Long-term Incentive Grant Practices for Executives

The following post comes to us from Frederic W. Cook & Co., Inc., and is based on a publication by James Park and Lanaye Dworak. The complete publication is available here. An additional publication authored by Mr. Park on the topic of executive compensation was discussed on the Forum here. Research from the Program on Corporate Governance on long-term incentive pay includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried, discussed on the Forum here.

The use of long-term incentives, the principal delivery vehicle of executive compensation, has long been sensitive to external influences. A steady source of this influence has come under the guise of legislative reform with mixed results. In 1950, after Congress gave stock options capital gains tax treatment, the use of stock options surged as employers sought to avoid ordinary income tax rates as high as 91%. Some forty years later, Congress added Section 162(m) to the tax code in an attempt to rein in excessive executive pay by limiting the deduction on compensation over $1 million to certain executives. Stock options qualified for a performance-based exemption leading to a spike in stock option grants to CEOs at S&P 500 companies.

Fast forward twenty years and the form and magnitude of long-term incentives continues to be a hot button populist issue. The 2010 Dodd Frank Act introduced U.S. publicly-traded companies to Say on Pay giving shareholders a direct channel to voice their support or opposition for a company’s pay practices. Another legislative addition to the litany of unintended consequences, Say on Pay has magnified the growing number of interested parties, increased the influence of proxy advisory groups such as Institutional Shareholder Services (ISS) and Glass Lewis, heightened sensitivity to federal regulators, and provoked the increased interaction of activist investors.

Compensation Committees are challenged to balance the oftentimes conflicting interests of a growing number of stakeholders. As a result, we observe a narrowing range of long-term incentive practices and a growing bias for homogenous plan design. It is arguably easier for companies to follow conventional market practices than to educate and defend innovative plan design.

These findings emanate from our study, the 42nd annual Frederic W. Cook & Co. Top 250 Report, which presents information on long-term incentives in use for executives at the 250 largest U.S. companies in the Standard & Poor’s 500 Index. For access to the complete Top 250 survey, including detailed market findings and study methodology, please visit our website at www.fwcook.com. Notable trends and key findings from this year’s study are presented below:

Summary of Grant Types in Use

Stock option use has stabilized over the past three years after an extended period of decline (71%). Once considered the most shareholder-friendly grant type due to its inherent alignment with shareholder interests, stock options appear to be recovering from mixed employee perceptions and investor concerns about potential dilution and performance orientation. The percent of companies granting restricted stock, including companies that disclosed performance-vesting criteria solely to satisfy 162(m) requirements, remained flat year-over-year at 63%.

The majority of Top 250 companies apply a uniform installment or ratable vesting approach (three equal installments) to stock options (81%) and restricted stock grants (54%). This is the first time we observed more than half of the companies using an installment vesting approach rather than a cliff vesting approach (100% vest at the end of the period) for restricted stock, but it is consistent with the broader trend towards greater use of the installment method for grant types that vest based on service.

On the other hand, performance awards rank as the most widely used grant type for the fourth consecutive year with 89% of the Top 250 granting performance awards settled in cash or stock. The proliferation of this award type is due, in large part, to Say on Pay as companies seek to demonstrate a relationship between pay and performance.

Long-term Incentive Mix

On average, performance awards comprise 50% of a Top 250 CEO’s total long-term incentive value. Stock options represent 30% and restricted stock the remaining 20%. This mix is influenced by the fact that proxy advisors and some shareholders no longer view, or in the case of proxy advisors never viewed, stock options as “performance-based” awards. While this view is fiercely debated, many companies have conceded to classify stock options as an award that is “at-risk” but not performance-based.

Performance Award Design

Performance Metrics

TSR and profit-based measures continue to be the most prevalent performance categories among companies that grant performance awards at 58% and 50%, respectively. Since demonstrating alignment between pay and performance is a requisite for securing Say on Pay support, companies are rethinking what performance goals to measure and how to measure them (i.e., absolute goals measured against internal targets versus relative goals measured against external benchmarks).

TSR, specifically relative TSR, has emerged as the metric of choice under Say on Pay. For shareholders, there is an elegance to TSR in that it demonstrates the return relative to alternative investments and avoids the need for long-term goal setting. It is also the singular definition of corporate performance used by ISS. As such, some companies view relative TSR as a means to “check the box” with regards to shareholder and ISS preferences.

Critics of TSR as an incentive measure denounce the fact that it does not drive performance, that market valuation can become disconnected from financial/operating performance, and that consistently high-performing companies may be disadvantaged when compared against companies that exhibit a performance rebound during the measurement period. In light of these drawbacks, we observe that 70% of Top 250 companies using TSR do so in combination with one or more financial metrics.

The Top 250 companies are split on how many performance measures to use, with just under half (45%) using one measure with the other half using two or more. Glass Lewis discourages the use of a single performance measure, even if that metric is relative TSR. They argue that the use of multiple metrics provide a more complete picture of company performance and that a single metric may focus management too much on a single target. The risk of putting “all eggs in one basket” and the potential to overemphasize one metric at the expense of other business priorities are concerns shared by some shareholders.

Measurement Period

Performance is measured over a period of three years in 82% of performance award programs, indicating that most performance periods run in tandem with the award’s vesting period. Companies that measure performance annually (i.e., reset targets each year over a three-year period) are included in this statistic. We anticipate this practice will decline as proxy advisors scrutinize this treatment for failing to require the achievement of sustained long-term results (i.e., operates more like an annual incentive plan).

In a similar vein, performance periods of one year or less with an extended vesting tail (i.e., one-year performance period followed by two additional years of time-based vesting) have declined in prevalence (8% in 2014). Many companies voice challenges in setting realistic long-term performance goals due to market volatility. Some shareholders dispute this argument, particularly when a company’s peers demonstrate the ability to set cumulative three-year goals and shareholders themselves make investments on the basis of company guidance and long-term performance expectations.

The complete publication is available here.

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