Abolish Long Term Incentive Plans? Or Just Fix Them?

A recent report published by UK think tank The High Pay Centre has recommended the abolition of long term incentive plans, claiming they have driven up executive pay to unwarranted levels without delivering a corresponding increase in company performance.Long term incentives

The report was the result of a year-long enquiry conducted by a committee that included the UK Institute of Directors’ Director General Simpson Walker as well as members of the media, academia and business organisations.

The report’s concerns about long term incentive plans included:

  • Their “long-term” nature is actually of a short enough duration that any investment in equipment or human resources expected to bear fruit in a longer time frame could impact negatively on incentive payout, thereby acting as a disincentive for executives to invest.
  • Incentives focus executives on one goal rather than the complex pattern of behaviour required to drive the company’s best interests and do not necessarily reward an individual for the right behaviour but rather for being in the right place at the right time.
  • Research suggested that long term incentive plan (LTIP) payments to FTSE 350 Directors increased by over 250% between 2000 and 2013, approximately five times as fast as returns to shareholders. It also found the correlation was weak between LTIP payments to executives and shareholder returns.

The report’s conclusion was that the concept rather than the design of long term incentive plans was flawed, as noted in the extract below:

Linking the largest component of executive pay to crude performance measures that imprecisely represent the complex role of leading a large company is clearly a mistake. Having committed their time, effort and career to obtaining and maintaining an executive position, executives are already invested in the long-term success of a company, so there is no grounds for concern that the abolition of LTIPs would cause the interests of a business and its managers to diverge.

Egan Associates would question the report’s conclusion, though we believe that many Boards’ management of long term incentive plans falls short of their stated objectives of rewarding superior performance and shareholder alignment.

In part our concerns have been due to the inflation in the value of long term incentive grants over time because of the increasing use of accounting standards to value equity for allocation purposes.

This practice, which has been going on for a number of years, is exacerbated by a lack of standard disclosure that leaves shareholders in the dark as to the value of grants executives are actually receiving and what the maximum potential reward is likely to be if the executive meets all performance requirements.

This lack of transparency has also complicated benchmarking of long term incentives in a meaningful manner.

We acknowledge the High Pay Centre’s concerns about incentive duration, noting that there is potentially scope for longer-term plans as long as they do not inflate the quantum of awards that have already been expanded due to the point noted above.

Finally, we have always endorsed long term incentives that are aligned with an organisation’s long term strategy. An incentive structure and performance benchmarking that is appropriate for a company in the resources sector will not be appropriate for one in the retail sector.

The High Pay Centre report has been critical of relative total shareholder return (TSR) measures – it has not been the only report to do so, with the latest from Citi Australia appearing in the media on 26 May. We support the initiative in recent times for companies’ adoption of bespoke incentives that match their long-term strategy and aspirations. However, we would also note that relative TSR with an appropriate peer group can be powerful if supported by a targeted performance hurdle or gateway and the considered exercise of Board discretion.

We do not believe that the problems with long term incentives are so severe as to require their removal from the remuneration equation. Yet there are some points that could benefit from reform. We intend to complete a larger body of work addressing issues with long term incentive grants, their disclosure and their motivational value in bull and bear markets.

Other Recommendations from the High Pay Centre Report

Along with its recommendation regarding long term incentives, the High Pay Centre report also suggested that:

  • Bonuses be paid in cash only due to executives undervaluing share awards.
  • A broader range of company specific targets be utilised in short term incentives with a focus on productivity.
  • Remuneration committees become more diverse.
  • Golden hellos be abolished for unadvertised positions.

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