’s the same standard with vesting, it’s where after X number of years, it vests 100%, it falls off a cliff. You can see dominant practice here, 90% of companies are using step vesting, and in terms of the number of years, they’re doing this vesting schedule over three years. None under three. So, it’s usually three or more. You can see four is pretty big. 89% of companies are using three or four years. A couple higher than that.
I think for a while there, we were seeing quite a few companies at the four-year timeframe, but three years has been dominant for several years.
If anyone ever asked the best thing for options, or restricted stock, three to four is always what we recommend. Now, time vested restricted stock. So, it’s the grant of shares, the promise to grant shares in the case of RSU and is contingent on meeting the requisite service period. As I mentioned before, options are an appreciation vehicle. This is where we get into our first of two full-value vehicles. It’s called full-value because like the option before, you’re only entitled to the appreciation in it. With a full -value share, you get a share of stock in the company. Now in this case, you have to wait a couple of years, usually that’s the vesting period, that’s the service period, but you do get a full share. So before with my $10 example, you only had the right and the option to get above $10. If you got a $10 share of restricted stock, if the company stock stays at $10, you still get $10. That’s sort of what we call downside protection. The option, if it goes below $10, is worthless. Restricted stock still has value. It’s why this is a very popular vehicle with executives and companies. It provides some downside protection and provides real value. With options you have to perform and raise the stock price. Restricted stock will have a value.
That leads right into the pros, as I mentioned, strong retention value, popular with employees; it’s very popular because you don’t have to increase the stock price. Options are not guaranteed to be worth anything. Restricted stock, unless the stock goes to zero, is guaranteed to be worth something and people will stick around for it. If you grant someone a couple $100,000 in restricted stock with a vesting period, they’re going to stick around for that value, probably. And then they don’t feel that it’s at risk too much. It absolutely could fluctuate with that in value, but not truly at risk. Very aligned with shareholders, like I just said, it’s a full-value share of the company stock. It’s basically making you a shareholder in the company. It’s less diluted than options. As I mentioned before, you needed three options with a third Black Scholes to equate to one full-value share. Well, this is the full-value share now. So now, you’re granting one share of stock to someone instead of three options. You can see how it will have a less dilutive effect over time. Also, it’s another vehicle that’s very easy to communicate, probably the easiest.
Even relatively speaking, when you talk about options, that’s more difficult when you’re looking at restricted stock.
Absolutely, the value can fluctuate, but it’s almost seen as cash. I’m giving you 100 shares of stock, that’s $10 today, that’s $1,000 worth of restricted stock. And if it goes up, the value goes up with you, if it goes down, it goes down. But it’s very easy to understand. And it gets people into the stock price, it’s a good vehicle to use. It’s a fixed expense. There are no performance conditions. So, the earn out will not be variable. So, it’s a fixed expense. What are the cons? So, it’s viewed negatively as “pay for pulse.” Which means, that if you are alive in a couple of years and still working at the company, you receive the stock. And obviously, shareholder advisory groups, ISS shareholders, institutional investors, they like to see performance conditions on things. They don’t enjoy seeing people get stuff just for being alive, basically, a few years down the road. That’s the second con. It’s not tied explicitly to company financial performance. Again, it does have a hook into the stock price, but not company financial performance. The other con is that you’re not leveraged as you are with options and it ties into the whole dilution, the number of shares you get, etc. You only have one share here.
So now, moving into the vesting, just like we looked at with options, but now there’s no term here. With restricted stock, you own a share, when it’s yours, you could hold it for life, if you want it. Options, you have an explicit set of time to exercise it. Here the vesting is very similar to what we saw with options. Three years is the dominant practice. 68% of top 200 companies use three years. 30% use four or five. So, basically, 90% do three or four-year vesting. Three or four-year vesting periods for options or restricted stock is the way to go. Not as dominant with options, but step vesting is still the preferred way and the most dominant practice of top 200 companies. Before it was 10% with vesting for options, but here it’s 27%. A much bigger contingent does do cliff vesting. It probably speaks somewhat to the ability you need to exercise an option and have some choice in when you’re exercising it. Sort of that “pay for pulse,” just being alive and still at the company.
When you think about restricted stock, often people are really thinking about it in terms of retention, more so than any other vehicle. So, you will see cliff vesting more often.
Exactly. And that’s why restricted stock often is used as a retention vehicle. You make people wait around for 100% of the value you just granted them.
We’ll move on to performance-based LTI. PSUs are performance share units. Which is when you’re granting someone the right to receive shares in the future, but their share is contingent upon achieving associated performance goals and meeting the requisite service period. It’s like time vested restricted stock almost exactly, but there’s a pretty big caveat. There is a performance condition. It has to be something related to company performance.
The pros: strong focus on performance, well-liked by shareholders, very popular with advisory firms. You think back to Sandra’s first slide, all those external constituents, media, shareholders, ISS, Glass Lewis, investors, they all want you to be performance-based. They all want you using performance-based LTI. If it was 100% performance-based LTI, they would applaud it.
The other thing: it’s a fixed expense, but may be subject to reversal, if performance goals are not met. The one thing about performance-based awards, you can basically track it quarterly with your accounting expense. You can sort of check-in on how people are doing. If you have a revenue goal of 10%, let’s say revenue didn’t grow at all the first year, you might adjust. You might have been assuming that they’re going to be earned at target. Now we’re assuming that it’s not going to be earned at target and start adjusting down the expense you’re taking. There’s a very big caveat, which is one of the cons.
They might be less dilutive than options. It can be more so because of the performance conditions and the possible earn-out. Usually, we’ll get to what payout percentages are, but it can be 200% of target, and it can end up that you are granting a lot more shares than you were expecting at target.
Some of the cons: one big challenge companies face is in setting performance criteria. Such as peer groups and setting goals. These are two of the biggest challenges we always hear. That is the big difficulty with performance-based awards. It’s great to have a performance condition, but what is that performance condition, even when you choose the right metric? What’s the goal? What’s the right absolute or relative level?
That leads right into the next con, because poor goal setting or low earnouts overtime, where people aren’t earning the performance-based awards, can lead to a program that is a disincentive to people. You want it to be an incentive, you want it to be powerful, but if people are getting performance-based LTI that they don’t think they’re going to earn overtime, it ends up having the opposite effect where they just don’t believe in it.
The other thing is to deny the reversal expense. The con there is that for market-based awards, which are basically TSR stock price metrics, you cannot reverse the award condition. It’s kind of a confusing part of the accounting, it tends to be built into the grant value when you grant a date, the accounting expense. If you’re using TSR stock price, that cannot be reversed. Other metrics like cash flow, revenue, net income, those expenses can be reversed based on the potential earn outs or what is expected.
Moving on, so performance period, okay, you set a goal, but how are you going to measure that goal? What period of time are you going to measure it over? As Sandra mentioned, in the first slide, long term incentives are goal periods of one year or longer. You can see, dominant practice here is three years. It’s the most common goal used by top 200 companies or any company out there. There’s a good chance it’s going to be a three-year performance period. There is some variance. There are some companies using two-year goals, four-year goals, etc. Sometimes companies put additional vesting on the shares you earn from a performance-based award. It’s not dominant practice, if you add up the bars on the right, it’s 11% total. So maybe one in 10 companies of top 200 companies use it. You can see that the most prevalent practice is two years, of which 5% is using it. Often, this is coupled with a performance period that is shorter than three years. So, if you’re going to go with a two-year or possibly a one-year performance period, which you shouldn’t, which we’ll get into, you tend to still want the retentive hook on people. So, you put a two-year additional vesting period on it.
So now, Payout Type. The most common payout type is stock, as you can see 83%, that giant red slice, and most performance-based awards result in stock payouts. There is a small contingent, that 10% slice in the upper left, that is cash. It is not something that companies, outside constituents love to see, but it is done. Often, you’ll see this coupled in a very developed or sophisticated compensation program. Let’s say you’re granting very large slugs of options and restricted stock already to executives, so you may feel they have enough equity. So maybe you have another performance-based LTIP and then you say you know what, we’re going to let this settle in cash. Let people diversify out a little bit or maybe even pay some of the taxes on other equity, etc. It’s not something you usually see, if performance-based LTI is the only vehicle.
Here are some quick stats on what the threshold of maximum payouts are; you can see, this is a percentage of target. Say you grant somebody a target number of shares, but then they have the possibility to bury that amount based on company or individual performance. So, you can see there, the median is 50% for threshold performance, that means anything below. So, when you set a goal, you have a target. You have a max and you have a threshold. Anything below the threshold, you don’t earn anything. So, for threshold performance, you’re usually earning half the target or 50%. And for maximum performance, you’re earning two times a target or 200%. Now, there is some variance in there. And that’s why we put in some average bars. There are companies that use a 25% threshold, there are companies that use 150% maximum, including some numbers in between. When you look at the average, it’s useful in this case, because you can see that there are some numbers lower than the median in this data set.
Okay, so let’s move on to performance metrics, which is really an important part of this whole discussion when we’re talking about performance-based awards. And often, the most difficult part of the design process is determining what performance metrics are the right metrics to motivate executives to drive corporate and shareholder value. Performance measures should be aligned with business strategy. They should reflect the key drivers of corporate value and shareholder value. You want to make sure that you create a clear line of sight for employees, as well. Because if they don’t feel like they can control some piece of it, employees might lose interest. It might not motivate them to drive company performance. The type of metrics that you’d use plays a role in whether the goal is expressed as an absolute metric or a relative metric.
When we talk about absolute metrics, we’re really talking about the performance of the company itself, versus plan, or budget, or prior year performance. It’s not compared to some other group, or anything like that. And that’s really dependent on the ability to predict future performance of the company. Most companies use a three-year performance period. Often, that’s as far out as many companies can project out in terms of their future performance. That’s why that performance period is not greater than that. These absolute metrics are not always viewed positively by shareholders, because they want to get a sense of how you perform relative to your peers.
That brings us into relative metrics. Relative metrics are based on performance of the company against some external group or index. When we talk about groups, sometimes those groups can be your competitors, sometimes they can be your client base, sometimes it can be a combination of both of those companies, or it can be against some index, like the S&P 500, or some industry index, that’s more relevant to your organization. Relative metrics are helpful because they can serve as plugs when absolute performance is difficult to predict. So again, going back to the absolute metrics, sometimes you just don’t have a good sense of where the company might be heading in a three-year timeframe. And so, you are kind of hedging your bets, in many respects, with relative metrics.
A lot of people call them set it and forget it type metrics, because it takes all the difficulty out of goal setting. Now the difficulty is selecting the group of companies you’re going to measure yourself against. But once you do that, it’s pretty easy to say median performance is going to get your target, and then you just move on. You don’t have to worry about what that median performance is, what that magic number is that you’re going to put into the plan that everybody’s going to key on.
Right. The most common relative metric that we talk about is relative TSR. One of the cons is there’s a possibility of payouts for negative or poor performance that is merely less poor than some of the comparators. And an example that we often talk about is if you are using relative TSR. TSR is total shareholder return or stock price. But if you are using relative TSR, and your TSR is negative 10, but everyone else is at a negative 20, you, of course, performed better. That’s not a bad thing. That’s a good thing. But sometimes there’s a negative reaction to these negative pay at these negative results, and then you get payouts on those negative results.
Think about a stock market that is in a downturn, and you happen to be first against an index or comparator group, and your plan is paying out at 200% at target in a market that is very down, and people are upset about, and your performance was not good, but less poor than others. It can be tricky, and we will get into how some companies are dealing with that.
Some companies have incorporated some type of a gatekeeper where there may be no payout below an established target amount or below the median of a group. And that’s one of the ways to get around something like that.
In this study, we saw that one or two performance metrics is the most common. Most companies use one or two performance metrics in their LPI plan. And that differs from annual incentive plans, because three performance metrics, or three or more, in some cases, is more common when you’re looking at annual incentive programs. Again, I think it ties back to the difficulty in projecting out longer than one year for many of those metrics.
Companies have enough time figuring out the three-year goal for any metric, so then they figure out one and they say: I got to do it for two more? Get out of here.
What are the types of performance metrics that are most prevalent? The two most popular are, as you can see on the slide here, earnings metrics, and total shareholder return our stock price metrics. That’s followed by financial returns. And you see that 59% use an earnings metric in their LTI plan. 55% use TSR. Followed by a not too distant 46% in financial returns. And in terms of weightings earnings, TSR, and financial returns are also the most highly weighted in long-term performance plans. They’re weighted 50% in those cases, and that’s a median metric weighting. Those are the most prevalent.
You can see that there’s three big players here in terms of long-term metrics: profit earnings, which uncovers a whole myriad of metrics, EPS, net income, EBITDA, there’s even more. Then TSR stock price and returns, your return on investment, return on assets, return on equity, and many more. And then if you think back to most people using one or two metrics, that should then make sense when you go down to the bottom, and see these medium weightings of 50%. If you ask me to interpret how a company is using these together; they’re probably using two of the three most popular sets of metrics up top in a 50/50 type scenario. That seems to be a very common approach as the data indicates.
Let’s talk about relative TSR. It is one of the most prevalent performance metrics used among LTI programs. It is useful to use when absolute performance is difficult to predict. It is viewed favorably by shareholders and shareholder advisory firms, in general. In fact, in terms of relative metrics, that’s often what all these shareholder advisory firms really want to see. I don’t think they really care what percentage you use on relative TSR, or how much you weight relative TSR. They do want to see some type of relative TSR metric applied to your LTI program.
The con is that it’s really difficult for management to get comfortable with this type of performance metric, because they feel like it’s not directly within their control. There might be other economic and industry factors at play that influence the stock price, and therefore, in no fault of management in many respects. When we talk about the Phoenix effect, if you’re using relative TSR, and you’re comparing yourself against a group, or an index, but most likely your group, is that’ll have the most effect on overall payouts and performance, etc. It can oftentimes penalize steady performers in favor of companies that are more volatile. Especially, since TSR performance is often calculated on a single stock price measured at the beginning and the end of the performance period. So, if you’ve got a company whose stock price has completely tanked and it’s been in the toilet, they can really only go up, and they’re going to mess all the results up for everybody else.
A big challenge that many companies have is selecting the right comparative group. Companies will either use a comparative group or some type of index. In general, the best thing you can do is to use a group that most closely resembles your business. Often, that’s just not possible. You might not have enough peers in that group to build a group that makes sense. Going outside of that group is often necessary, and then your business model might not be the same. Therefore, that’s an issue or a challenge. So, companies will jump to using an index. That might not be the perfect solution for the company. It just depends. Each company is different. And as Mike mentioned, expense is recognized, even if the award is not earned. If there’s no payout, you’re still paying from an accounting point of view.
So, what are the folks in our survey doing? The majority of the companies using TSR, use it on a relative basis, as you can see here, 91% use relative TSR. A small percentage use absolute TSR. And then another small percentage about 2%, use both absolute and relative TSR. We have 22 companies use relative TSR as a modifier. That’s the hybrid approach to how you’re using absolute metrics in your overall long-term incentive plan. But you don’t want to apply a percentage to relative TSR in your plan, but maybe you want to have a piece of it based on it. What some companies will consider doing is basing their long-term programs on absolute financial performance metrics. And then they apply this modifier so that if you achieved TSR that is greater than the median, or below the median, your overall payout will be affected, either on a plus or minus basis, depending on your goal and how your goal was set, initially.
Right. And this is a recent evolution we’ve seen, it’s interesting, and we only expect it to rise. One of the big cons is that management doesn’t feel like TSR is in their control. They feel like it’s an outcome. And they would rather have what they believe to be are the financial operational drivers in creating shareholder value, like an ROI, or a revenue growth or EPS, etc. So, it’s a way to keep everybody happy and keep your internal constituents happy. And to keep the external, ISS and investors happy.
We talked about peer groups and index. Also, this is what companies are doing, or at least in this study sample, when we looked at who’s using a custom peer group, we saw that 55%, were using some type of custom peer group. The median number of peers in the group is at about 14, which I think we’d all like to see that number a little bit higher. But I think that’s probably the right number. And then we have 40%, use an index, of which 61%, use the S&P 500. So, that’s the dominant index used. We had about 5% that used both an index and a peer group when using relative TSR.
Okay, so that gets us through the data section of our slides today. So now we’re going to shift gears a little bit, and I’m going to talk about some recent changes in policies out there from the shareholder advisory firms. We’re going to look at some tax reform stuff and how that can have an impact.
I’m going to go briefly through this. We just put up there what the ISS pay performance test is, the only change recently was the multiple median. They lowered the threshold for medium concern from 2.33 to 2.0. In the 2018 update, they added a secondary screen called the financial performance assessment or the FPA. And they’re basically adding additional non-TSR performance metrics. They’re going to compare your company to a set peer group using ROI, ROE, ROIC, and EBITDA growth, at least at the primary set, it can vary, but that’s basically it. The big takeaway here is ISS is starting to look at stuff beyond TSR. And what they can do is if you’re a low concern, it could change you to a medium concern. Or the other way. If you’re a medium concern, it can lower you to a low concern. Now that they added non-TSR metrics, it looks an awful lot like the Glass Lewis policy.
You can see Glass Lewis includes people beyond the CEO. ISS only includes the CEO. One change, the metrics are slightly different. You can see that Glass Lewis been using metrics beyond TSR, for a while. So, ISS kind of caught on with them. On the bottom, you can see the grades A, B, C, D, and F, it kind of denotes schoolhouse grades. They actually had a clarification on this recently that a C is not a poor grade, because if you look at this, P is performance, C is compensation. So, a C is actually perfect alignment. That’s where your performance and your compensation are aligned, that it’s aligned versus peers in both manners. A or B, that’s if your compensation is less than your performance denotes versus peers. Obviously, it’s what they want to see. But it’s not really perfect alignment. That perfect alignment is a C.
Moving on, we would be remiss if we did not mention recent tax reform. I’m sure everyone’s heard about in the news. The tax cuts and jobs act of 17; as consultants we were excited, for a while. We thought there was an early version of the bills that had very radical changes the treatment of equity and deferred compensation, stock options. We might have cut that whole section because they might have been dead. Lawyers were very excited about potentially deferred compensation being dead because anyone that knows section 409(a), knows it is something lawyers see in their nightmares. But all this was removed. There is one major change that both the House and Senate versions have, which basically affects the tax deductibility of compensation. Now, they have to get together for one more vote, and they have to put the two bills in the House and Senate together and come up with one final bill. But a lot of people expect it to pass at this point. What it does is it removes the performance-based exception for compensation paid over $1 million. It also returns the CFO to the group that’s under 16(m). But that’s not a major change. It’s really the first part that’s major. What this could mean moving forward, you know what we’re going to talk about how like objective metrics and TSR is a referred metric, this could be the return of discretion. This could be the return of you know, in three years, I’m going to look at your individual performance and let you know how you did. That’s a metric that won’t really fly too well with 162, and it won’t get you performance deductibility. But it could come back. Now, of course, shareholders, investors, ISS, they’re probably going to push back on that. For example, if Say on Pay was repealed, it’s probably still not coming out of people’s proxies, because it’s in there now. Everyone likes it. ISS loves it. And if you were to remove it, if you were allowed to by the government, ISS would probably ding you very heavily for it. Expect some pushback. I think companies are going to try to bring back subjection and discretion, but there will be pushback.
So last, we’re going to talk about key considerations and some pitfalls to avoid in designing LTI programs. The first thing to avoid is pay for performance misalignment. You want to be careful that the majority of equity awards are performance-based. As we mentioned, ISS has a test on the CEO. They want 50% of a CEOs’ LTI to be performance-based, but options do not count. They want this third vehicle, performance-based awards, to be half of the LTI program.
Another one to keep an eye on is increasing target LTI awards in a year of poor corporate and stock price performance. ISS will track targets year over year, and if your performance is not up to snuff with them, they might ask why you are increasing awards when the company is not performing. It kind of goes hand in hand with payouts of awards in years where TSR has declined. This is one of the biggest issues a company runs into with using non-TSR metrics. Then you have something that’s an operational metric that’s supposed to create shareholder value, but doesn’t always work like that. There’s an outside party of investors that have to see the value and buy your socks. It’s a variable. So, you can have plans where your ROE, your revenue growth is great, but your TSR is kind of “meh” and you have payouts. The payment of dividends on unearned or unvested shares is deemed poor governance. You can pay them for performance-based LTI, but you want to only pay them if the shares are earned. Same thing with restricted stock. If the shares are forfeited, you probably don’t want to be paying dividends on it. It’s something that ISS will really go after you for, as well as other groups.
Another thing to keep an eye on is the size and concentration of awards. Large awards outside of the annual program such as sign-on and retention awards are useful and popular, but you don’t want it to be a pattern. They don’t like things outside of the annual program.
Another thing to be aware of is how the percentage of awards that your NEOs, your CEO in particular, get as a percentage of total awards. You disclose in the 10K all equity awards granted in the year. You disclose in the proxy or Neo awards. Someone can do the math very easily.
Another thing, performance metrics discretion is usually viewed negatively, especially with 162(m). That’s why there will be pushback from the Tax Act. Avoid double-dipping. Try not to use the same metrics in both the short-term and long-term programs. You know, certain outside groups don’t like when you pay twice for the same performance. Also, a single non-relative metric is likely problematic.
Design Parameters: we saw before some companies do one-year performance periods. Often, they’ll have a three-year plan with three one-year cycles. And that is something ISS will get on you about. They want sustained long-term performance to be the focus of the plan. You want to have caps on your plan. It’s a way to mitigate risk. Not having ownership guidelines or holding requirements. People want to see your executives have skin in the game.
Not having a clawback policy is another pitfall. You know, Dodd Frank has a mandated clawback policy that hasn’t come about yet, but it’s still alive out there. Companies have gone further and already adopted clawbacks, which allow you to get stock and other incentives back if something goes wrong.
One quick note on change of control, you want to avoid single trigger vesting of equity awards, which basically means a change of control of the company. You want it to be a double trigger, which relies on the termination of them.
In closing, some key considerations in long-term incentive design; you want to align with strategy. Well-designed incentive plans are aligned with your organization’s strategic plan. They allow you to focus and reward executives for accomplishing executive objectives that will drive long-term shareholder value. And you want to look at your business plan, what’s the key metric, what is going to create shareholder value, that’s what you want your plan based on.
Balance is crucial. Use a mix of vehicles and performance metrics. They should all provide an appropriate and balanced focus on achieving those strategic key objectives and making sure you have enough so that you can retain executive talent.
Reevaluate your plans on a regular basis. Just because you put something in place now doesn’t mean it has to stay that way forever. Plans need not remain static. Companies should periodically review to ensure they continue to support the organization’s strategic objectives. Maybe the plan changes. You could change your mind on what the key metric is. The world changes all the time. Make sure your plan and strategy coincide.
Understand the ramification of those changes. If you’re making any types of substantial modifications, make sure you understand the legal and accounting ramifications. Also understand what will get under shareholder advisory services firms, what your shareholders want to know about, and how you need to address those changes.
Assess risks: this is important. Make sure performance targets are attainable and fair to both executives and shareholders. You don’t want people reaching too far beyond their means and doing risky things that put the company in material risk to achieve payouts. It’s great to have max goals, but you don’t want them to be ridiculous and unattainable because it can drive people to do risky things. You don’t want to encourage them to take on excess risk. They should be thoughtfully selected and complementary with other goals used in your entire program, both short and long-term sides.
Communicate: If you want any incentive program to really succeed and work, you need to communicate it to your participants, which will be critical in making sure that it’s successful, but also communicating to all of your stakeholders, both internal and external.
Last but not least, don’t simply follow the herd. You don’t need to do what everyone else is doing. Do what you believe. If you have a metric that isn’t that popular out there, but you believe is a driver of shareholder value and will deliver that value, go with it. If no one else is using it, that’s not the perfect reason to not use it yourself. Believe in what you’re doing. If TSR isn’t what you want to focus on, just move on and do what you believe will drive that TSR. That’s our key, do what you believe in, what aligns with your strategy, not simply following what others do. With that, I believe we are complete. And thank you very much for listening.
If you have any questions, submit them in the question box on the GoToWebinar control panel. In the meantime, we do have a couple of questions for you guys. And the first question: For cash-based LTI plans that are based on a percent of base salary, is the percentage applied to the salary at the beginning of the LTI, or is it based on their current salary?
Usually, when you would grant an award, if it is a percentage of base salary, it’s going to be set at the base salary at the time of grant. Often, what companies are doing and what we usually recommend to companies, is that they have a rolling long-term incentive program, which means you’re making a new grant every year. There are some that do a once every three years, but we’d like to see annual growth programs. As base salary is adjusted, there’s a new grant, based on that base salary for the executive to be excited about that takes into account his current compensation.
Next question: Are you seeing companies using LTI for only executives or also sales positions?
It definitely goes below the executive. Sales incentive compensation is usually cash and based on total sales numbers. There is a whole world of products and consultants out there that are focused on sales and set the program.
It really depends on the level of the sales executive. If they’re a high-level executive that’s in the sales group, then they might get LTI. I think deeper down, there’s usually a specific sales incentive program that focuses on those employees in particular. It’s more focused on their particular goals. At least, that’s what we’re seeing.
Right. But definitely, we have seen it. It’s something that depends on the organization, and how deep down the salespeople are.
Next question: Do you think the relative use of performance metrics will change in the future?
Probably, I definitely don’t think it’ll decrease.
I think we’re going to see an increase. I’ve spoken to quite a few colleagues that believe it will continue to increase, and some folks definitely believe relative TSR will continue to increase. When you’re talking about metrics other than TSR, I think companies feel like that’s difficult to compare across the board. Because you’re talking about gap versus, non-gap metrics, and how to measure those particular performance metrics. But in terms of relative TSR, there are different viewpoints on that. I think we’ve kind of hit a plateau, and others think it’s going to continue to increase.
And it’s interesting, because beyond TSR, none of the other metrics are used in a dominantly relative nature, it’s absolute, and those types of goals. Relative measures may rise because of the challenges in goal setting. The environment is only more volatile, and variable year by year. I don’t think it’s going to change anytime soon. When companies get fed up with their absolute goals and the world-changing the day after they set the program, you might see them return to relative goals. That’s why goal setting challenges will always have relative goals around because like we said, it’s sort of a set and forget it, type measure.
Okay, and I want to thank everybody for continuing to join us. We’ll take one more question. What are the differences in LTI programs at companies below the top 200 sample referenced in the study?
When you go beyond the C suite or the executive level, you’re more likely to see the dominant LTI vehicle being used is restricted stock. And I think that has also moved over the last several years as companies used to be a little bit broader-based in how they were granting their equity. They don’t necessarily do that anymore, below a certain level of executives. But below the executive level, what we typically see is restricted stock. Maybe even some cash plans in there, as well. It’s easy to understand, easy to communicate, and less dilutive.
Beyond the top 200 companies in the sample, what you see with LTI programs is less complexity, usually a lower number of vehicles, maybe an increase in options, maybe a decrease in some of the performance-based LTI. As you go up to these top 200 companies, that’s where you see more complexity and sophistication. They’re using more vehicles like we saw with the sample today on the webinar. There are more companies using one and two vehicles listening today than the top 200 because a smaller company isn’t going to use all three vehicles. They might see an uptick in options and a decrease in performance-based awards and total number of vehicles.
Great. I encourage everyone to email us any other questions that you might think of after the presentation, Michael and Sandra, that was an excellent presentation. Thank you for your time today.