Performance Awards: Rewarding Results or RSUs in Disguise? Research indicates that performance awards tie to company results.

Transcription

1 Performance Awards: Rewarding Results or RSUs in Disguise? Research indicates that performance awards tie to company results. Introduction For the fi rst time in executive compensation history, more than half of companies are granting performance-based incentive awards as part of their standard long-term incentive program. 1 The most likely reasons for the rise in performance awards include shareholders expectations for better alignment between executive pay and performance and increased shareholder pressure with Say on Pay (introduced to U.S. publicly traded companies in 2011 as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act). Additionally, some shareholder activists as well as many proxy advisory fi rms do not believe that time-vested stock options motivate better performance. Add it all up, and performance awards are becoming a more prominent component of many companies executive compensation programs. For purposes of this research, a performance award is a Stock Award or Unit where the payout of the underlying shares is contingent on the achievement of specified performance metrics. While the use of performance awards is becoming increasingly common, their effectiveness in aligning pay with actual company performance has remained in question. To answer this question, ClearBridge Compensation Group and Fidelity Investments teamed up to examine the relationship between performance awards and company performance. We discovered that the majority of payouts under performance awards are in alignment with a company s relative performance, indicating that these awards are an effective tool for aligning pay with performance. This is particularly true when performance is measured based on total shareholder return (TSR) or earnings per share (EPS) versus performance of the S&P 500 Index. This alignment exists regardless of the actual performance measure used to determine the award payout, signaling that performance awards can serve as a meaningful vehicle to align employees interests with shareholders interests. Details of our research findings, as well as a summary of our methodology, are provided in this report. Research Highlights Performance award payouts are aligned with company performance: Approximately 70% of awards refl ected this alignment with TSR or EPS, regardless of the actual performance criteria used to determine award payouts. No single measure stands out as yielding higher payouts or driving better results. Relative metrics versus absolute metrics yield little difference in award payout. Three-year performance awards have a statistically stronger correlation between pay and performance than performance awards with shorter performance measurement periods. 1 Equilar 2012 Equity Trends Report covering equity practices among companies in the S&P 1500 index. A research study conducted by: ClearBridge Compensation Group and Fidelity Investments

2 Research Methodology Company Statistics ClearBridge analyzed performance award data collected from Fidelity s Stock Plan Services for 89 clients with share-based performance awards having performance periods of one year or more. The total number of participants in these plans ranged from two to 2,439 employees, with an average of 178 employees. Additional research statistics are provided in Exhibit 1. Exhibit 1: Key Statistics among Companies with a Performance Plan (# companies; n = 89) Number of Employees Market Capitalization % of Employees Receiving Performance Award Vesting Years Performance Period Years <2.5K 2.5K 10K 10K 25K 25K 100K >100K <$1B $1B $5B $5B $10B $10B $25B >$25B <1% 1% 5% 5% 10% 10% 15% >15% year 2 years 3 years 4 years 5 years 18% 23% 51% 7% 1% 1 year 2 years 3 years 4 years 32% 14% 44% 10% Analyzing the Pay and Performance Relationship We analyzed 106 performance award payouts spanning a period of fi ve years (2008 through 2012). These payouts were compared to a company s performance, measured by a company s performance relative to performance of the S&P 500 index. Specifi c performance measures analyzed included: Revenue growth Net income growth Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) growth Earnings per Share (EPS) growth Return on Capital (ROC) Return on Equity (ROE) Total Shareholder Return (TSR) 2 2 Total Shareholder Return (TSR) is defi ned as stock price appreciation, including reinvestment of dividends. 2

3 The pay and performance relationship was analyzed over the same period as that of the performance award measurement period. For example, the payout for a performance award with a three-year performance measurement period ending on December 31, 2011, was compared with a company s performance relative to the S&P 500 for the same three-year period ending December 31, Each performance award payout (ranging from a zero payout to a maximum payout under the plan) and a company s corresponding performance ranking relative to the S&P 500 were plotted on a pay/performance scale. The pay/ performance scale was divided into four quadrants refl ective of the pay-and-performance alignment (see Exhibit 2). Exhibit 2: Pay/Performance Alignment Max Low Performance/High Pay High Performance/High Pay Performance Award Payout Target Low Performance/Low Pay High Performance/Low Pay 0% 50% 100% Company Performance Percentile Rank Relative to the S&P 500 Payouts falling in the upper right quadrant ( High Performance/High Pay ) or lower left quadrant ( Low Performance/ Low Pay ) are considered to be aligned with a company s relative performance. Payouts falling in the other quadrants represent a potential disconnect between pay and relative performance. In addition, regression analyses were performed to assess the statistical correlation between payouts and relative performance. 3

4 Performance Awards: Aligned with Performance? Performance Award Payouts vs. Relative Performance As described, performance award payouts were assessed versus a company s relative performance over the same time period as the performance period covered by the performance award. When performance award payouts were compared against a company s TSR performance versus the S&P 500, 76 of 106 observations (72%) fell within the upper right and lower left quadrants, indicating that there was alignment between payouts and relative TSR performance (see Exhibit 3). Exhibit 3: TSR Performance versus S&P 500 (n = 106) Max Low Performance/High Pay (n = 19) High Performance/High Pay (n = 50) Performance Award Payout Target R 2 = Low Performance/Low Pay (n = 26) High Performance/Low Pay (n = 11) 0% 25% 50% 75% 100% TSR Percentile Rank Relative to the S&P 500 It is worth noting that not all performance award payouts are based on a company s TSR (in this case only 29 of the payouts, or 27%, are based on TSR). However, in the majority of cases, award participants were rewarded when the company s TSR outperformed the S&P 500, and were not rewarded when company TSR underperformed. This signifi es alignment between employees and shareholders interests. While the results of this analysis indicate that pay and performance are aligned overall, almost one-third of the payouts indicate a potential disconnect between pay and performance. Moreover, there are several signifi cant outliers where we see high payouts for relatively poor performance, and, conversely, payouts below target when performance is 4

5 relatively strong. These outliers are primarily due to the payouts being based on measures other than TSR. However, if a performance award is based on metrics other than TSR and in the near term, payouts appear to be misaligned with TSR performance it is important for the company to understand the reasoning behind this potential pay-and-performance disconnect and have a sound business rationale for it, particularly in today s Say-on-Pay environment. In any case, the performance criteria used in performance awards should ultimately create long-term shareholder value over time. Replicating the TSR pay/performance analysis for EPS growth performance versus the S&P 500, we fi nd similar results. In 61 of 87 observations (70%), payouts align with performance payouts tend to be at or above target when relative EPS growth is at or above the median EPS growth for S&P 500 companies, and payouts are generally below target when relative EPS growth is below the median S&P 500 EPS growth (see Exhibit 4). Similar to TSR, only 21 of the 87 (24%) performance award payouts were actually based on a company s EPS performance, yet there is still clear directional alignment between a company s relative EPS performance and payouts. Exhibit 4: EPS Growth Performance Versus S&P 500 (n = 87) Max Low Performance/High Pay (n = 14) High Performance/High Pay (n = 41) R 2 = Performance Award Payout Target Low Performance/Low Pay (n = 20) High Performance/Low Pay (n = 12) 0% 25% 50% 75% 100% EPS Growth Percentile Rank Relative to the S&P 500 Interestingly, the correlation between performance award payouts and relative EPS growth is greater than the correlation between payouts and relative TSR, and with fewer signifi cant outliers. 3 While it is uncertain as to why EPS has a stronger statistical correlation than TSR, we surmise that EPS is less infl uenced by external market forces compared with TSR and, therefore, is more closely representative of the performance measures actually used to determine payouts. 3 The correlation between performance share payouts and relative EPS growth has an R-Squared of , while the correlation between performance share payouts and relative TSR has an R-Squared of

6 Not surprisingly, relative growth in other earnings-related metrics provided similar results to those of relative EPS growth. However, metrics such as revenue growth and returns (e.g., ROC and ROE), when also measured on a relative basis, did not result in as strong a correlation between performance and payouts. Exhibit 5 summarizes payout alignment relative to the S&P 500 for various performance measures. Pay-and-Performance Alignment refl ects the percentage of observations falling within the top right quadrant or the bottom left quadrant of the pay/performance chart, while Payand-Performance Disconnect refl ects the percentage of observations falling within the top left or bottom right quadrants of the pay/performance chart. Exhibit 5: Relationship between Pay and Relative Performance (% of Observations) TSR 28% 72% EPS Growth 30% 70% Net Income Growth 30% 70% EBITDA Growth 32% 68% ROE 40% 60% ROC 42% 58% Revenue Growth 43% 57% Pay-and-Performance Disconnect Pay-and-Performance Alignment 6

7 Pay for What Performance? Prevalence of Performance Measures in Performance Awards As shown in Exhibit 6, TSR and earnings-based metrics (such as EPS and net income) are the most common fi nancial performance measures used among companies with long-term performance awards. Additionally, it is not uncommon for companies to use more than one measure in the formula for earning performance awards. Exhibit 6: Prevalence of Performance Metrics Used in Performance Share Plans (% of companies) EPS/Net Inc/EBIT 36% 43% 48% TSR 28% 35% 45% ROC/ROE 17% 21% 26% Revenue 11% 20% 24% Cashflow 6% 8% 11% 0% 10% 20% 30% 40% 50% Fidelity PwC Equilar Source: Fidelity Stock Plan Services Participant Survey, January 2011; Equilar.com/knowledge-network/research-articles/2012/ performanceshares-article.php; PwC Equity Compensation Study, January In addition to fi nancial measures, several companies also incorporate strategic measures in their performance awards. Examples of strategic measures include cost-reduction goals, quality control and internal project milestones. 7

8 Are Companies Cherry Picking Performance Measures? We analyzed the relationship between the fi nancial performance measures used in performance awards and actual performance award payouts. Based on this analysis, performance awards earned based on TSR, EPS, or a return measure paid out at or above target nearly two-thirds of the time, more often than performance awards based on other fi nancial metrics (see Exhibit 7). While no single performance measure stands out as yielding a higher payout over others, performance awards based on revenue goals resulted in below target payouts more often (approximately 70%) than any other measure. This may be due to a low sample size, where only 11% of clients analyzed use revenue as a performance measure for their performance awards. On the other hand, companies may be less likely to use revenue as a basis for determining performance award payouts because they are not as confi dent in their ability to set realistic revenue goals, particularly those companies in highly cyclical businesses. Exhibit 7: Performance Award Payouts by Performance Measure TSR 14% 21% 3% 52% 10% EPS 23% 18% 59% Other Earnings 33% 33% 33% Revenue 29% 43% 14% 14% Returns 9% 18% 55% 18% Other Financial 33% 50% 17% 0% 25% 50% 75% 100% Zero Below Target Target Between Target and Max Max 8

9 Absolute vs. Relative Metrics: Which Are Better? When designing a performance award, the decision on what performance to measure is quickly followed by how performance should be measured. Specifi cally, should performance goals be set based on absolute (internal) standards or relative to an external benchmark, such as a peer group or a broad market index like the S&P 500? Institutional investors and proxy advisory fi rms generally evaluate a material portion of a company s pay-and-performance relationship on a relative basis. Therefore, companies may feel pressured to adopt measures that align with advisor guidelines based mainly on analysis of relative measures to garner positive Say-on-Pay vote recommendations from proxy advisors. Challenges also exist with setting absolute long-term performance goals in volatile and uncertain market conditions. Therefore, many companies although not yet a majority have adopted relative measures in their performance awards. This helps to ensure that all companies are subjected to and affected equally by uncertain markets, and that participant payouts are not negatively affected solely by poor markets. Despite the challenges compensation committees and management are facing when selecting performance measures and setting goals, there is little difference in how performance awards based on absolute goals and performance awards based on relative goals paid out. Performance awards based on a combination of absolute and relative measures, however, more often (75% of the time) paid between target and maximum compared with awards based solely on absolute or relative performance (see Exhibit 8). Exhibit 8: Performance Award Payouts, Absolute vs. Relative Metrics Relative 17% 28% 6% 39% 11% Absolute 18% 23% 3% 45% 13% Both 13% 13% 75% 0% 25% 50% 75% 100% Zero Below Target Target Between Target and Max Max 9

10 When Business Results Decline: How Do Performance Awards Perform? Regardless of the manner a company chooses to measure and track performance, shareholders expect that when business results decline, incentive award payouts should respond accordingly. Shareholders do not want performance awards to result in lavish compensation on underperforming executive management teams. An analysis of performance award payouts vis-à-vis a company s growth in revenue and net income over the same performance period indicated that performance awards are in fact rewarding positive business performance and are punitive for negative business performance. Exhibit 9: Revenue Growth versus Performance Award Payout Positive Growth Negative Growth Number of Payouts Max Between Target and Max Target Below Target Zero Award Payout Exhibit 10: Net Income Growth versus Performance Award Payout Positive Growth Negative Growth Number of Payouts Max 0 Between Target and Max 3 2 Target Below Target 1 Zero Award Payout As a positive sign that performance awards are aligned with business results, Exhibits 9 and 10 illustrate that performance awards pay out above target most often when companies realize a positive business result, while most occurrences of zero payout are associated with negative results. Particularly when business performance is measured by net income growth, our analysis showed strong alignment between payouts. Payouts at or above target most often aligned with a positive net income growth; conversely, payouts below target or zero aligned with negative net income growth. 10

11 The Impact of Performance Periods on the Pay-and-Performance Relationship Three-year measurement periods continue to be the most common time horizon to assess performance under performance-based incentive awards (see Exhibit 11). 4 However, in recent years we have seen a rise in shorter performance periods, such as one or two years. This refl ects another approach companies have taken to mitigate the diffi culties in setting multiyear performance goals in an uncertain economic environment. Exhibit 11: Prevalence of Performance Periods in Performance Awards 76.8% 68.5% % 14.7% 13.0% 2.2% 3.2% 5.3% 1 Year 2 Years 3 Years 4+ Years Source: Based on data from ClearBridge 100, a proprietary database of executive compensation practices among 100 S&P 500 companies representing a cross section of industries. Given the notion that setting realistic performance goals over a shorter period tends to be easier than setting goals over a multiyear period, we would expect that performance awards with a one-year measurement period would result in better pay-and-performance alignment than performance awards with a three-year measurement period. We tested this theory and found the converse to be true. As Exhibit 12 indicates, the pay-and-performance relationship, where performance is defi ned as EPS growth relative to S&P 500 companies, does not correlate as well as we would have expected for one-year performance awards. In fact, we found high pay resulted from low performance 53% of the time (8 out of 15 occurrences of low performance paid at or above target), which is counter to achieving alignment between pay and performance. 4 Based on data from ClearBridge 100, a proprietary database of executive compensation practices among 100 S&P 500 companies representing a cross section of industries. 11

12 Exhibit 12: EPS Growth Performance versus S&P 500 One-Year Plans (n = 34) Max Low Performance/High Pay (n = 8) High Performance/High Pay (n = 16) Performance Award Payout Target R 2 = Low Performance/Low Pay (n = 7) High Performance/Low Pay (n = 3) 0% 25% 50% 75% 100% EPS Growth Percentile Rank Relative to the S&P 500 On the other hand, despite the struggle many companies experience with setting meaningful, realistic goals over longerterm periods, three-year performance awards have a statistically stronger correlation between pay and performance, and fewer signifi cant outliers, than performance awards with shorter measurement periods (see Exhibit 13). 5 Given that short-duration performance awards did not yield better alignment with payouts, we tried to understand why there was an unexpected outcome. One theory to explain the stronger correlation of payouts to three-year performance measures could be the time it takes for strategy to correspond with performance. 5 Three-year performance awards have an R-Squared of , while one-year performance awards have an R-Squared of

13 It is diffi cult for a senior management team to create a strategy, communicate the direction to its executives and to drive execution all in a one-year time frame. In situations where performance is relative, it may be that over a three-year period a company has more opportunity to develop, implement, and execute a strategy effi ciently. Then, company performance relative to peers or benchmarks can be better realized. The longer three-year duration allows for the performance to be adequately refl ected against the measurements, and it s possible that the one-year time frame does not allow this dynamic to occur. Exhibit 13: EPS Growth Performance versus S&P 500 Three-Year Plans (n = 41) Max Low Performance/High Pay (n = 5) High Performance/High Pay (n = 18) Performance Award Payout Target R 2 = Low Performance/Low Pay (n = 11) High Performance/Low Pay (n = 7) 0% 25% 50% 75% 100% EPS Growth Percentile Rank Relative to the S&P

14 Performance Awards vs. Stock Options: Which Better Aligns with Creating Shareholder Value? As the prevalence of performance awards has been on the rise, the prevalence of stock options has been declining. In 2007, 78.8% of companies were granting stock options compared with only 70.0% in Given this evolution in longterm incentive plan design, we wondered whether the economic payoff was greater for employees granted performance awards instead of traditional stock options. To answer this question, we compared the value delivered from a performance award with the hypothetical in-the-money value of a stock option award granted at the same time as the performance award. Conventional wisdom would suggest that, over time, in-the-money stock option values would surpass the payout values earned from performance awards. Surprisingly, this was not always the case. Assuming all performance awards earned and stock options granted were held (i.e., not sold) for the same time period, performance award values remained higher than the in-the-money value of stock options in a majority of the cases. When we assumed all performance awards earned were sold immediately after they were paid out (i.e., when the performance period ended), the in-the-money value of stock options exceeded performance award values, but only after 10 years from grant, and only by a slim majority. Exhibit 14: Performance Awards versus Stock Options: Which Has More Value? 93% Stock Options 68% Performance Awards 43% 57% 46% 54% 52% 48% 32% 7% End of Perf. Period 7 Yrs. from Grant Performance Awards Held 10 Yrs. from Grant 7 Yrs. from Grant Performance Awards Sold 10 Yrs. from Grant Source: Equilar 2012 Equity Trends Report covering equity practices among companies in the S&P 1500 index. 6 Equilar 2012 Equity Trends Report covering equity practices among companies in the S&P 1500 index. 14

15 Conclusion The results of this study clearly support the market trend toward greater use of performance awards. Performance awards have resulted in strong pay-for-performance alignment, especially when assessing performance against key metrics such as TSR and EPS over a longer performance measurement period, such as three years. Shareholders are placing considerable weight on the relationship between pay and performance when assessing a company s executive compensation program, and performance awards are effective vehicles to demonstrate that a pay-for-performance relationship exists. Equally important as addressing shareholder concerns, an effective long-term incentive program should also address employee perspectives. Fundamentally, employees look for their long-term incentive awards to motivate and reward them for increasing company value. Based on our fi ndings, performance awards tend to deliver greater rewards versus traditional time-vested stock options, and therefore are likely to have greater perceived value by employees, which in turn is likely to be more motivating for employees. The alignment we see between performance award payouts and TSR or earnings-based metrics might suggest that companies should adopt performance awards based on these metrics to simplify awards and potentially enhance the pay-and-performance relationship. In the end, however, the choice between TSR and other performance metrics comes down to recognizing the primary objectives of the performance award. If these objectives are to pay for results and ensure strong pay-for-performance alignment, then TSR may be the best metric. If the performance award is intended to be used as a tool to drive performance and change or focus employee behaviors, use of fi nancial and/or strategic-based metrics may be more benefi cial to ensure direct line of sight, provided that these metrics ultimately result in the creation of longterm, sustainable shareholder value. 15

16 About the Authors: Yonat Assayag Partner, ClearBridge Compensation Group, LLC Yonat Assayag is a partner at ClearBridge Compensation Group, an independent executive compensation consulting fi rm. Ms. Assayag has over fi fteen years of experience advising boards and senior management on performance measurement and compensation strategy and design, with the ultimate goal of aligning reward programs with the creation of shareholder value. Her client experience includes working with both publicly-traded and privately-held companies in a variety of industries. Prior to joining ClearBridge, Ms. Assayag was a Principal at Mercer specializing in executive compensation, and prior to that she held various corporate HR roles. She has spoken frequently at conferences and authored numerous articles on executive compensation issues. Ms. Assayag holds an MBA from New York University s Stern School of Business and a BS in Business Administration from Syracuse University. Carl J. Stegman Senior Vice President Product Management, Fidelity Stock Plan Services Carl Stegman is Senior Vice President of Product Management for Fidelity Stock Plan Services. With fi fteen years of experience in fi nancial services and managing system applications, Mr. Stegman helps drive the success of Fidelity s Stock Plan Services product offering, serving U.S. multi-national public companies and their global participant base. For the last seven years, he has been dedicated to the Stock Plan Services business focused on delivering enhanced functionality to clients and their participants. Mr. Stegman earned a Bachelor s degree from Northeastern University, Boston, MA and an MBA in Management Information Systems (MIS) from Bentley College, Waltham, MA. He is Series 7, 63 and 24 registered. RESEARCH METHODOLOGY: Analyzed performance award data collected from Fidelity s Stock Plan Services for 89 clients with share-based performance awards having performance periods of one year or more. Analyzed 106 performance award payouts spanning a period of fi ve years (2008 through 2012) and only included payouts where a company s plan allowed a maximum payout to be above the plan s target payout. Payouts were categorized based on the company s TSR and EPS performance relative to the performance of the companies in the S&P 500 index for the same measure. The pay and performance relationship was analyzed over the same period as that of the performance award measurement period. For example, the payout for a performance award with a three-year performance measurement period ending on December 31, 2011 was compared to a company s performance relative to the S&P 500 peer group for the same three-year period ending December 31, FOR PLAN SPONSOR USE ONLY. ClearBridge Compensation Group and Fidelity Investments are not affi liated. The Fidelity Investments and pyramid design logo is a registered service marks of FMR LLC. Investment and workplace savings plan products and services offered directly to investors and plan sponsors are provided by Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfi eld, RI CB/Fidelity-WP-1112