Long-Term Incentive Plans (“LTIPs”) are a common element of executive compensation across all listed companies. Alongside short-term bonus plans, they comprise the variable element of executive pay which is typically 60%-plus of the total potential payout (although this figure varies significantly), up from 20% or so a decade ago.
Set by remuneration committees, they have two principal aims, according to Citi analysts:
to retain key senior executives in the “war for talent”, and
to align the executives’ decision-making to both the fundamental mission of the organization and the interests of various stakeholders.
Short-term bonus programmes are by definition aimed at the shorter-term objectives of the board and rely heavily on financial performance. LTIPs represent a better opportunity for remuneration committees to interpret the over-arching philosophy of the organization and bring in the longer-term interest of other stakeholders.
Another characteristic of LTIPs is that their terms are relatively stable. Studies carried out over several years in the annual flagship “Trawling The Accounts” research published by the Citi Business Services team suggests that only around 5% of surveyed groups change the terms of the annual LTIP award in any one year (usually by adjusting the weightings of the individual components).
Do LTIPs work?
Despite the large body of research on the effectiveness of different compensation structures, there is still debate. One potential effect of LTIPs is to increase executives’ shareholding in the company. Anecdotal evidence suggests that overall employee share ownership might have a stronger correlation with long-term performance as it enhances overall employee engagement. This could be a future LTIP target for committees to consider.
Why are LTIPs so similar?
When setting LTIP performance criteria, the Citi report says there seems to be a clear fear of being different from peers and just as strong an emphasis on peer performance – especially in share price terms – as there is on the performance of the company itself. This goes back to the war for talent but what it means in practice is that change, when it comes, is likely to come rapidly.
What is likely to drive change?
Remuneration structures of listed company management teams are generally very transparent. As such, the structures are easily scrutinised by regulators and government bodies. It is from these sources that analysts say the impetus for change will come. Some evidence has already emerged of popular pushback against the influence that large technology companies have in society today and the impact that new technology can have on the workforce (see Citi GPS: TECHNOLOGY AT WORK v4.0 - Navigating the Future of Work.
What changes can be anticipated?
A broader set of performance targets is likely in the future beyond the standard financial criteria used today. Pressure could rise for a greater proportion of the performance assessment to be carried out by independent third parties, which in turn would bring greater transparency.
Climate change and LTIPs
Climate change and ESG-related metrics have begun to appear more frequently in corporate statements and are slowly finding their way into remuneration reports, albeit in fragmented fashion. How quickly these initiatives make themselves into the specifics of LTIP schemes will be worth monitoring. Furthermore, investors will be watching what steps boards take to ensure that measurements are carried out and/or corroborated by independent parties.
On the latter point, the role of third parties (specifically those who uphold accounting standards worldwide) seems to have been somewhat sidelined in discussions between management and financial analysts by the widespread use of adjusted financial data (and remuneration committee discretion) when measuring executive performance.
Some 2021 remuneration reports even suggested that ESG measurement was not yet sufficiently developed to be included in that year’s plans and this could be due to lack of robust and verifiable data or simply resourcing. Arguably, the urgency of climate change means that it is better addressed in shorter-term performance targets, particularly if the alternative is a relatively modest weighting over three years (or more) in an LTIP.
Citi’s ESG Research team has argued for some time for near-term, forward-looking climate metrics to effectively evaluate executive oversight and ownership of ESG-related issues. Investors are acutely aware that many ESG targets are in some cases beyond the tenure of the current management team, so having credible near-term targets is an effective way to evaluate progress.
Although LTIPs can play an important role in focusing leaders’ minds on climate change, the Citi analysts say it would be wrong to place the full burden of meeting performance targets on a chief executive. More reasonable and effective would be to design LTIPs in harmony with overall board accountability. In a climate context, this could include asking questions such as:
To what extent are climate risks and opportunities incorporated into the board’s understanding of directors’ (fiduciary) duties?
Do board directors undertake decisions informed by the best available information on climate risks and opportunities? How is this disclosed or evidenced?
Does the board conduct internal performance reviews? Is accountability for climate risks and opportunities considered during internal evaluations of the board?
Are independent performance audits undertaken? If so, do these include climate considerations?
For more information on this subject, please see European Small & Mid-Cap - Lessons and trends from long-term incentive plans and ESG & SRI - Part II: What Issues Should Investors Prioritise? Boosting an ESG Engagement Strategy.
Citi Global Insights (CGI) is Citi’s premier non-independent thought leadership curation. It is not investment research; however, it may contain thematic content previously expressed in an Independent Research report. For the full CGI disclosure, click here.