Compensation Foundations: Long Term Incentive Plans

This week’s column is the third in a series that I co-author with Ray Everett, the chief executive of Aon Hewitt in the Middle East.

In our previous articles we spoke about salary – what you give people to show up every day, and incentives – what you pay them to do their job well. In today’s column we’ll cover Long-Term Incentive Plans (LTIPs) – what you pay people to do their job well over the mid to long term.

There are two basic forms of LTIPs:

  • Full value awards, which have value immediately and the value can go up and down; the best example of this would be a restricted stock award. In this case there is both a carrot, the value can go up, and a stick, the value can go below that of the initial award.
  • Appreciation awards have no immediate value but can have value over time. The best example of this would be a stock option which usually will only become valuable as the stock price increases.

There are several considerations when thinking about LTIPs. A major one faced in the region is whether the award is actual shares in the company or whether a cash value equal to the shares is awarded. There are several issues involved, one of the main ones faced in the region is that a physical share award is often unwanted – for example, a family group does not want employees introduced into the shareholder structure, or it can be impossible, such as with a government institution or a division within a company.

The second issue in the stock versus cash debate is how it is funded. If shares are awarded then this will not affect the operating cash flow, an important point. If the company pays cash in lieu of stock it not only has a cash outflow, for unlisted companies there is the issue of how to price the shares.

A third issue affects the physical share award in an illiquid company, such as a family company. Employees are not going to be thrilled about receiving shares that cannot be converted into cash.

The final issue that we will look at is that LTIPs can have a serious and unpredictable effect on the profit of the company. Understanding these effects is critical to avoid any unpleasant surprises in later years.

We defined LTIPs as medium- to long-term incentive plans. The time component is related to what is called vesting – how and when the rewards are transferred to the employee. There are two conventional variables here: time and performance. At one end of the scale an employee simply has to remain in his job for his awards to vest. At the other end, the employee has to meet certain performance targets, such as return on equity (ROE), to vest. Most plans will have to meet a combination, for example, achieving an annualised ROE of 12 per cent over a five-year period.

A major question is what happens if an employee leaves early? If the award is purely time based, say three years, and the employee leaves after two and a half, do they forfeit everything? Or do they get a pro-rata share? Perhaps something in between makes sense?

These are complex issues with many more not highlighted. Thinking through them for the first time and then making all the decisions that have to be made can seem daunting to the executives of the company, let alone the board, which usually needs to approve such programmes. As a result, a powerful tool that a company can use to recruit, retain and motivate employees is abandoned. This is a double blow during challenging economic times when the value of top employees skyrockets.

Resolving this unique situation of developing and deploying an LTIP, which should happen once with less major works such as reviews and maintenance becoming the norm, requires two major adjustments.

The first is to accept the age-old adage that building something takes a skill set an order of magnitude greater than the skill set needed to maintain what is built. This clearly points to a consultant to come in and help.

The second adjustment is at the board level. The HR team can easily be upgraded to manage an LTIP via training. The board, or representatives of the board, needs training as well. The first step is to ensure that there is a Nomination and Remuneration Committee (NRC) of the board, a standard corporate governance requirement. Among the NRC’s responsibilities would be the ability to understand LTIPs and give recommendations to the full board. Although the NRC could all be trained as necessary, it makes sense for at least one member to have board experience in the matter beforehand.

Ray Everett is the Global President of McLagan (an Aon company).

This article was originally published in The National.