Incentive Pay Metrics: The Long and the Short of It

Income statement-related performance metrics (revenue, operating income) are typical of short-term incentive (STI) plans, whereas market-related metrics (total shareholder return, stock price appreciation) are relatively rare in STI plans but common in long-term incentive (LTI) plans, reveals a Mercer analysis of compensation for executives at companies in the Standard & Poor’s 100 Index.

The analysis finds that LTI plans are generally less complex than STI plans at the same large U.S. companies, using fewer performance metrics and incorporating fewer special conditions.

Mercer analyzed last year’s proxy statements for the S&P 100 as comprised on Jan. 1, 2014.

The most common STI metrics were:

•Profit-based (36 percent of S&P 100 companies use earnings per share; 49 percent use other profit measures).

•Revenues (47 percent).

The typical weighting for income statement-derived metrics such as revenue, operating income, pretax income or net income in STI plans is 55 percent, followed by earnings per share at 40 percent.

The most common LTI metrics were:

•Total shareholder return or stock appreciation (used by 55 percent of the S&P 100).

•Return on assets or return on equity (49 percent).

In LTI plans, the most common metrics—total shareholder return/stock appreciation, return on assets/return on equity, earnings per share, and asset/equity growth—are all typically weighted at 50 percent.

“While nonfinancial metrics like operational efficiency, customer satisfaction, workplace diversity and milestone objectives commonly have lower weightings than financial measures, they can play an important role in signaling the importance an organization places on the different aspects of its operations,” said Peter Schloth, a principal with Mercer specializing in executive compensation, in a commentary accompanying the findings. “For example, it’s common to see safety and environmental metrics at energy companies—and investors are generally supportive of such measures, recognizing the shareholder value that can be destroyed if an organization’s safety or environmental performance is poor.”

A Complementary Mix

“STI and LTI programs need to complement each other,” said Schloth. “Properly designed LTI programs should motivate executives to develop strategies and policies to achieve long-term growth and increase the value of the organization. Effective STI programs should motivate executives to execute on strategies and policies, and make good operating decisions to maximize performance over the course of a year.”

For STI plans, the majority of awards (70 percent) use pre-established targets to evaluate performance, with many compensation committees opting for income statement-based metrics to assess annual performance. LTI awards are more often tied to stock market returns. “This aligns with companies’ goals to grow revenue and expand profit margins over the short term and create market value for their shareholders over the long term,” said Ted Jarvis, Mercer’s global director of executive compensation data, research and publications, in the same commentary.

Number of Metrics

More than 60 percent of companies in the S&P 100 use three performance metrics or less in their STI plans, while 90 percent use three or less in their LTI plans.

“Committees are hesitant to micromanage executives with a lot of performance measures,” said Jarvis. “Metrics and weightings tend to be identical for LTI grantees to ensure alignment within the executive team on the same long-term goals. Some companies take this approach for their STI program, while others tailor metrics and weightings to account for differences in responsibilities among executives.”

Added Schloth, “Too many metrics could diminish an executive’s focus on the most important ones.”

Multiyear Cycles, Annual Awards

The analysis shows that 85 percent of LTI plans use equity shares or units to deliver awards rather than cash. Moreover, three-year cycles are the most prevalent period of time over which performance is evaluated, representing 84 percent of awards.

Even so, most organizations grant LTI performance shares or units annually (based on the just-ended multiyear cycle). According to Schloth, this use of overlapping cycles serves a purpose. “With annual awards, an executive’s rewards are tied to three [annual] performance cycles at all times, which creates a strong motivational and retention device.”

Stephen Miller, CEBS, is an online editor/manager for SHRM.