Although LTIPs provide many opportunities and benefits both to the company and its recipients, in order to deliver the expected results the plans need to be correctly calibrated and deployed. Here are some caveats you should consider when designing an LTIP for your C-suite, HiPos, MRTs, and others:
Although long-term incentive plans have been around for a while, their popularity has not waned. In fact, to the contrary, more and more companies include LTIPs as a part of their executive compensation package. In order to outmatch the competition in attracting top talent, both public and private organizations develop increasingly sophisticated vehicles of value provision and implementation tools aimed to design the most attractive and effective long-term incentive plan.
At this point, however, the executive compensation market is saturated with myriads of refined versions of LTIPs to the point where they are simply habitually bestowed. The novel combinations of stock-based, cash, or profit share options are no longer impressing the potential candidates neither in form nor the amount granted. Commenting on LTIPs, one of the CEOs surveyed by Alexander Pepper in his book on the Economic Psychology of Incentives, stated that they are “a necessary but not sufficient condition for motivating a senior executive.” The initial “wow” effect has been replaced with plain expectancy. Therefore carefully tailored package is a must for any company that wants to stay competitive in the current market.
One of the original ideas behind the implementation of LTIPs with long vesting periods has been rotation prevention. However, this argument does not seem to be valid any longer.
Once the LTIPs became so popular, nowadays there is nothing that bars a company from poaching key talent from their competition and offering them the same package in lieu of the old one. Companies sometimes refer to these types of grants as the “off-cycle” or “buy-out” awards, as they are tailored to replace any deferred compensation that has been lost by the grantee during the transfer to the new firm. In other words, some organizations have begun to bait attractive potential new joiners with like-for-like awards, a practice that ,in essence, compromises the retention-fostering nature of LTIPs and renders it as not that obvious anymore.
This practice has been going on for a long time, at least 20 years. I was routinely doing it 15 years ago in my first role as a global head of performance & reward. And that was for UAE-based company, which were not the first ones to adopt this approach."
Sandrine Bardot Independent Consultant at compensationinsider.com
Granting LTIPs also obliges the company to make long-term financial preparations in order to secure the amounts granted in the award. This is particularly important for LTIPs that are not tied to performance, such as restricted stocks and restricted stock units, since market fluctuations may substantially affect the size of the grant. The abovementioned financial preparations need to be forecasted, accrued, and tracked, which is complex and poses a challenge on its own.
In my experience one of the most challenging tasks, both intelectually, logically, and technically related to LTIPs is the accrual reporting and keeping track of who needs to pay what and when. This is the task that is easy to derail in Excel. That's when the dedicated LTIP software comes in handy."
Bartek Podolski CEO of GGS IT Consulting
The external environment, especially negative press attention, plays an important role in determining LTIPs and executive compensation in general. In fact, scientific research indicates that excessive bonuses attract unfavorable coverage. The media pick and focus on the companies that bestow extravagant grants leaking that information to the public.
Subsequently, other firms afraid of the negative opinions, take voluntary actions to constrain the C-suite compensations. Under media pressure, organizations seem to change the equity-linked components of the package, and shift towards cash-based awards. Since the LTI amounts ballooned in recent years, it is crucial for your company to carefully craft the remuneration package in order to avoid any accusations of pay disparities and camouflaging. You can start by asking, how will the media react?
In the US, the overwhelmingly negative public response to the 2008 crisis centered on the role the financial institutions symbolized by Wall Street played in it. Riots and pickets in New York City’s financial district lasted weeks, and the general public’s anger was so huge that the then governing Obama administration had no choice but to pass extensive regulations of the financial services industry.
As a result, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 introduced several control mechanisms of executive pay and corporate governance requirements, such as pay for performance, alternative pay disclosures, no-fault clawback policies, say on pay, or mandatory votes. The implementation and corporate compliance of these are, in turn, the responsibility of the Securities and Exchange Commission (SEC) that carries ongoing reviews and audits.
The governmental regulations on executive compensation vary from country to country and are also constantly updated, so it is essential for your company to stay current with all the changes in the legal world in order to assure compliance.
Since LTI plans have been gaining in popularity and packages are becoming more varied in form and amounts granted, you have to stay current with market trends in order to keep up with the competition. As a result, many firms conduct executive benchmarking surveys every one to three years to ensure their pay plans are up to par.
Organizations that have not conducted such studies in a while and who have not been monitoring the C-suite compensation market may discover that their LTIPs are far behind the packages offered by the competition.
If you realize that the present LTI plans your company awards are insufficient, you can still make proper adjustments.
Performance metrics are key to the successful implementation of any LTIP.
Poor criteria or an incorrectly chosen reference aka "peer" group will lead to confusion and misunderstanding of the basis on which the grant is awarded. Once that happens, the employee will perceive the LTI plan as a worthless gimmick. To avoid that, you need to carefully consider whether to apply absolute, relative, or a combination of both metrics in designing the long-term performance criteria.
We also recommend not to use the same metrics for both short-term and long-term evaluations, known as “double-dipping,” because it leads to rewarding or punishing the recipients twice for the same performance result.
What are absolute metrics?
Absolute metrics are metrics that rely on quantitative measures that are not dependent or relative on any variable. Since the growth of the company and its performance is contingent on so many changing conditions and environments, the potential to forecast future results without taking these risks into account presents a serious disconnect with what a security-oriented leader should prioritize.
Preventing damage from these risks is the key concern to the shareholders, especially in today’s uncertain economic environment, therefore it’s a good practice to use absolute metrics in tandem with relative, but not on their own.
What are relative metrics?
Relative metrics are metrics that rely on quantitative measures that are mapped to the priorities of the company. They take absolute metrics and fit them to the risks and conditions that most concern the board and that the executives can control, filtering out the macroeconomic noise. Since each firm, depending on its size, place in the maturity cycle, sector, etc., will have a unique set of priorities, each should develop relative performance metrics inside the organization that will fit its particular goals. One of the most prevalent relative metrics used in long-term incentive plans today is relative Total Shareholder Return (TSR).
Relative Total Shareholder Return is a metric that compares the company's total shareholder return (TSR) to the TSR of the selected peer companies.
Once the comparator group has been decided, the next step is to rank your firm along with the other organizations from highest to lowest according to their respective TSRs. After this ranking, the percentile performance of your company relative to your peers can be determined by using either discrete or continuous percentile rank approaches.
Which approach to choose depends on the size of your peer group as well as customs in your location, for example, the discrete percentile rank approach is overwhelmingly popular in the United States - above 87% of cases- for all comparator class sizes, while in the UK, continuous percentile rank (linear interpolation) is selected for 90% of peer groups of less than 20, they split half and half for sizes 21 to 50, and go down to just 10% for sizes o 50 or more.
TSR - the total amount of what a stock or equity has returned to the investor, including capital gains and dividends, etc., typically expressed as a percentage.
It turns out that executives consistently prefer less-risky options. Alexander Pepper, in his 2015 study of the economic psychology of incentives, discovered that 63% of the surveyed executives would rather take a guaranteed award of less money over a 50% chance of receiving its double.
The executives consistently subjectively perceive the value of the long-term incentive plan as less than its actual economic cost to the company. The employee who is risk-averse won’t see much value in the more risky elements of the LTIP, rendering such package less attractive than economic theory would suggest. This leads to the sky-rocketing amounts of the performance-based long-term incentive payouts, as in order to make them worthwhile, one needs to receive more.
Pepper’s research, The Economic Psychology of Incentives: An International Study of Top Managers, also indicates that the C-suite persistently prefers smaller certain payouts over larger amounts received in a distant period of time. This shows that the promise of grand award disbursed in 3 to 5 years is of little value to them today - a phenomenon called by behavioral economists “hyperbolic discounting.” The surveyed executives consistently chose to receive $56 250 tomorrow over receiving $90 000 in 3 years. Key concepts of the Austrian School of Economics also suggest that preference of receiving the consumable value now over that in the future is in-born and natural to everyone. One executive from Pepper's study summed up the findings constating that “Companies are paying people in a currency they don’t value.” To counter that trend, you should balance LTIPs with other forms of awards like short-term bonuses and the like.
Behavioral economists have long known that people are sensitive to relative earnings and prefer to outearn their peers even if that means that their income would be smaller in absolute terms.
Studies show that the executives are no different, and that “scorekeeping” matters particularly in the case of CEOs, one of them even claimed that “the only way [he] thinks about compensation is ‘do I feel fairly compensated relative to my peers?’”. If presented with an option to receive $100 000 in a society where the median relative income for their comparative peer group is $50 000 versus $150 000 where the absolute median income for the whole society is $200 000 they would pick the $100 000 option despite it being actually less money. This is counterintuitive since the rational decision would be to take the higher option that would simply allow one to purchase more goods regardless of what others earn.
Nevertheless, employees value the relative pay since they treat it as a proxy to measure one’s success. Competitive by nature, CEOs and other key figures like being compared to peers within the same organization as well as rival ones. One of the CEOs from Pepper's study put it like this: “Once you are at a threshold level on the financial structures, a level which is felt to be fair and appropriate to the market, then other factors become really important.... but if you are at a significant discount on the monetary part then the other things will not make up for it.”
We can conclude then that relative compensation is one of the primary concerns and motivating factors for the top leaders. No wonder this mentality is among the driving factors behind the ballooning LTIP packages.
Although the majority of LTIPs recipients regard financial gratification as important, the emphasis on high pay dramatically wanes after achieving a certain threshold. This contrasts with the assumptions of the standard agency theory, which states that money is the primary motivating factor and that the will to succeed rises proportionally to the reward bestowed. In his research, Pepper found out that pay is neither sole nor the primary incentive for the high earners once they have been fairly compensated on a sufficient level.
The excessive LTI packages, however, overwhelmingly favor pecuniary gratification over other factors that drive people’s performance and will to work. Achievement, personal growth, stimulating environment, overcoming challenges, broadening horizons, status, power, sense of duty, and teamwork are all meaningful motivating factors. In fact, the surveyed executives claimed that they would be willing to reduce their compensation packages by an average of 28% in exchange for a job that was better in other aspects. And as one of them summed up, “I do not believe, nor have I ever observed, that $100 million motivates people more than $10 million or $1 million,” focusing solely on big payouts doesn’t seem to create stronger performance but importantly ignores non-material stimuli.