How long-term incentives are designed to align pay with performance and retention goals

Long-term incentives (LTIs) are a valuable part of a total compensation package both for delivering rewards and for focusing employees on desired future outcomes and objectives. They serve as a retention tool because the value of the reward is typically realized in the future, thereby encouraging the employee to stay engaged and focused on desired results and remain long term with the organization.

Overview: meaning and purpose of long-term incentives

Just as the name suggests, LTIs are those that have an extended time horizon (generally longer than one year). They can be a strategic tool to promote long-term retention and alignment with company goals. When done correctly, LTIs can be a win-win for all participants:

• For employers, LTIs present an opportunity to reward the achievement of long-term plans, promoting buy-in to corporate performance..
• For employees, LTIs can be a reward for outstanding performance and are a vehicle for capital accumulation..
• For shareholders, LTIs are a vehicle that aligns employees with the performance of shares (for market-based equity vehicles) and the long-term vision of the company. When employees become shareholders themselves, they have incentive to increase company value as the performance of the shares directly affects their own compensation.

Next, let’s take a look at how different types of LTIs are designed to meet different objectives.

What are the different types of long-term incentives?

LTIs can be generally broken down into three types:

1. Appreciation-based: Value is delivered based on the increase in the company’s underlying value, which in the case of a public company, is reflected in share price. Employees will receive only the difference between the value of the underlying unit at some point in the future, and the underlying value at the time the units were granted.
2. Stock-based: Value is delivered in shares of the company stock. Payout may be tied to achievement of performance goals, but ultimately, employees will receive a share of the company stock. Note that some companies (and the majority in Canada) may grant “phantom shares,” which track the movement of the value of the underlying shares but pay out in cash.
3. Cash-based: Value is delivered in cash and is not tied to the performance of shares; employees will receive a cash payout, based on service, achievement of predefined performance goals, or both.

What are common long-term incentive vehicles?

Let's first define what an LTI vehicle means. It is the method used to deliver the LTI to an employee. Here are six common LTI vehicles:

Stock options

A stock option entitles the grantee the right to purchase shares of a company at a fixed price (known as the exercise price) in the future. Generally, the option’s exercise price will be the stock’s closing price on the date of the grant. Once a stock option vests (see “What is a vesting period?” below), the grantee can exercise the right to purchase stock at the exercise price. For example, if a share is trading at $10, and the exercise price is $5, the grantee can purchase a share at $5 and sell at $10 in the open market, resulting in a $5 profit per unit.

The window of time that a grantee can exercise the option is referred to as the term. Most companies grant options with 10-year terms. An option has no value if in the future the share of the company is below the exercise price (since the grantee would be paying above-market price, and there would be no impetus to exercise the option). These options are referred to as being “underwater".

Stock appreciation rights

Stock appreciation rights, or SARs, function very similarly to a stock option in that a recipient of an SAR will receive the value of the increase in stock price in cash (though sometimes it is received in stock). The major distinction between an SAR and a stock option is that an SAR does not require the actual purchase of shares.

Time-based restricted stock/restricted stock units

Time-based restricted stock/units are shares that vest based on a predetermined length of time. A company can choose to grant equity based on a predefined value on the grant date or a predefined number of shares (the former is more popular). Unlike an appreciation-based award, a restricted stock will still have value upon vesting even if the per-stock value decreases.

Performance shares/units

Performance shares are also full-value shares; however, the vesting of these types of shares is contingent on meeting predetermined performance goals. These goals can be internal or external, and can be measured on a relative basis (compared to other companies), absolute basis (compared to predefined achievement levels), or both. This LTI vehicle has grown in popularity over recent years due to the ease of linking payout to long-term performance. Metrics used by companies differ but are generally consistent within each industry, since the metrics that define good performance tend to be similar. One of the most popular metrics is total shareholder return, which measures the increase in share price over a predefined period (most commonly three years).

Companies will generally grant 100% of shares at a target level and give the shares both downward and upward leverage (meaning shares can vest at less than 100% for poor performance, and shares can vest at greater than 100% for outstanding performance).

Long-term cash units

Long-term cash units are non–equity-based long-term grants that pay out in cash. The grantee will receive a cash payout after the vesting period.

Performance cash units

Performance cash units are cash-based long-term grants that vest based on performance achievement. These are more common at private companies, due to the difficulty of share valuation.

What are pros and cons of different incentive strategies?

What is a vesting period?

LTIs are typically granted with what is known as a vesting period. A vesting period is the time period that an employee must wait before they can receive the benefits of their LTI. What this means is that grantees are conditionally granted equity, but they do not actually own it until the vesting period is completed. This is the retentive feature of LTIs; unless the grantee fulfils the applicable vesting requirement (e.g., staying with the company for three years after grant or meeting a performance goal), they forfeit the grant.

There are two types of vesting: cliff and ratable. Awards that cliff vest are paid out all at once, at the conclusion of a predetermined time period. Awards that vest ratably vest a portion at a time (e.g., an award that vests 25% each year for four years). If an employee terminates prior to the end of the final vesting period, the employee still owns the portion that has vested.

Who receives long-term incentives?

Commonly, LTIs are more prevalent for employees at higher levels of an organization because the value of the company is predominantly affected by those with line-of-sight into the long-term strategic vision of the company. Let’s say a company grants performance shares that are contingent on achieving a net income target. Would the CEO be able to influence corporate profitability? Most likely yes (at least we hope so). But an entry-level accountant? Probably not. There is less value in offering performance-based LTIs to lower-level positions, since these roles do not have sufficient impact to effect change. For this reason, LTIs for lower-level employees typically focus more on retention.

LTIs are more prevalent at public companies because of their liquidity and ease of valuation (i.e., a share of a public company is valued by and can be sold on the open market, whereas the value of a share at a private company can differ widely based on valuation methodology)..

Conclusion

The most appropriate LTI vehicle ultimately varies from company to company. No one LTI vehicle is superior, and selecting the optimal vehicle typically requires an overall assessment of culture, company strategy, and goals to select the right mix, amounts, and vesting mechanics. Mercer consultants have experience in every industry and can help you determine the right approach when it comes to utilizing LTIs as part of the total rewards package for your employees.

To help you consider the best long-term incentive solutions for your employees check out the Mercer Benchmark Database: Long-term Incentive and Equity Report for the United States or Canada.

If you’re interested in learning about competitive short-term incentives (STIs) as well as LTIs, Mercer also offers short-term reports for the United States or Canada.

About the author

Kanak Rajan, Partner

Kanak specializes in developing talent and rewards strategies for executives, workforce and sales teams.

Andre Rooks, Partner

Andre is a Partner at Mercer, where he is responsible for developing strategies that improve the outcomes from rewards programs. Prior to his current role, Andre was head of the Career Business for the Upper Midwest.