Executive Remuneration l Mercer Career Australia

Executive Remuneration l Mercer Career Australia

Executive Remuneration

Long Term Incentive Plans Review - Is it time to look again at relative TSR?

Paul Hunter, Senior Executive Remuneration Consultant, investigates the current long-term incentive trends among ASX listed companies.

A recent review of the ASX 500 and their Long-Term Incentive Plans (LTIP’s) revealed some interesting current trends, including the following:

  • Relative Total Shareholder Return (TSR) is the most common primary performance measure
  • For the ASX Top 20, Relative TSR is used by up to 80% of all organisations as the primary LTIP hurdle, although many also typically employ a secondary  or additional hurdles
  • Other common measures include the following:
    — Growth in Earnings Per Share (EPS)
    — Growth in Return On Equity (ROE)
    — Absolute levels of EPS within a defined band
    — Absolute levels of ROE and Return on Assets (ROA) within a defined band
  • The vast majority of organisations supplement their primary measure with a second performance hurdle whilst some organisations include up to three performance hurdles in the analysis
  • The typical performance period is a three year period with some organisations now starting to stretch this to up to four or even five years
  • Where relative TSR is employed as either the primary or one of a combination or series of performance measures, the vast majority of organisations have adopted a payoff profile that shows zero vesting up until the 50th percentile of the nominated peer group’s performance and then linear vesting between 50% up to 100% vesting when TSR performance reaches the 75th percentile of the nominated peer group
  • Disclosure is generally good for the majority of ASX 200 companies but becomes more erratic and thin in the ASX 200 to ASX 500 range

The case for and against Relative TSR

Relative TSR, in addition to being the most popular primary LTIP performance metric on the ASX has gained many supporters around the world and is also used by more than 50% of all listed US companies. Its supporters claim that it better narrows the gap between performance and the creation of long term shareholder value than other measures, and advocate its use on that basis for paying senior executives equity based incentives. It is supposedly also easier to convince investors and proxy advisers that using relative TSR better aligns management and shareholder interest and that bonuses should not be paid if shareholder returns are not better than the market. The calculation is fairly simple and various time and volume weighted smoothing techniques can be adopted to manage short term spikes in an organisation or peer companies ’s share price around the time of the announcement of annual results. Goals are also comparatively very easy to set under a relative TSR approach.
Critics on the other hand point to the following as shortcomings in the measure:

  • A weak line of sight between individual or even collective executive actions and their impact on the share price which can undermine the intended motivational impact of the plan
  • The definition of the peer group can sometimes determine the outcome of the incentive and in some cases the appropriate peer group can be difficult to define outside of industries where an obvious peer group usually exists, for example Financial Services or Oil and Gas
  • The common plan approach with vesting beginning at above median performance with maximum payout for top quartile performance will in fact have a 1 in 2 chance of paying no incentive and only a 1 in 4 chance of paying a full incentive
  • TSR is measured and reported as a percentage and does not measure the absolute dollar value of shareholder value created.  Earning a 20% return on $100m of invested capital is not the same as earning 20% on $2b of invested capital from a dollar-value added perspective, and as such the measure can sometimes favour smaller or newer high growth entrants in a particular market over established incumbents who nonetheless generate the majority of total shareholder wealth in that industry
  • Relative TSR might not make sense for industries in decline where excessive value destruction might still occur despite the employment of a relative TSR measure
  • There is little evidence, both in Australia or globally, that companies that do employ a relative TSR performance based hurdle actually outperform their peers over time. Given the preponderance of organisations now employing a relative TSR approach this would be expected, however it could also be argued that there is consequently limited potential for competitive advantage now in employing the measure as part of a strategic reward model
  • In industries with higher inherent industry volatility, like resources and commodities, greater variability in relative TSR measures can also be observed. Different operating models, cost structures and geographical spread of underlying assets, amongst other factors, will accord different firms more or less competitive advantage at different stages of the business cycle. This can exacerbate the perception by management that the measures they are measured on are substantively outside of their sphere of influence. It is not uncommon for companies in such industries to be awarded bonuses in a regular periodic hit and miss fashion where the key driver is paradoxically the underlying business cycle

The way forward

A successor to the popular relative TSR performance measure is not immediately obvious. Some organisations have tried to temper the limitations inherent in the relative TSR approach by making the primary measure of performance an internal one, for example ROE or Profit Margins, with relative TSR employed then rather as a modifier in order to mediate shareholder expectations. What is clear however is that as additional complexity is built into the LTIP architecture, so too are the discount factors applied to the potential payout by executives. Studies show that the potential payout of an LTIP is typically materially discounted by the executives as additional complexity, hurdles and modifiers are included in the plan’s design. The way forward in terms of better LTIP design therefore lies in a combination of the following approaches:

  • Simplify the plan mechanics as far as possible without oversimplifying the design
  • Improve communication and understanding of the plan and its workings
  • Don’t necessarily adopt a “me too” approach of a primary relative TSR measure without first understanding its implications in your industry and for your organisation
  • Wherever possible try to measure performance, be it long-term or short-term, using metrics that all participants understand and where there is at least a reasonable perceived line of sight between executive actions, results and bonuses
  • Balance financial with non-financial metrics, but with caution. Where employed, good non-financial metrics should capture the underlying drivers of sustainable long term financial success and good governance considerations

When was the last time you reviewed your Long-Term Incentive Plans? Are they resulting in the performance you expected? If you’re interested in discussing any of the above content, get in contact using the form below.

Paul is a Principal and Senior executive Remuneration Consultant with Mercer in Australia.

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