The Fashion of Long-Term Incentives
Carl Sjostrom is a Senior Advisor working across Europe with 20+ years advising boards and management on executive compensation and corporate governance matters. Writing for Global Shares, this article discusses the call to arms in Europe for more shareholder intervention and for simpler and longer long-term incentives, and how it may pay to briefly reflect on how fashion keeps changing.
Incentives go back a long time, but skipping quickly from the apple in the garden of Eden to the end of the last millennium, there are plenty of LTI equivalents to the mini-skirt, the flared trousers and leg warmers. Some are practical, some perhaps not so much.
The staples of the wardrobe
Equity-based incentives really took off when the Clinton administration in the US decided to cap executive compensation at $1 million. Stock options got around this as they could be granted at no cost to the organisation (very much ignoring any dilution). However, share prices couldn’t all increase forever, so to make sure executives didn’t leave they were given an interest in the company through full value restricted stock. The shares were either awarded as a separate long-term incentive or through mandatory or voluntary-with-a-match deferred bonuses.
Then in the 1990s UK investors began to recognise the correlation between well run companies and those with executive compensation under control. Performance conditions were insisted on for stock options and Reuters in the UK were the first onto the catwalk with performance shares instead of restricted stock. Executive pay was no longer about paying a going rate with an attractive lock-in mechanism but more about rewarding both past and future performance.
Following the introduction of the performance share plan there has been no real innovation of “staples” but there have been a lot around variations and accessories. We have seen options morphed into premium priced as well as “super options”, restricted stock into sweet equity, deferrals into bonus banks and performance shares into co-investment vehicles, to name but a few.
What has brought design features in or out of fashion has mainly been twists and turns in regulation and proxy advisors’ and investors’ agendas. Like colours of clothing collections, design requirements change all the time. The regulatory impact moves from tax to disclosure and risk whilst for the investment community anonymous trendsetters determine that 2-year restricted periods are very bad but 3 years are good – and then it is 5 or even 7 years.
Retro and vintage
Just as in the fashion for clothes, the fashion for incentives sees a lot of recycling.
Stock options came back in the late 1990s with the cash strapped tech companies of the “New Economy”, but quickly lost popularity again when the tech bubble burst, followed by spate of corporate scandals and then the near mortal blow of IFRS2 putting them firmly on the Income Statement in 2005. They still do re-emerge from time to time – typically as an indicator of expected bull markets.
When companies turn away from options they tend to opt for performance shares. The mantra moves to “alignment of interests with shareholders” whilst “not paying for failure” with whole shares being combined with reward for delivery of long-term performance. But the anxiety over the in-built complexity of performance shares is always a topic for debate. If performance targets make sense to participants they are often opaque to investors – and vice versa. This has led to annual reports spending more ink on explaining incentives than corporate strategy, with a constant search for simplification. But observers use different yardsticks, so depending on country and sector, different absolute and relative metrics and whether or not Boards should be allowed to exercise discretion go in and out of fashion perennially.
There was a renaissance in restricted stock through deferred bonuses following the financial crisis. Deferral into shares, with an additional holding requirement, was no longer there to retain staff, but instead to reduce risk-taking. Incentives were blamed for the crisis and politicians now over-ruled investors on financial services pay design. The fact that Lehman Brothers had been key to the crisis whilst deferring between 64% and 88% of executive bonuses, with an additional two-year holding period, was rarely reflected on. The fundamental consequence of this is that executive compensation is now determined more by a broad societal agenda than by owners or the business.
What is in and what is out this season?
With this broader agenda comes a recognition of an increasing financial divide in society, and investors are pre-empting regulatory attacks on their stewardship by joining the offensive on executive pay. There are calls from several significant investors for simplified long-term incentives, such as using restricted stock rather than performance shares, and over a much longer period of time. The thinking is that performance is too difficult to set and understand over several years, and therefore it is better to provide a simple award that ensures executives are invested in the company’s equity over a very long time. Some even want to go further and drop incentives altogether.
One may or may not agree with the arguments but, regardless, the real problem is the prescriptiveness of fashion – there is very little room for dressing for purpose. Innovation is great and while the constant search for a universal model that will lead to equally universal success is fun for clothes, it is flawed for business. Incentives are not the Philosopher’s Stone that will cure everything and lead to eternal life – they are tools to help manage people with. Do they align the interests of executives with those of shareholders? Yes, sometimes, but it depends. Do they, as most remuneration policies say, attract, retain and motivate? Perhaps to some extent, but that is rarely what incentives do best. Fundamentally the best use for incentives is as signalling tools, which need to be consistent and fit for purpose.
People who participate in and observe incentive plans receive loud and clear signals as to what is expected of them in the way of performance and behaviour. Like a business suit, a tutu or a doctor’s white coat. That signalling needs to be continuously worked on to make the incentive right for the organisation but it is difficult to think of a more effective way to communicate it. It is therefore much better to wear an unconventional incentive that is right and appropriate than to have to look back in a few years’ time and realise the message that was conveyed with that mullet of an LTIP.
About Carl Sjostrom
Carl is a Senior board advisor, executive compensation and corporate governance professional working across Europe. Over his 20+ years advising boards and management, Carl’s work has spanned almost every industry, all types of ownership and he has advised clients across most of Europe and North America, as well as large parts of Asia and Africa. Carl has lived and worked in the UK, Sweden, the US, Hong Kong and France. With a focus on compensation and performance, Carl is a frequent speaker and commentator on topics like strategy, executive pay and corporate governance issues from an international perspective.
Carl started his own firm, Viti Solutions Limited, in 2015 and also remains an associate of Hay Group, where he worked since 2011 holding roles like Managing Director, European head of all reward consulting. Prior to joining Hay Group he was Vice President and Global Head of Compensation & Benefits, member of the Global HR Leadership Team, at Ericsson, based in his native Sweden. Carl began his career advising banks and investment management companies on levels of compensation with McLagan Partners, based in the U.K., the U.S. and Hong Kong. He then moved into executive compensation on joining Arthur Andersen in the UK. In between Andersen and Ericsson he was a partner in the U.K. executive compensation practices of Deloitte and KPMG. Carl has an undergraduate business degree from the University of Buckingham and master and doctorate business degrees from Oxford University.
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