Poking Holes in Performance Plans

Following on a recent Meridian piece calling for a re-evaluation of the “cookie-cutter” approach to incentive plan design, Farient Advisors is “reconsidering performance shares” based on a study showing shareholders are not benefiting from their use in executive compensation. The 2020 study found S&P 500 companies that only use time-based equity outperformed sector peers every year from 2009-2018.

Farient’s article points out that incentive plans are structured to reward certain behaviors, assuming that the metrics selected will prioritize an executive’s actions to contribute to outcomes from those metrics.   However, the article suggests, performance shares are insufficiently long-term to truly incentivize long-term outperformance, encourage gaming, and add unnecessary complexity to incentive plans.  

While acknowledging that PSUs make sense for some companies, Farient notes that they have become the universal standard “not because of their universal utility but because of investor pressure,” along with ISS standards.  Three alternatives are proposed that may help firms mitigate the downsides of performance plans while still receiving the “blessings” of the proxy advisor firms.

• Option 1: Base PSUs solely on TSR or relative TSR over a three-year period. This eliminates the accidental selection of short-term metrics and the subjectivity of goal setting, while placating investors with the fact that overlapping TSR plans require any gains achieved in one cycle to increase the bar for the next.
  
  
• Option 2: Premium options (with an exercise price premium of 15%). While executives may perceive these as being riskier than regular options, the 10-year exercise period balances the risk. ISS generally considers the 15% premium performance based.
  
  
• Option 3: Milestone achievement plans where awards are achieved at any point in time when the goals are achieved. This design requires a great deal of thought on choosing the right metrics but eliminates the short-term focus of the traditional PSU plans.

A fourth, less palatable alternative is also suggested – completely ignore the proxy advisory firms and eliminate PSUs despite “investor wrath.” Amazon is cited as a company that will not conform to the PSU norm despite a recent low Say on Pay vote, instead maintaining that compensation should not be tied to short-term performance goals due to the firm’s long-term focus beyond the 5, 10 or even 20-year mark.