Performance-Based Long-Term Incentive Plans: Are They Effective? How to Improve Shareholder Alignment

Donald Nemerov, Managing Director, Compensation and Benefits Consulting, 
Grant Thornton LLP 
The form and amount of equity-based compensation awarded to public company executives is a highly publicized and controversial topic. A clear decline in stock option grants has occurred in favor of performance-based long-term incentive plans (“LTIPs”). This can be attributed to a number of factors, including mandatory expensing of stock options, increased pressure by shareholder advisory groups to grant performance-based awards, and the perception that stock options may induce unnecessary risk taking. Grant Thornton examined over 300 plans implemented by about 100 S&P 500 companies from 2007 to 2012 to understand their alignment with the total shareholder return (TSR) realized by each company and offer insights for their improvement. We will cover:

• How did the LTIPs pay out as compared to shareholder return? How did this compare to compensation realizable from time-vested restricted stock or stock option?
• Which plans worked best: for example, financial-based plans vs. plans based on a relative return (“RTSR”) metric?
• Success factors to consider for the “next wave” of such plans.
• How to consider capital markets characteristics in determining the right mix of long-term incentives; and how to use this information in discussions with shareholders and proxy advisory firms.

Larry W. Miller, Managing Director, 
Innisfree M&A Incorporated 
Institutional shareholders and the leading proxy advisory services prefer that companies
base their long-term incentive plans on performance-based awards, at least in part, rather
than wholly on time-based awards.

• ISS – Compensation policy begins with a statement that “shareholders … want
  assurance that top management’s compensation is primarily performance-based”

   

  First three factors to be considered as part of qualitative review are:

  • The ratio of performance- to time-based equity awards;
  • The ratio of performance-based compensation to overall
    compensation;
  • The completeness of disclosure and rigor of performance goals
• GL – “[A]n integral part of a well-structured compensation package is a
  successful link between pay and performance”
• Shareholder policies

But adopting a performance-based plan does not guarantee a favorable recommendation nor favorable votes from shareholders

• Both ISS and GL, at least as a first step, start with quantitative measures mapping CEO compensation against TSR, on a company-specific basis and as compared with a peer group
• A company without a performance-based LTIP may pass the quantitative screen and generally expect a positive recommendation, while a company with a performance-based LTIP may find itself with an elevated concern and subjected to a qualitative review of its compensation program

In the qualitative review, the devil is in the details – each aspect of a performance-based plan is a potential minefield:

• Target and maximum payout opportunity as a percentage of base salary
  • Too high?
  • Increasing in the face of poor stock performance?
• Metrics
  • Too easy?
  • Duplicative of metrics for annual incentive plan?
• Absolute vs. relative?
• Length of performance period
  • Too short/long?
  • Re-testing permitted?
• Discretion (or absence of)
  • Adjustability of targets?
  • Subjective factors?

Matthew G. Isakson, Lead Senior Consultant, 
Meridian Compensation Partners, LLC

• Compensation Committees want to see a greater proportion of “performance-based” LTI. Correspondingly, the use of restricted stock in the annual LTI program is being increasingly scrutinized.
• Contrary to some outside observers’ perspectives, most management teams, directors and frequently institutional shareholders include both multi-year performance plans and conventional stock options as “performance-based” LTI. Stock options are included because notwithstanding their time-based vesting, in order to realize value, the underlying stock price must increase and this generally means improving company performance.
• Broadly, we are seeing greater Committee participation in performance metric selection and in the stress testing of annual and/or multi-year performance goals.
• Relative total shareholder return (TSR) has become the most prevalent long-term performance measure with approximately 50% of long-term performance plans including this metric to some degree; at the same time there is close evaluation of when the metric is a “good fit” or not and the potential tradeoffs of strong alignment but potentially weaker incentive qualities

Robert McCormick, Chief Policy Officer, 
Glass, Lewis & Co.

• Shareholders are increasingly closely examining how all forms of compensation are granted including long term equity incentives. They particularly want to know what, if any, performance metrics are tied to either or both the granting of equity awards and the earning of the awards. Shareholders are interested in knowing how the granting and vesting of awards under long term incentive plans are linked to the overall compensation strategy of the company. They further want to understand how long term awards incentivize executives to achieve the strategic goals of the company. Therefore, shareholders closely review the choice of award (e.g. options, restricted stock, performance shares, etc.), the performance criteria, the challenging nature of the performance metric(s) and the how the long term incentives work in conjunction with other forms of compensation, with a preference for having the largest portion of compensation tied to long term performance.

Mark R.S. Foster, Partner, 
Morrison & Foerster LLP

• Overview of new litigation risk relating to executive compensation, say-on-pay, and stock-incentive plans
• Proxy statements: a target rich environment for disclosure claims
• Fuel for the fire: benchmarking reports, simulations, and projections
• Containment strategy: how to minimize litigation risk, and sanitize documents for litigation