Rethinking long-term incentive

schemes
by Stuart James, Executive Compensation Consulting Leader

There is growing urgency for companies to rethink their long-term incentives

for employees. In recent conversations with heads of several companies in
Southeast Asia, I have heard less than encouraging comments about their
long-term incentive plans.

Stuart James
In the last two decades, companies have tried to So where do the problems lie?
use long-term incentives (LTIs) primarily to achieve
two objectives: to focus the work behaviour of the The subject of LTIs has always been complex. The
covered employees on the desired performance, and design, or re-design, of an appropriate and effective
to assist in the retention of executives and other key long-term incentive plan for an organisation involves
employees. the careful consideration of many questions,
including:
But, when asked how successful their long-term
incentive plans are in achieving the objectives, •• What are the appropriate LTI vehicles?
senior management of the companies interviewed •• Are we using the right performance metrics in
generally conveyed non-specific or unsatisfactory performance share plans?
outcomes. Four responses were common: •• Are we including the right people in the plan?
•• Should participants be able to simply exercise or
•• The company’s long-term incentive plan is not cash-out an award without maintaining ownership?
cost-effective. •• Has the plan encouraged stock ownership?
•• We are not sure how much our long-term incentive •• Have the benefits enjoyed by participants
plan contributes to the retention of employees exceeded the expense incurred by the company?
and/or motivating desired performance. •• Do we have a “status quo” plan, i.e. compared
•• Our employees are “throwing away” the shares, to what other companies offer, does the LTI plan
divesting the shares too soon before they fully allow us to maintain a competitive position?
benefit from them.
•• We are dissipating the company’s shares. We
issued new shares to fund the long-term incentive
plan and we have diluted the earnings per share.
 Comparing LTI vehicles Eligibility
Long-term incentive vehicles include stock options, The choice of participants in the long-term incentive
performance shares and restricted stock plans. plan is an important decision which must be carefully
Each has strengths and weaknesses. The right modelled based on the amount of equity available.
vehicle to adopt depends on the organisation. For Some companies, in trying to be inclusive, make the
example, a high-growth organisation may prefer an mistake of including too many people. This results
employee stock option plan – which gives employees in a limited number of shares being spread over a
the right to purchase a specific quantity of shares of large number of people and the value of each award
the company’s stock at a stated price within a set becomes too small to motivate or drive the right
time period – to help attract and retain talent while behaviours. Actually, this is an inefficient use of the
keeping fixed costs low. A mature organisation may company’s reward dollars.
be better served by a performance share plan to
This problem is somewhat mitigated by the
drive and reward employee performance, which can
introduction of an accounting expense for all equity
be measured against predicted performance targets.
awards. As a result, more companies have focused
In recent years, market practice is moving away from their long-term incentive plans on a selected group
stock options towards performance shares, which of senior executives who can directly influence
are given to managers only if certain company-wide company performance.
performance criteria are met, such as earnings
per share (EPS) targets. Towers Watson research
also points to increased use of performance-based
restricted shares, which are granted with restrictions
on the vesting period (the full performance period).
The popularity of performance share plans stems
from the ability of such plans to motivate and reward
performance, create ownership and limit dilution.

Performance management
Responding to shareholder concerns about pay-for-
performance, companies have continued to explore
additional performance metrics. One of the most
challenging tasks of a compensation committee
today is determining the performance metrics for a
plan. Selected measures must be both meaningful
and achievable. Performance measures that are
unrealistic or not within the control of participants do
little to influence desired behaviours. For example,
while EPS is a common metric, some argue that it
is an unstable measure. Earnings per share may
rise or fall, due to uncontrollable external business
factors like changes in the worldwide prices for raw
materials.
An interesting insight from Towers Watson research
is that in terms of compensation mix, high-
performing companies place greater emphasis
on long-term incentives than what is typical in the
market. They also rely on at least two performance
metrics in their LTI plans.
Total shareholder return (TSR) is the most common
metric used. In fact, in the US, the prevalence of TSR
as a metric in long-term performance share/cash
plans has surged by about 30% in the past two years
and the metric is used by more than one-third (35%)
of companies in 2011.

2 towerswatson.com Addressing the hard questions about long-term incentives

Reasonable performance period performance share programmes and other long-term
incentives, companies need to be careful that their
How long should the performance period be? The long-term incentive plan supports a sharp focus on
general practice when designing long-term incentive performance and aligns executive behaviours with
plans is to set the performance period at three shareholder interests.
years. But some CEOs argue that it is difficult to set
achievable goals for a multi-year period because The right long-term incentive plan for an organisation
their business change too frequently. Then should is one that drives high performance and contributes
the performance period be flexible, depending on to overall business goals including sustainable
industry and business strategy? For example, a long-term growth. Achieving this requires thoughtful
shorter time period of two years may be appropriate consideration and precision in the design process.
for a start-up or a company in the high-growth stage,
or an organisation undergoing radical changes such
as merger and acquisition.

For other companies, setting a performance period

of three to five years may be necessary to ensure
participants don’t take a short-sighted view and will
be driven to work for the long-term financial success
of the organisation.

The question of leavers

It is a fact that in spite of the best intentions of
the company, employees do leave. How will their
long-term incentives be affected when they leave?
Typically, companies give “good” leavers a pro-
rata benefit while “bad” leavers forfeit their future
entitlements. Companies have to consider if such
an approach is consistent with the objective of key
employees retention.
Performance reward is a sensitive issue. Experience
shows that shareholders do not mind rewarding
performance but are concerned and even outraged
when they perceive that poor or inconsistent
performance is rewarded.
Performance share plans are a key component of
senior executive compensation today. In designing

towerswatson.com Addressing the hard questions about long-term incentives 3

About Towers Watson
Towers Watson is a leading global professional services
company that helps organisations improve performance
through effective people, risk and financial management.
With 14,000 associates around the world, we offer
solutions in the areas of employee benefits, talent
management, rewards, and risk and capital management.

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TW-AP-13-32946. Month 2013.

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