3. Denomination of Award & Performance Period

Denomination of Award

While annual incentive plans are generally denominated as a cash opportunity, performance plans can be denominated as a cash/cash unit target or a share/share unit target. Executives prefer cash performance plans that keep them focused on the achievement of the specific performance objectives identified under the plan and insulate them from the impact of stock price movements. While this may not support the objective of alignment with shareholders as effectively as a share-based plan, another reason cash payouts tend to be favored by executives is that they do not need to sell shares to realize value from these awards. Given the insider trading rules that restrict an executive’s ability to sell shares and the scrutiny that investors apply to insider sales, a cash-based plan has obvious advantages. Since stock options and time-vested restricted stock are both stock denominated, performance plans are frequently the only cash-based, long-term incentive offered by publicly traded companies. In addition, companies that have had high levels of shareholder dilution from stock-based compensation may prefer a cash-based, long-term incentive, as they do not need shareholder approval to fund shares for awards.

However, share-based plans are more common than cash-based plans because denominating the award in shares helps to align executives with shareholders while also encouraging pay-for-performance through the plan design. In fact, 87% of the CAP 120 choose share/share units design. While executives may generally prefer cash, denominating the plan in shares allows for greater upside opportunity as the executive can benefit not only from outperforming relative to the pre-established performance criteria and thereby earning more shares, but also from stock price increases. The same is true on the downside.

Key Questions for Committee Members to Ask:

• Do we have adequate shares available under our shareholder-approved plan to fund awards if delivered in shares? Will it reduce the number of years of long-term incentive plan awards that we can make under the existing reserve?
• Are executive plan participants’ liquidity constrained? Would they benefit substantially from a plan design feature that improves liquidity?
• Do executives have enough “skin in the game”?

Performance Period

The decision on the performance period is frequently intertwined with the selection of performance measures. Approximately 80% of performance plans use a three-year performance period. For companies that use financial performance metrics, this usually aligns with the length of time that the companies project future performance in their mid-term/long-term financial plans. For companies that use stock price-based metrics, such as TSR, though there is no obvious reason for a three-year performance period, it remains the most common practice. Regardless of the denomination used, very few companies use performance periods that extend beyond three years. For financial performance objectives, this is likely due to the difficulty of making long-term projections. For stock-price based measures, the performance period is likely selected to ensure that the award feels tangible to executives. Given the diminished role of stock options in long-term incentive designs, there may be pressure over time to lengthen performance periods for relative TSR plans given the emphasis most shareholders place on long-term performance.

A minority of companies — approximately 10% — use a one-year or two-year performance period and will typically have additional vesting of 2–3 years on the award to ensure that executives cannot get paid until at least three years from the grant date. The rationale for this approach is that these companies do not have confidence in projecting financial performance objectives three years out. Additional vesting beyond the performance period is added to assure shareholders that the award is intended to reward for the long term, even if the performance objectives are short term in nature. Shareholder advisory firms prefer that companies commit to multi-year performance goals and view one-year goals as problematic, particularly if they overlap substantially with the annual incentive performance goals.

Key Questions for Committee Members to Ask:

• Does the company have a credible mid-term financial plan that can be used as the basis for setting long-term performance objectives?
• What is the appropriate period of time for assessing whether or not management is making progress in achieving its strategic objectives?
• Will the program be externally credible with the performance period we have selected?