Executive compensation
proportion of companies (39%) also include ESG metrics in their annual incentive plans. “Relative TSR allows you to withstand cycles from a payout or value perspective, as you are incentivising executives to outperform their peers and preserve or build value better than competitors,” says Szabo. The transition that Szabo described in the oil and gas sector includes a change in metrics for performance-based LTI programmes. Absolute TSR, rather than return relative to peers, has become much more prevalent over a three-year period.
“It is now a very common practice in upstream oil and gas companies, though they also use return on capital employed (ROCE), cash return on capital invested (CROCI) or other similar measures that all focus on a common outcome, which is creating shareholder value and generating cash,” Szabo explains. “Energy companies were forced to get more creative to bring investors back.”
In a cyclical or commodity-sensitive industry, such as
energy, the key question is flexibility. Though relative TSR remains a widely used metric, it might be used in conjunction with return on capital in a capital-intensive industry. The Meridian survey further showed that relative TSR is still widely used either as a discrete weighted metric or a performance modifier among the broader marketplace. Its popularity stems from the fact that it provides a clear and direct link to share price performance, all without the need for setting multi- year financial goals. It also serves as a key driver of pay and performance testing models for the leading proxy advisory firms and the new SEC pay versus performance disclosure requirements. It is particularly useful for avoiding reliance on financial forecasting in the current climate, with unpredictable macroeconomic conditions making predictions of future performance extremely challenging. “When performance-based LTIs became more prevalent in the mid-2000s – due to changes in accounting rules and greater shareholder pressure to align LTIs with performance – TSR was preferred for its simplicity,” Szabo says. “It was hard to set a three- year financial target, and with TSR you only had to choose a comparator group and percentiles against which to define awards.”
Moskovitz makes a similar point: “The environment where interest rates decreased for a long time has now inverted, and we have started to see some industries consolidate in response to these external factors. “Instead of trying to measure everything, can we simplify this down to performance and return measures that demonstrate long-term sustainable performance. Relative TSR designs do not come without their challenges; for example, what is the right comparator group when the peers are changing/reducing? The key challenge is how can we create innovative, simple
Chief Executive Offi cer /
www.ns-businesshub.com
designs that align with and drive strategic objectives.” A move to relative TSR as a metric is understandable in a changing market as it asks executives only to outperform their peers in the industry rather than hit an internal target. That allows emergencies like pandemics or operational challenges like supply chain disruptions to be factored in more easily.
Special circumstances Inevitably, situations will arise when awards need to be made that appear to be outside the normal compensation process. Special retention awards made to keep key talent are a prime example. Such awards could be made to prevent management teams from moving elsewhere. Alternatively, they may be used to assuage doubts over new management teams or else dampen bitterness if individuals aren’t chosen for promotion.
“These awards are often shorter-term in focus, maybe 12–24 months, to get a company through a period in which it needs to keep that person or team in place,” Szabo explains. “They are typically time- based, especially if a company is distressed, so they are more likely to become subject to external criticism but are sometimes necessary to preserve continuity of leadership.” “We have seen a lot of these awards in the public domain. Some are reasonable, others less so in the eyes of certain external stakeholders,” Moskovitz adds. “The rationale and design are critical. Companies need to explain the ROI for shareholders. It is not enough just to say an executive is a flight risk.”
In a turnaround situation, an award may be made to drive stock performance. In challenging market conditions, special awards can be tied specifically to stock price. If a company changes remuneration design or else makes special awards, it is sending signals to the market. The more it deviates from market convention, the more shareholders will express concern. The key, therefore, is to achieve sufficient engagement with a diverse base of shareholders, including activist investors, large funds and others – all of which may have different priorities. Therein lies the driver for creativity: designing an award that suits the company’s goals but is also endorsed by shareholders. “I’m surprised the use of premium-priced stock options hasn’t become more prevalent,” says Szabo. “It has its challenges but has an unlimited upside. It could incentivise management to grow value, and proxy advisors see it as performance-based if the goal is at least 10% above the grant date stock price.” “Options have fallen out of favour as proxy advisers do not see them as performance-related,” Moskovitz adds. “But seasoned non-executive directors often prefer the vehicle as they view it inherently performance- based. You win when our shareholders win.” ●
Jon Szabo, partner, Meridian Compensation Partners
Darren Moskovitz, partner, Meridian Compensation Partners
“The
environment where interest rates decreased for a long time has now inverted.”
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