Key differences exist between long- & short-term incentives

Key differences exist between long- & short-term incentives

Key differences exist between long- and short-term executive incentive awards

  • March 10, 2015
  • United States, New York

Mercer’s latest analysis of compensation for executives at companies in the S&P 100 shows that income statement-related performance metrics (revenue, operating income) are typical of short-term incentives (STIs) whereas market-related metrics (total shareholder return, stock price appreciation) – relatively rare in STIs – are common in long-term incentives (LTIs). Additionally, the analysis finds that LTI plans are generally less complex than STI plans at the same companies, utilizing fewer performance metrics and incorporating fewer special conditions.

“Until recently, specific information about metrics, weightings, and even performance hurdles associated with incentive plans hasn’t been available broadly,” said Ted Jarvis, Mercer’s Global Director of Executive Compensation Data, Research, and Publications. “Public corporations are sharing much more detail about incentives to their senior executives and this newly disclosed data provides invaluable insight about the way companies design and administer their incentive plans.”

According to Mercer’s analysis, financial metrics are included in the majority of short- and long-term incentive awards. Non-financial metrics are fairly common in STI programs, but not LTI. The most common STI metrics are profit-based (36% of organizations use earnings per share; 49% use other profit measures) followed by revenues (47%). Total shareholder return or stock appreciation is the most common LTI metric (used by 55% of the S&P 100) followed by return on assets or return on equity (49%). 

“STI and LTI programs need to complement each other,” said Peter Schloth, Principal with Mercer specializing in executive compensation. “Properly designed LTI programs should motivate executives to develop strategies and policies to achieve long-term growth and increase the value of the organization. Effective STI programs should motivate executives to execute on strategies and policies, and make good operating decisions to maximize performance over the course of a year.”

Many compensation committees opt for income statement-based metrics to assess annual performance, while long-term awards are more often tied to market returns. “This aligns with companies’ goals to grow revenue and expand profit margins over the short term and create market value for their shareholders over the long term,” said Mr. Jarvis.

Some of the differences are a result of varying philosophies for measuring value creation. “While total shareholder return and stock appreciation are directly aligned with shareholders, they are influenced by economic conditions and market perceptions of future performance of the company outside the control of executives,” said Mr. Schloth. “Executives have a more direct line-of-sight and ability to influence value creation metrics like return on assets and return on equity, but there is a risk that performance on these metrics may not directly align with the value shareholders are realizing over the typical two- or three-year performance period.”

Mercer’s analysis also finds that more than 90% of STI performance metrics are evaluated against pre-established goals set by the Compensation Committee. LTI performance metrics are more likely than STI metrics to be assessed relative to a defined peer group or index. For STI, the majority of awards (70%) use pre-established targets to evaluate performance. “Effective calibration of goals is one of the most important and difficult aspects of incentive programs,” said Mr. Schloth. “A holistic approach should consider the organization’s business plan and financial projections as well as the expectations of stock analysts and historical performance for both the company and its peers.”

Number of performance metrics

More than 60% of companies in the S&P 100 use three performance metrics or less in their STI plans, and 90% use three or less in their LTI plans. “Committees are hesitant to micromanage executives with a lot of performance measures,” said Mr. Jarvis. “Metrics and weightings tend to be identical for LTI grantees to ensure alignment within the executive team on the same long-term goals. Some companies take this approach for their STI program, while others tailor metrics and weightings to account for differences in responsibilities among executives.”

Added Mr. Schloth, “While every organization must manage a multitude of metrics to be successful, care should be taken in selecting which metrics to base pay decisions on – too many metrics could diminish an executive’s focus on the most important ones.”

Features of LTI plans

Mercer’s analysis shows that 85% of LTIs use shares or units to deliver awards rather than cash. Moreover, three-year cycles are the most prevalent period of time over which performance is evaluated, representing 84% of awards analyzed, followed by two-year cycles. “Denominating LTIs in shares provides an extra dimension to the awards in that the payout value is impacted by performance against the plan metrics and the organization’s share price at the end of the performance cycle,” said Mr. Jarvis.

According to Mr. Schloth, the use of overlapping cycles is most common. “For most organizations it’s appropriate to grant performance shares or units annually as opposed to granting larger multi-year awards every three years. With annual awards, an executive’s rewards are tied to three performance cycles at all times which creates a strong motivational and retention device.”

Financial metrics

Financial metrics carry the most weight in both STI and LTI awards. Mercer’s analysis finds the typical weighting for income statement-derived metrics such as revenue, operating income, pretax income or net income in STIs is 55%, followed by earnings per share at 40%. In LTI plans, the most common metrics, total shareholder return/stock appreciation, return on assets/return on equity, earnings per share, and asset/equity growth, are all typically weighted at 50%.

“While non-financial metrics like operational efficiency, customer satisfaction, workplace diversity, and milestone objectives commonly have lower weightings than financial measures, they can play an important role in signaling the importance an organization places on the different aspects of its operations,” said Mr. Schloth. “For example, it’s common to see safety and environmental metrics at energy companies – and investors are generally supportive of such measures, recognizing the shareholder value that can be destroyed if an organization’s safety or environmental performance is poor.”

Mercer analyzed proxy statements for the S&P 100 (as comprised on January 1, 2014) that disclosed compensation data between 2013 and 2014.

About Mercer

Mercer is a global consulting leader in talent, health, retirement and investments. Mercer helps clients around the world advance the health, wealth and performance of their most vital asset – their people. Mercer’s more than 20,000 employees are based in more than 40 countries and the firm operates in over 130 countries. Mercer is a wholly owned subsidiary of Marsh & McLennan Companies (NYSE: MMC), a global professional services firm offering clients advice and solutions in the areas of risk, strategy and people. With 57,000 employees worldwide and annual revenue exceeding $13 billion, Marsh & McLennan Companies is also the parent company of Marsh, a leader in insurance broking and risk management; Guy Carpenter, a leader in providing risk and reinsurance intermediary services; and Oliver Wyman, a leader in management consulting. For more information, visit Follow Mercer on Twitter @MercerInsights.

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