01. Introduction to Long Term Incentive Plans
For the past 25 years, long-term incentive plans have been a sizeable component of the compensation packages at the executive level. Commonly thought as being designed to primarily entice and motivate the C-suite and Material Risk Takers (MRTs) in the case of financial institutions, it seems that the real benefactor of LTIPs are the companies themselves, as scientific research surprisingly shows, that the executives prefer other forms of payouts and are not as motivated by the LTIs as previously thought.
Nevertheless, LTIP’s popularity only rises and in recent years, private firms, in particular, have been a driving force behind LTIP’s widespread adoption. According to the WorldatWork survey, 62% of private organizations offered some form of LTIP as part of their C-suite remuneration. This is a significant increase from only 35% in 2007 when the survey was conducted for the first time.
Interestingly, long-term incentive plans vary from sector to sector, with health care offering the largest part of executive compensation in LTIs - between 379% - 525% of base salary for emerging, mid-size and stable companies, according to Grant Thornton’s Russell 2000 Index Survey. In general, for mature organizations, it’s quite typical to grant more than three-quarters of the total compensation in LTIPs.
A well-designed LTI plan, now more than ever, can help companies navigate the uncertain post-pandemic economic landscape by providing executives with substantial rewards for hitting all the key performance criteria without losing immediate cash flow and incentivizing financial or operational performance goals over a multi-year period. Regardless of a company’s size, ownership, or stage in the lifecycle, a long-term incentive plan can be designed to address all relevant circumstances and is a vital element of a long-term human capital strategy.
From this e-book, you will learn:
- what is long-term incentive plan
- why should you consider granting LTIP
- who should participate in your long-term incentive plan
- the forms and vehicles of LTIP
- what challenges associated with these types of grants should you reckon with
- what are the future trends in LTIPs
- how software can help with LTIP design and implementation
What are Long-Term Incentives?
Long-Term Incentives are a form of variable pay that rewards employees for reaching specific performance goals over a specific period of time, resulting in the company’s increased value and maximizing shareholders’ returns.
Both private companies and publicly traded firms implement LTIPs based on performance metrics in addition to fixed income and short-term variable pay. The LTI component of the compensation is earned in the present, and the payment is deferred and spread over a course of time, with first payouts usually taking place after the initial performance period. Typically such a period runs for the first 3 to 5 years, and during this time, the executive has to stay with the company and is receiving the base salary and usually short-term bonuses while waiting for the vesting of the LTIP. The salary and pension are independent of the executives’ performance, meaning they are paid regardless of the results while annual incentives are paid for the achievement of shorter-term goals.
LTIP often is the main variable component of the total compensation package. In order to receive the long-term incentive payout, the beneficiary typically has to meet a certain array of criteria that are commonly based on total return to shareholders, operational measures such as earnings per share, and return measures such as return on assets with respect to a set of performance metrics. If these goals are not fulfilled, the employee typically forfeits the bonus - mechanism known as the clawback clause. However, if they achieve superior performance, many companies reward them with the so-called stretch, which is an extra award granted on top of the payout for meeting the targeted objectives.
The LTI payouts can come in various forms including
- cash,
- stock,
- stock options,
- shares,
- profit-sharing,
- and often include a mix of each.
About 50% of companies from the top 200 publicly traded organizations in the US use stock options and restricted stocks, and most use a portfolio approach, with the use of two or more vehicles being the most common. Performance-based grants are also the largest component of LTI package. Long-term incentives are an important part of executive compensation as the median for the S&P 500 companies allocates over 60 percent of the total remuneration to the LTIP.
What is vesting?
Unlike with other forms of equity-sharing or pay, where equity or cash may be granted outright, long-term incentive plans always include a vesting schedule, such that the payouts are not actually awarded to the employee until a specific period of time has passed. In other words, the vesting period is a predetermined span of time after which the employee’s rewards are disbursed according to the agreed-upon schedule.
If the executive leaves early or is terminated, they typically forfeit the bonus. Companies usually apply a good/bad leaver distinction according to the circumstances in which the termination or departure occurred to determine whether the bonus should be entirely withdrawn or other arrangements should take place. Typically, vesting periods tend to last from 3 to 5 years, after which the individual gradually starts to own the assets.
There are two types of vesting: cliff vesting and gradual vesting.
In Cliff Vesting the individual receives the whole prize all at once, instead of over a period of time. For example, if the vesting period is 3 years and the reward is 50 shares total, the employee will have to stay with the company for 3 years after which they receive all of the 50 shares.
In contrast, Gradual Vesting continues over time, with a certain proportion of the award vesting each year. It is quite common for no percent of the reward to vest for the first couple of years, with additional years vesting at different percentages until the total amount is earned in its entirety. To illustrate, if an executive’s award is 50 shares total, let’s assume that the initial vesting period is 3 years, after which he or she will receive 20% of shares each year after vesting, namely 10 in the 4th year, another 10 in the 5th year, another 10 in the 6th, etc., until the entire amount is disbursed. This means that the employee has to stay with the firm for the first 3 years during which they obtain no bonus. Only after that period, they receive the shares over the next 5 years. The times, amounts, and percentages of the awards offered vary widely from one company to the other.