Selecting the right performance period for long-term incentive plan

LONG-TERM Incentive (LTI) Plans have been in existence in Singapore for nearly two decades. Aimed at aligning shareholder and management's interests, they constitute as much as 40 per cent of the senior executive remuneration in many large-cap Singapore companies.

But a quick glance at the remuneration disclosure statements of the Straits Times Index (STI) 30 companies reveal that their LTI plans bear a striking resemblance to one another. More intriguing is that 90 per cent of the STI 30 companies that have a performance-based share programme use a three-year horizon for vesting of their awards.

Almost three in four companies in the Australian Securities Exchange (ASX) 30 vest their performance-based share awards over a three-year period. The corresponding figure for the Standard & Poor's (S&P) 500 companies is an unsurprising 80 per cent.

Most companies use a three-year planning cycle and that conceivably could be the reason behind the widespread adoption of the three-year performance period. A three-year performance window may have also emerged as a "consensus" solution - one that is reasonably long enough to provide shareholders a track record of sustainable returns, but also short enough to take management's interests into consideration.

But the question is, are such three-year performance plans serving their purpose?

RETHINKING THREE-YEAR PERFORMANCE PERIOD

Consider the following scenarios:

In each of the above cases, it is quite probable that a three-year performance window would provide an incomplete view of the management's ability to create value for shareholders.

Worse, it could incentivise management to play safe and refrain from the bold bets required to make their strategy work and drive sustainable performance. For example, management can use a disproportionate share of operating cash to pay dividends or buy back shares to boost three-year shareholder returns.

Thus, their share awards would vest and the plan would end up with an unintended consequence of rewarding management for sacrificing the strategy.

Proponents of a shorter-term performance period argue that long-term alignment can be achieved by requiring management to hold shares for a reasonable period of time (say two or three years) after they have vested.

Alternatively, require them to accumulate stock to a certain ownership level, defined in dollar value or number of shares.

In fact, more than 80 per cent of Fortune 100 companies implement a formal stock ownership policy covering their key management personnel.

But stock ownership policy by itself cannot solve short-termism - since management's priorities will be guided by what they need to achieve in order to vest the share awards, before needing to hold them for the required period.

ASSESSING LONGER-TERM PERFORMANCE TARGETS

If the case for longer-term performance targets is so deceptively simple, why are there few companies implementing it?

The reason may lie in a phenomenon behavioural economists call "hyperbolic discounting"; which they argue is wired in the way our brains work. The October 2016 issue of Harvard Business Review refers to a study that suggests that executives discount distant payouts at 30 per cent per annum, about four-five times compared to what the rationalist economic model would suggest. Thus the perceived value of a performance award that vests over five or six years is drastically lower than one that vests over two or three.

How do we mitigate the problem of hyperbolic discounting when it comes to LTIs?

Potentially, by structuring a remuneration package that strikes a good balance between annual performance, retention and longer-term performance. This may be contrarian to the widely-held opinion that calls for a greater proportion of pay to be delivered through LTIs; but it does alleviate the problem of executive management heavily discounting the performance pay package, thus rendering it ineffective. Singapore large-cap companies also have fewer constraints to structure a more balanced executive compensation package, given the conspicuous absence of proxy advisors or tax guidelines that are more benign towards long-term incentives.

Another contention often held against longer-term performance periods is that locking targets upfront over a five- or six-year period is challenging, with all the fluidity around regulation, competition, economy or the equity markets.

Perhaps the solution to this lies in choosing a succinct set of performance criteria (ideally two and no more than three) that constitute an indispensable aspect of management's remit. Management's ability to generate Shareholder Returns in excess of Cost of Equity over a long-term horizon is one such measure.

Besides, when shareholder returns are computed over a longer-term horizon, they tend to dampen the impact of short-term market volatilities on performance evaluation. Another essential performance component could be milestones or outcomes that represent successful deployment of the strategy. Examples include revenue/profit from new platforms, products or services, and penetration/expansion of target customer base.

RECENT TRENDS

Some prominent global companies have stepped beyond convention and developed a more progressive performance share programme. Exxon Mobil's performance share programme is awarded based on a combination of several performance criteria including trailing shareholder returns, returns on capital, and strategic business results. Half of the awards vest at the end of five years and the other half at end of 10 years or retirement, whichever is later.

In its annual remuneration disclosure, the firm states that the Exxon Mobil share programme is better aligned with sustainable shareholder value, promotes long-term accountability, discourages under-investment to boost short-term shareholder returns, and is consistent with the impact of project decisions that typically span over a period of more than 10 years, compared to a traditional three-year performance vested plan.

Apple's performance share programme vests based on three-year shareholder returns relative to S&P 500; however it also awards a restricted share programme that vests over an eight-year period.

Three years may be the optimal performance horizon for a share programme but must not be the default performance period. So, as remuneration committees decide on executive pay, they may find it well worth revisiting their LTI plan, and solving the "time" horizon with the firm's unique context in consideration.