Long-term incentive plans are a rewarding alternative

Long-term incentive plans may offer a more prudent method of executive reward, says Tom Washington

If you read nothing else, read this…

•  Long-term incentive plans (L-tips) are designed to drive business performance, ultimately producing an increase in shareholder value.
• The award is based on staff meeting certain performance conditions that prove they have contributed to increasing shareholder value.
•  L-tips help protect against actions that could harm a company in the long term.
•  Future plans could feature a mix of options and L-tips, reverting to one or the other, depending on performance.

After the scrutiny executive remuneration has come under in the past 12 months, long-term incentive plans (L-tips) seem to offer employers a prudent choice. But following high-profile cases such as Lehman Brothers, the effectiveness of L-tips has been called into question. Having much of his compensation tied up in long-term equity incentives did not stop Lehmans’ former chairman and CEO Dick Fuld from bankrupting the bank, leading to the loss of thousands of jobs.

Typically, L-tips are used to reward senior staff with company shares. The award is based on them meeting certain performance conditions that prove they have contributed to increasing shareholder value. Employers can design plans to fit strategic objectives, basing targets on criteria such as earnings per share, total shareholder return or company performance against competitors.

L-tips have a value for employees even if, say, the share price has halved. If the conditions of the L-tip are met, then all the shares are paid out, regardless of the market price, usually after a minimum of three years.

Bonus tied to performance

In theory, L-tips seem a no-brainer. Bankers’ bonuses were paid out before profits were made, but an L-tip means an employee’s bonus is locked in against performance conditions typically over three years and will be released only when these are met.

Martin Osbourne-Shaw, managing director of Killik Employee Services, sees Ltips becoming more commonplace and even rolled out to employees beyond executives. “For staff who may not need regular massive cash bonuses, employers might use shares and equity in an L-tip instead,” he says. “It gives a lot more protection to the companyand they are a healthy way to bring shareholder and executive alignment together.”

Duncan Brown, director, HR business development at the Institute for Employment Studies, adds: “All that has gone on in financial services has given a lot of emphasis to longer-term incentivisation. The risk with short-term incentives is people just go for it to get the money, taking risks that might be detrimental [to the company] long-term. At senior level, this has been felt outside the financial services sector. A lot of remuneration committees are asking: ‘Have we got the short-term/long-term balance right?’ Putting more into longer-term incentives is the way
it will go over the next six to 12 months.”

Faults of previous L-tips

But some say L-tips have not been designed well enough in the past. Although they are designed to increase performance-pay sensitivity, they may also give executives the opportunity to manipulate the terms of the plan in their favour. Leena Beejadhur, principal at Mercer, says some employers should test payouts under different scenarios to mitigate perverse outcomes in cases of extreme performance. “The biggest challenge for such plans is selecting the right performance conditions and setting stretching targets to ensure pay is truly linked to performance,especially over a long timeframe.”

Brown says many employers develop a plan they think is good practice, rather than consider strategies more suited to their needs. “We are seeing more [employers] getting more confident and saying ‘we have got a strategy and want our incentives to reinforce that’. So we will see more variety.”

But because short-term incentives are generally more popular with workers, offering a mix of short- and long-term incentives is crucial. Osbourne-Shaw believes plan designs will become more elaborate, featuring a mix of options and L-tips so if share prices do outperform, the plan reverts to an option, and if not, the L-tip award takes precedence.

But designing the right L-tip is one thing, forecasting what the business will look like in three years’ time is quite another.

Click here for more articles on employee share schemes