Long-term incentive plans (LTIP) can take many forms: cash or multi-year stock payouts, 5-10 year options, and career-long stock ownership and/or holding requirements. While these are elements of truly “long-term” compensation, the actual results of LTIPs are often hard to discern. Unfortunately, standard proxy disclosures and proxy advisors’ analysis can give the impression that such plans cover three years or less. In reality LTIP disclosure only estimates the targeted potential value—often realized and payable many years in the future.
For better or worse, what gets reported is what gets analyzed. The Summary Compensation Table (SCT), the basis for many external analyses and reporting, is a mixed bag of information—historical salary and bonus, grant date value of restricted stock, hypothetical future value of options and estimated target value of performance shares.
To make matters worse, the “pay for performance test” used by Institutional Shareholder Services (ISS) then compares this SCT hodgepodge with 1- and 3-year total shareholder return (TSR). That’s like driving forward by looking in the rear view mirror—not a very comfortable feeling and certainly not effective over the long-term.
Why analyze past TSR performance for only three years or less? Why compare it to estimated future LTI values? How might that distort judgments in the marketplace about pay-for-performance and shareholder value?
Comparing historical TSR with changes in targeted CEO LTI is far from the most meaningful way for shareholders to understand compensation. Among the inherent flaws in the analysis:
- Comparing current cash and future LTI to historical TSR to measure a plan’s effectiveness is an “apples and oranges” litmus test.
- Despite the push for stock ownership and holding requirements, it does not consider the impact of stock price on total executive equity values.
- Estimated future LTIP values are not compared with the resulting shareholder value.
- Using only TSR to measure program effectiveness ignores financial fundamentals such as revenue, profit and balance sheet health—chasing any “single metric” may promote excessive risk-taking.
- Underscoring the disconnect, long-term performance-based LTI awards account for a significant portion of executive pay.
- According to our firm’s study of 2011 CEO pay among the 200 largest U.S. publicly traded companies, 43 percent of pay (excluding time-based restricted stock awards) is based on future performance— meaning that a comparison of nearly half the CEO’s estimated future pay to historical performance tells us very little.
The bottom line issue is not whether executives should be paid more or less, but how compensation committees and boards can reframe the discussion for all stakeholders. The advent of “say on pay” already has improved directors’ skill at communicating compensation practices to investors and advisory groups.
Members must now deepen their understanding of what they probably know instinctively: performance-based pay should not be evaluated on the basis of simplistic formulas with unrelated variables over disconnected and inappropriately short time periods.
Some recommendations to consider:
- Widen analytical time frames to five years or more, forward and back, and communicate to investors why this is a better perspective on pay.
- Evaluate realizable pay (long-term awards actually earned) and performance over matching time periods.
- Quantify the impact of stock performance on cumulative share-based executive wealth.
- Compare the future value of LTI opportunities to the corresponding changes in shareholder value.
- Quantify the relationship between financial performance and stock performance to evaluate the quality of all incentive plans.
- Change incentive plan designs when warranted.
Directors can avoid being the victims of well-intentioned disclosure requirements that evolve into new, unintended “rules.” By learning more about how LTIPs actually link pay and performance directors can better understand and communicate how they promote alignment with company performance over the long-term.
Randy Harrison is a managing director in the Chicago office of Pearl Meyer & Partners.