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Long-term Incentive Plans (a positive view)

Long-Term Incentive Plans (LTIP) are largely used by companies in order for executives to pursue long-term objectives (as a balance to the short-term focus imposed by annual bonuses and other short-term payments), to retain executives, and to tie top executives` behavior to shareholder value and strategy.

Since 1973 Frederick W Cook publishes a study of LTIP by US bigger companies. We will follow their 2014 study (1) to describe the structure companies use for their LTIP, the different tools, their relationship with corporate performance and some other topics.

They consider a LTI can be defined as an award included in a plan, not limited by both scope, (very restricted number of beneficiaries) and frequency, (a one-time award for hiring purposes for instance). The grants must reward performance, continued service or both for a period lasting more than a year.

There are different tools used by companies in the sample:

  • Stock options and Stock Appreciation Rights. Dilution concerns, the so said performance disconnect, its asymmetry, back-dating practices, the fact that markets sometimes determine underwater periods and frustration, …, have all been at the roots of its (relative) decline in recent times.
  • Restricted Stock: actual shares or share units earned by continued service, often called time-based awards.
  • Performance Shares: stock-denominated actual shares or units, (performance shares), and cash-denominated units, (performance units), that are both earned for performance against certain objectives.

What`s the usage mix? Firms in the sample use on average 50% of performance awards, 30% of stock options or SAR`s and 20% or restricted stock. There is no relevant difference between the mix for Ceo and other C-suite executives included in the LTIP`s.

Other LTIP practices.

  1. Stock option and SAR term: term is the period between grant and expiration date. In the sample, with the exception of Information Technology firms, all sectors had an average term of more than 10 years.
  2. Vesting schedules: a majority of firms use partial vesting approaches to stock options and restricted stock, rather than a cliff vesting approach. This can be due to the stronger retention effect generated by the (recently more prevalent) performance awards, so that vesting can be given partially before.
  3. Vesting period: the mostly used period is three years. This has been questioned by IRRC in a recent study on the Connection between Pay, Performance and Long-term value creation; they suggest that less than five years periods do not fully capture long-term performance objectives; see our posts on this study noted below, (2).
  4. Performance metrics: TSR and other Profit-based metrics are used in more than half of the companies in the sample. Only 40% of firms use Capital Efficiency metrics, (Roe, Roa, Roic, etc). I again suggest you to read our previous posts in the subject, and the critics to all metrics not introducing the cost of capital in their evaluation of long-term performance. (2).
  5. Performance metric approach: the prevalent method is its absolute measurement, versus relative measures that are not always possible.
  6. Number of metrics used: in general, 50% of companies use one and the other half uses two measures.
  7. Performance measurement period: performance is measured in more than 80% of cases in 3 year periods, so that vesting periods and measurement periods are reconciled. See our comments in (2).
  8. Performance Leverage: maximum payout levels is 200% of target in 56% of performance awards programs, whereas 16% use 150%. Financial institutions are more conservative than other sectors, (such as utilities, for instance).

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