Even with its share of detractors, total shareholder return (TSR) is becoming an integral element of executive pay. In 2015, 25.2% of long-term incentive plan performance awards for S&P 500 CEOs were based at least partially on TSR, a figure that has nearly doubled in the last four years. Many executive compensation professionals are concerned about this because they feel that TSR does not appropriately reflect value creation over a short period of time. Since nearly 71% of CEO performance awards are structured in three-year periods—another figure that has increased each year—the concern about tying TSR performance to pay is rising.
A recent Equilar study took a deep dive into long-term incentive plan design for CEOs in the S&P 100, revealing plan details such as the weight assigned to specific performance metrics, as well as performance goal and award payout ranges, to show how public companies balance incentives meant to drive both financial and operational strategy with shareholder value. Effective executive compensation programs aim to align executive pay with measures of company performance, and a well-designed incentive plan achieves this alignment through a rigorous process, including the selection and weighting of performance metrics. While TSR is a prominent part of many executive incentive plans, it is by no means ubiquitous, and companies are weighing many different factors when determining how to pay for performance.
Companies commonly assign multiple performance metrics for the payout of one incentive award. For example, assigning a measure of sales (revenue) and of profit (EPS) to a single award aims to motivate an executive to focus on both top- and bottom-line growth. In these cases, plan designers assign weightings to individual metrics, with greater weight translating to larger influence on the payout.
In the most recently reported fiscal year, relative TSR, EPS, return on capital or invested capital (ROC/ROIC), revenue and cash flow were the most popular performance metrics for long-term incentive awards to S&P 100 CEOs. Relative TSR was by far the most often used, assigned to more than 40 performance awards. Each of the other most popular metrics appeared more than 15 times, where no other metrics appeared more than 10 times. (Graph 1)
Popularity does not correlate directly to weighting. For example, relative TSR was the most popular metric in terms of prevalence but was weighted less than 25% for about one in five of the CEO incentive awards when it was included. Awards that measure TSR to partially determine payouts, yet do not depend solely on TSR to encapsulate performance, provide incentive to deliver both strong financial or operational performance—critical elements of strategic achievement—and value to shareholders—a fundamental concern of proxy advisors and shareholders.
Along with being the most popular, relative TSR accounted for 100% weighting in nearly one out of every three awards to which it was assigned, more commonly than any other metric. Revenue was weighted between 26% and 50% more often than any metric in the study—76.2% of the time. Most prevalent on the low-end, cash flow was assigned a weighting in the bottom quartile 31.3% of the time. (Graph 2)
Performance ranges set expectations for the degree to which executives will receive and maximize their payouts. The connection between set performance goals—or targets—and award payouts creates the link between pay and performance. These types of incentive plans inevitably result in portions of executive pay being “at risk,” or variable, meaning that poor performance can result in little or no payout compared to target amounts.
Among CEO performance awards in the study, performance thresholds—or the minimum performance that results in the payout of an award—for long-term incentives were largely above 80% of target performance in 2015. Of the 65 awards that included reported threshold performance, 51 were between 80% and 100%, meaning that in order for these executives to receive any payout, the company would have to hit at least 80% of its target performance goal. The largest grouping of performance thresholds occurred even higher, between 91% and 100%.
Maximums, or the point beyond which higher payouts are no longer achieved, occurred largely in the 101% to 120% of target performance range. Of the awards that included reported maximums, 49 fell within this range, meaning that executives would receive the largest possible award if the company achieved 101% to 120% of target performance.
Award payout ranges as a percentage of target amounts were much wider than performance ranges, indicating that incentive plans leverage small, incremental changes in performance into larger changes in award payouts. The most popular threshold as a percentage of target payout for long-term incentives of CEOs in the S&P 100 was 50% in 2015, and the risk of earning 0% of the target award was not uncommon. In other words, if a company did not reach its threshold for company performance, most executives were eligible for at most half of their target payout, and frequently nothing at all.
Maximum payout was most typically capped at 200% of target, with more than half of the awards in the study topping out at twice the target amount. The largest maximum in the study was 300% of target.
1 “Performance Awards: Trends, Challenges & Equity Edge®,” E*TRADE Financial Corporate Services, Inc. Equilar Inc., and Hay Group White Paper, 2009.
2 “2015 Equity Trends Report,” Equilar Inc. featuring commentary from E*TRADE Financial Corporate Services, Inc. , 2015.
The data and analysis contained in this article has been prepared by Equilar. The commentary, where noted, has been provided by E*TRADE Financial Corporate Services, Inc.
Equilar is not affiliated with E*TRADE Financial Corporate Services, Inc. or the E*TRADE Financial Family of companies.
The contributing authors of this report were Heather Kerr and Hannah Dumas, Equilar Research Analysts, and Matthew Goforth, Equilar Research and Content Specialist.