It has been widely reported that CEO pay has been flat or decreased in the past few years, but is this true? A Grant Thornton LLP examination of CEO pay at S&P 500 companies from 2007 to 2012 shows a clear decline in stock option grants in favor of grants of performance-based long-term incentive plans (LTIPs). However, actual pay to these CEOs may not have decreased.
Long-term incentives comprise a significant portion of a CEO's total compensation package: 62% for S&P 500 CEOs in 2012. Of this, 26% was delivered in restricted stock, 30% in stock options and 45% in performance-based LTIPs (percentages are rounded). This shift in compensation challenges companies trying to align executives' goals with shareholders' interests. Like stock options, the award opportunity is granted annually to executives.
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In contrast to stock options, which benefit the holder only if stock price increases from the grant date, payout and shareholder alignment with these plans depends primarily on three factors:
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To better understand how well performance-based LTIPs have aligned with shareholders compared with how stock options have aligned with shareholders, Grant Thornton studied 311 plans maintained by 172 companies in the S&P 500 from 2007 to 2012 (six calendar years of data and four payout periods). The study examined the degree to which plan payouts "tracked" the total shareholder return (TSR) for each company.
Types of LTIPs
The ultimate payout from LTIPs relies on actual performance versus pre-established goals, usually for a three-year period, and is typically based on one of the following:
- Financial-based plans reward for the company's financial results, including such metrics as earnings per share (EPS), sales, revenue, profit, return measures like return on investment capital, cash flow and the economic value added
- TSR/stock price‒based plans reward for a market return to shareholders, either TSR/stock price plus dividends paid or change in stock price from the grant date
Plan payouts versus shareholder return
For plans that paid out in the 2009 to 2011 time periods, the payouts generally corresponded with company total shareholder return and value: As share return and company value increased, payout increased. However, for 2012, the median LTIP payout was $2.7 million, higher than the 2011 median payout of $2.35 million, while the market capitalization of the companies with 2012 payouts was lower than in 2011: $12.2 billion versus $13.2 billion. Similarly, annual TSR over the performance period dropped for these companies in 2012, to 9.5% from 13.9% in 2011. As a result, a greater percentage of shareholder value was transferred to CEOs in 2012, and payouts were higher for lower TSR.
Relative TSR (market)‒based plans versus financial-based plans
Relative TSR (RTSR) plans have constituted the fastest-growing performance LTIP design, mainly because of the difficulty in setting long-term financial goals. Many companies have responded to more-volatile capital markets with the sense that RTSR is a "fair" way to measure shareholder return versus absolute return. In addition, proxy advisory firms such as Institutional Shareholder Services have emphasized RTSR versus a peer group when developing their annual say-on-pay recommendation, as well as their support of share authorization requests.
Unfortunately, these plans have perhaps been the least aligned with shareholders. Compared with plans based on financial goals, the payouts for above-target performance (referred to as a percent of the grant date fair value, or GDFV), RTSR plans appear excessive regarding the level of shareholder return. We also analyzed the degree to which these plans "tracked" EPS growth over the performance period, with similar results. For above-target performance, plans based on financial metrics delivered a CEO payout of $5 million for 32.3% annualized EPS growth, whereas RTSR plans delivered a $4.5 million payout for about 8% less annualized EPS growth (24.5%).
Performance LTIPs versus stock options
Most companies use GDFV, which is what is reported in the SEC proxy tables each year, to determine the number of shares and stock options to grant their CEO each year. To provide deeper insight, Grant Thornton looked at the actual value of the performance LTIP awards realized by CEOs.
We created a hypothetical grant of performance shares and stock options using a common exchange ratio of 1 performance share for 2.5 stock options. We compared the value delivered from a grant of 100,000 performance shares (assuming each share was worth $1 at grant) with the value delivered from a grant of stock options of equivalent GDFV (equating to 250,000 stock options). We modeled this comparison for each payout year using the underlying actual payout levels and annualized TSR for each three-year period. For example, our sample of performance-based plans in 2012 had a median payout equal to 126% of target. So, a $100,000 performance share grant would deliver $126,000 in value following the three-year performance period. Annualized TSR over the three-year performance period was 10.1%. Removing an estimated dividend yield of 2.2% (S&P 500 average dividend yield), a grant of 250,000 stock options would have delivered about $64,000 in appreciation.
Lessons learned
Performance-based LTIPs are probably here to stay. Establishing a performance-based LTIP that aligns appropriately with shareholders is obviously challenging. To assist compensation committees and management in determining if it makes sense to establish a performance-based LTIP, with all the associated work, the Grant Thornton study offers three insights:
- A potential two-times payout multiple for above-target performance for plans that are equity-based (versus cash) provides too much upside pay potential versus risk to the executive. This structure provides greater "leverage" than stock options because of the combination of potential additional shares that can vest along with the likely increase to share price from grant date for plans that exceed set goals. Companies need to carefully consider the combination of a two-times payout multiple with the potential increase in fair market value of the underlying stock at payout date.
- Relative TSR plans in particular are problematic. Most are structured with two-times upside leverage, coupled with the fact that above-average relative rank hasn't meaningfully increased value to shareholders or improved earnings. Relative rank also provides a downside risk protection to the executive that does not exist with a financial-based plan. Companies should look to implement these plans in combination with a minimum absolute return or share-price target hurdle, in tandem with an earnings metric or, if as a standalone plan, with reduced upside potential.
- You can't rely on GDFV to determine a fair tradeoff between stock options and performance LTIPs. These two equity incentives have different risk dynamics and time horizons (which can differ by company). Companies need to undertake "dynamic modeling" that examines potential realizable value, to be realized in the future for each award, and then set an "exchange ratio" of stock options for performance shares that is fair to the executives and the shareholders.
Coming up with an aligned long-term incentive plan is hard work. Stock options have been heavily criticized, and in many cases — such as when a company's stock volatility correlates poorly with its fundamentals — they may not be the right performance incentive. However, our analysis shows that stock options can still be a very cost-effective incentive and more straightforward to implement than a performance-based LTIP.
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