Designing an effective long-term incentive plan (LTIP) may oftentimes prove to be an arduous task, as boards must be aware of the high costs that come with an overzealous LTI design. Similarly, boards must be privy to the short-term and long-term gains associated with an effective plan, both for shareholders and the executives themselves. Consequently, compensation committees must work diligently to determine multiple factors that go into such a LTI plan.
In early 2019, Equilar completed its annual study of executive long-term incentive plans employed both by Equilar 500 and Equilar 100 companies—subsets of the largest companies in the U.S.—in the past year. The report found a number of prominent trends, some of which have continued from previous years and others that seem to be quite new.
In general, metric usage and weighting has remained steady in the Equilar 500 over the last several years, with return on capital (ROC), total shareholder return (TSR) and earnings per share (EPS) leading the field. Relative TSR has long been the metric of choice among these top three, and, overall, its usage increased by 9.8 percentage points among CEO LTIP awards and an average of 9.2 points among LTIP awards to other NEOs. 54.7% of all CEO LTIP awards utilized relative TSR to assess performance.
According to E*TRADE Financial Corporate Services, Inc., who provided commentary for the report, relative TSR is quite common among their technology client base, largely due to the high degree of transparency that it offers shareholders as a direct measure of company performance. Material line business metrics such as revenue and return on equity have seen a rise in usage in these incentive plans, though. Equilar found that ROC and EPS also saw usage gains of 5.3 and 1.4 percentage points, respectively, in the last five years in CEO LTIP plans. Another important item of note is that the cash flow assessment has become increasingly prevalent in CFO awards, to the tune of 14.9% of Equilar 500 companies, a 26.3% increase over the last five years.
In designing incentive plans, the vast majority of Equilar 500 compensation committees have elected to use the three-year performance period, with this percentage only increasing year-over-year. From 2013 to 2017, it rose by 12.9 percentage points. During the last five years, it is evident that companies have continued to shift toward the usage of three-year performance periods. While one-year performance periods are the next most commonly chosen length, only 13.8% of companies chose to use them in 2017. Even awards with one-year performance periods continue to decrease in usage, as they have seen a 35.5% drop over the last five years.
E*TRADE has found that approximately 30% of their client base implements three-year performance periods in their LTIP plans. “That rate has not changed over the last three years, which suggests companies find it to be an effective component of their compensation strategy,” said Craig Rubino, Director of Corporate Services at E*TRADE. “By equity compensation standards, three years is on the longer side of the scale, which can provide a more balanced approach to executive compensation, allowing payouts to be averaged over a longer period of time, as opposed to one- or two-year performance periods.”
During the last five years, it is evident that companies have continued to shift toward the usage of three-year performance periods.
Three years is considered to be substantial enough to weather fluctuating business conditions, as companies will often measure an average of performance over this time span. However, it is also not uncommon to see metrics measured year-over-year, in combination with a cumulative assessment.
One of the most well-established and crucial parts of designing a long-term incentive plan is specifying the terms of performance. This is primarily done by determining the range of performance—the span below and above a metric’s target over which an executive can earn a payout. Target performance is bookended by a threshold and maximum performance, which form the overall performance range. In contrast, the performance payout is a percentage of the target. Performance payouts and ranges have remained quite consistent over the past five years for Equilar 100 CEOs. Threshold and maximum payouts in combination determine the range of the payout, and they are often a multiple of the target. Linear interpolation is used to determine the payout that an executive will receive when performance is between threshold and target, or between target and maximum. Compensation committees, in the process of setting both performance and payout ranges, aim for challenging, yet realistic metric targets as well as payouts that will incent a formidable effort from executives. According to E*TRADE, they have increasingly communicated with executives, creating a culture of transparency and cooperation between the committee and management.
Nevertheless, persistent trends in these ranges continue to emerge among Equilar 100 companies. The most common performance range required for a threshold payout was between 90%–99% of the metric’s target. Similarly the most common performance range associated with a maximum payout is 101%–110% of the specified target. Payout ranges remained very consistent as well, with threshold payouts being 50% of the target and maximum payouts being 150% of the target. E*TRADE finds that payouts tend to be higher—often up to 200% of target—when compensation committees set stretch goals to be achieved in the short term.
As executive pay remains in the spotlight, particularly as the investor community seeks better alignment with performance, there is no doubt that compensation committees must be meticulous in constructing LTI plans. Decisions made in the LTI design process affect the overall outcome of pay and performance, and compensation committees are cognizant of this reality.
Joseph Kieffer is Lead Author of Equilar Research reports.