Over the past 5 to 10 years, executive compensation programs have evolved from emphasizing stock options that have 10-year performance horizons to performance-based restricted stock with mid-term performance horizons — usually just 3 years long. While there are a wide variety of performance-based compensation designs in place, the single most popular mid-term plan performance measure across companies is to pay based on relative total shareholder return (TSR). But combined with a three-year horizon, TSR has the potential to be dangerous — payouts to executives may reward short- to mid-term stock price volatility rather than sustained long-term TSR performance.
The typical relative TSR plan measures performance against a peer group or broad market index, such as the S&P 500 Index. A participant will be granted a target number of shares that can increase or decrease based on TSR performance over the three-year performance period. These plans are highly leveraged, because higher performance levels will translate into more shares being delivered that are also more valuable.
To assess the concern about relative TSR plans that use a short horizon, we looked at TSR performance over four rolling 10-year periods for S&P 500 companies. We compared the distribution of payouts on a typical performance-share design using overlapping 3-year performance periods with a series of 5-year performance periods over the same time period.
At a strategic level, it is preferable to see “low performers” receiving a stream of negligible payouts over the 10-year period and “high performers” receiving payouts that are well above target or close to maximum. Our test was designed to investigate whether a longer-termed performance period of five years could help facilitate this preferred outcome.
We designed a study based on the 449 firms currently in the S&P 500 that were in the S&P 500 between 2004 and 2014.
The first interesting conclusion from the study is that shorter-termed awards led to a higher variability in payouts within individual firms. While this is not surprising, we think it yields insight to compensation committees struggling with the incentive impact of their awards. If there is too much variation in payouts over time, especially when overlapping award cycles exist at once, recipients are more likely to view their awards as lottery tickets. And, of course, the problem with a lottery ticket framework is its passivity — it’s nice if the award happens to pay out but outside one’s control if it does not.
Next, by plotting the distribution of payouts across companies, shown below in Figure 1, we found a higher variation in payouts on three-year awards versus five-year awards. In addition, the clustering between a 75% and 125% payout (where 0% to 200% is possible) on three-year awards is concerning.
Company performance (by definition) is evenly distributed from a percentile ranking perspective. But with shorter performance measurement periods, a large majority of companies pay out near target even though their relative long-run performance will be varied. Tighter synchronization between relative performance and payout level is preferred.
The “right” answer exists when payouts to LTI recipients mimic payouts to long-term shareholders. To analyze this, we constructed two hypothetical awards (one, a three-year TSR award, and a second, a five-year award) and compared the payouts on each with a company’s cumulative 10-year TSR .
With the hypothetical five-year awards, at 179 companies the awards matched 10-year TSR. For the more common three-year awards, only 147 companies had awards that matched 10-year TSR. Stepping back, a 10-year award would generally have 100% alignment, but such a long-term award is obviously not practical.
Our analysis raises questions about the appropriateness of 3 years as a performance period for relative TSR plans and suggests a few possibilities for action.
First, finance executives can collaborate with their partners in human resources to model alternative scenarios as we’ve done in this paper. This might reveal interesting findings that prompt discussion about whether to redesign the current award in some capacity. There is potential that the relationships between short-term and long-term TSR will vary by the nature of the index used. Our analysis was done for the S&P 500, but many companies use peer or industry indices for relative TSR comparisons.
In an ideal world, TSR would likely be measured over a truly long-term performance period like 10 years or 7 years, which also more closely corresponds to the life cycle of business strategies (inception to execution to ROI — or lack thereof). However, executives’ own tenure horizons do not always extend past five years, suggesting anything longer would be impractical.
Second, as a healthy compromise, we encourage compensation committees to think about a performance period of five years or even four years, which may provide a better balance between executives’ reluctance to wait to receive compensation and shareholders’ concerns that equity awards should reward long-term value creation.
Additionally, if there are tenure concerns with five years, it is possible to structure a five-year performance period on an award that only requires three years of continuous service. In fact, the additional two years can qualify as a post-vesting restriction that will translate into a valuation discount; this means more shares can be granted for the same accounting cost.
Eric Hosken is a partner with Compensation Advisory Partners, LLC. He advises the compensation committees and corporate management on executive compensation, with a focus on annual and long-term incentive design. Takis Makridis is the president and CEO of Equity Methods LLC. Equity Methods assists clients in the valuation and accounting of equity compensation awards, with a specialization in larger or more complex equity award vehicles.