Performance shares earned contingent on performance metric of Relative Total Shareholder Return (“RTSR”) are the most prevalent in the global marketplace. Further, recent studies show that an average of 2.1 different metrics were utilized in the typical CEO performance plan in 2018. However, there are distinct approaches for incorporating multiple metrics into a long-term incentive plan (“LTIP”). The intent of this article is to provide an overview of the approaches for integrating Relative TSR into a performance plan with other metrics.
Multiple Metric Approach #1: Independent – The first approach (and arguably the simplest) is to treat each of the performance metrics independent of one another. The result is that the RTSR metric has no bearing on the results of the operational metric.
Multiple Metric Approach #2: Modifier – Some companies using multiple performance metrics have opted to use a hybrid approach to incorporate both. Because RTSR doesn’t always have a clear line of sight of the actions that will drive shareholder returns, some companies prefer to use an important operational goal that is easily understood to employees (for example, EPS or cash flow). At the same time, they understand the importance of shareholder alignment, thus adding a “modifier” to the internal goal based on RTSR.
Example 1: Company X grants performance stock units with the primary performance goal based on Earnings Per Share growth.
| EPS Growth | Payout Percentage |
|---|---|
| EPS Growth <5% | 0% Earnout |
| EPS Growth of 5% | 50% |
| EPS Growth from 5%-10% | Interpolated between 50%-100% |
| EPS Growth of 10% | 100% Earnout |
| EPS Growth from 10%-15% | Interpolated |
| EPS Growth of >=15% | 200% Earnout |
Further, the earnout is modified ranging from 67% to 133% dependent on RTSR as compared to a peer group, with interpolation ranging between Threshold and Maximum.
| Percentile Rank | Payout Percentage |
|---|---|
| <25th Percentile | 67% Modifier |
| 25th - 50th Percentile | Interpolated |
| 50th Percentile | 100% Modifier |
| 50th - 75th Percentile | Interpolated |
| >= 75th Percentile | 133% Modifier |
This example is seen as a “multiplicative” modifier which is the most common. Occasionally, we do see plans that are designed as “additive” modifiers which can add or subtract incremental shares dependent on RTSR performance (which have their own additional complexities).
Multiple Metric Approach #3: Matrix – This approach incorporates both metrics into a single payout function based on a matrix of earnouts. Consider the following example:
Example 2: Company X grants performance stock units that are earned based on RTSR over the three-year period following the grant date dependent on both the Company TSR compared against peers and against predetermined EPS Goals.
| EPS >5% | EPS >10% | EPS >15% | |
|---|---|---|---|
| 25th Percentile | 0% | 50% | 100% |
| 50th Percentile | 50% | 100% | 150% |
| 75th Percentile | 100% | 150% | 200% |
Now that we have provided an overview of the approaches for integrating multiple metrics, we wanted to provide some high-level pros and cons.
| Approach | Pros | Cons |
|---|---|---|
| #1: Independent | • Most prevalent in the marketplace • Simplest to understand • Easiest to administer | • The RTSR portion may not have clear line of sight of the behavior necessary to drive shareholder returns higher |
| #2: Modifier | • Primary incentive on performance shares are on operational goal with more line of sight • Minimizes the weighting on RTSR which may be out of control of executive (could be a con when viewed from the investor perspective) • Checks the investor guidelines box for having a RTSR plan | • Could potentially yield pay for performance disconnects if strong earnout from the operational metric during poor RTSR periods • “Additive” modifiers can create even more complicated accounting challenges which we don’t recommend |
| #3: Matrix | • Captures the entire award into a single grant | • Potentially significantly more complex accounting and administrative challenges • Can largely be achieved using Independent Approach #1, but not communicating it in the form of a matrix |
