4. Performance Measures

In contrast to annual incentive plans, where companies rarely use stock price as a performance measure, in long-term performance plans, relative TSR is the most common performance measure and is used by 69% of CAP 120 companies. While many companies use TSR, financial performance measures (e.g., revenue, EPS, ROIC) are the most common metrics. Most companies use a blend of 2–3 performance measures.

* Return measures include return on invested capital, return on equity and return on assets. Source: CAP 120

Companies that use TSR will, in most cases, establish performance goals relative to other companies, as it is very difficult to predict what level of absolute performance will be viewed as strong performance over a multi-year period. Relative TSR plans tend to be well received by shareholders because outperforming a group of competitors in terms of stock price performance is an indicator that the company was a better investment than alternatives over that investment period. From an executive perspective, relative TSR can be viewed positively as it helps to insulate management from movements that affect all companies under comparison and offers rewards for the company’s relative performance. While in an “up” stock market, it may be harder to earn large payouts under a relative TSR plan than under a stock option plan, in a “down” stock market executives can earn payouts in a relative TSR plan when stock options would likely be underwater.

As was the case when setting short term incentives, a key challenge in implementing a relative TSR plan is identifying the right peer group of companies to use as a comparison. Since two of the main goals are to reward executives for outperforming alternative investments and to insulate management from external factors beyond their control, a natural starting point is to identify companies that are viewed as viable investment alternatives or impacted by similar market conditions. Companies that meet these criteria can be identified by looking at who investment analysts compare the company to and by identifying which companies have had stock price movements that are highly correlated with movements in the company’s stock price. For companies with a clear set of industry competitors or a well-defined industry index, this is likely the best set of companies for TSR comparisons. Companies with few direct industry competitors may either decide not to use relative TSR as a metric or may select a broad market index (e.g., the S&P 500) as the basis for comparison. However, some may criticize the use of a market index because movements in stock price relative to the broad market can be driven by general sector performance, as opposed to company-specific performance.

Companies that use financial performance metrics in their long-term performance plans will generally use the performance measures that they view as most clearly aligned with shareholder value creation over the long term. These performance measures will be embedded in the company’s strategic plan and viewed as keys for long-term success. For capital-intensive industries, a return measure like return on net assets or return on invested capital may be used in combination with an earnings measure like net operating profit or EPS. For high-growth industries, the performance measures may be revenue growth and operating margin. Multiple measures are often used in tandem to recognize that there may be tradeoffs between different objectives (e.g., growth at any cost vs. profitable growth).

The key advantage of using financial performance objectives over relative TSR plans is that financial performance objectives are generally viewed as being more within the control of management. A three-year EPS goal provides management with a clear message about what the compensation committee is expecting from them in terms of performance. Management can think through the specific activities that can contribute to improved earnings. With a relative TSR plan, there is no clear goal. It is much more challenging to identify the decisions and activities that will contribute to outperformance in the stock market. As such, relative TSR plans are considered to be less effective at driving management decisions and better at aligning management pay with shareholder outcomes.

Key Questions for Committee Members to Ask:

• What are the best measures of the company’s success in achieving its mid-term business strategy?
• What measures do investment analysts focus on in evaluating our company’s performance?
• Do most senior executives understand how they can impact performance on the measures under consideration? Are there alternative measures that are easier to understand and still accurately capture the economics of our business?
• Is there a credible basis for establishing mid-term performance goals on performance metrics? If not, can we assess our performance relative to peers?

a. Absolute vs. Relative Measurement

Similar to annual incentive plans, most companies set long-term performance plan goals to be equal to the performance levels in the company’s mid-term or long-term business plan. Where companies have extreme difficulty in setting multi-year goals, a few alternative approaches are available:

• Use of a Performance Standard: Companies can base their performance on growth from current levels using a long-term standard for the industry (e.g., EPS growth of 10%) or based on a long-term industry standard of performance (e.g., ROE of 12%). This avoids an internal negotiation with management about the level of difficulty of the goal. While this approach may be effective over a long period, it may be challenging for any one performance cycle because it does not take market conditions into consideration.
• Relative Performance Assessment: Instead of establishing an upfront goal for a multi-year performance period, the goal can be established relative to other companies, a market index, or the companies that compose the index. While this does not take into consideration the absolute level of performance, it does implicitly correct for external market conditions.

Relative performance measurement can be challenging for financial measures as it is sometimes difficult to provide apples-to-apples comparisons. The most common financial measures assessed on a relative basis are financial returns or profit ratios (e.g., return on equity, return on capital, operating margin, etc.). As mentioned earlier, total shareholder return is also frequently measured on a relative basis.

When TSR is measured on a relative basis, most companies use percentile rank among the comparable companies as the basis for the comparison. This is a relatively straightforward approach as the company’s payout relative to target will be tied to the company’s relative performance, as demonstrated in the table below:

Performance	Percentile Rank	Shares Earned as a % of Target
Below Threshold	<25th	0%
At Threshold	25th	50%
At Target	50th	100%
At Maximum	75th	150%
Above Maximum	>75th	150%

Performance and corresponding payout levels are generally interpolated between threshold and target and target and maximum. A similar approach can be used for financial measures. A key issue in implementing this approach will be the treatment of companies that exit the peer group due to bankruptcy or acquisition. The “rules” for how to handle companies that exit from the peer group should be defined at the beginning of the performance period to avoid any uncertainty or potential legal and accounting issues.

An alternative approach, which can be difficult to calibrate and may overly rely on large cap index constituents, is to set goals relative to the performance of a market index itself (e.g., the S&P 500), rather than the component companies of the index. This approach is much less common than the approach discussed above. Below is an example of what performance goals might look like for this approach:

Performance	Annualized TSR Performance vs. Index	Shares Earned as a % of Target
Below Threshold	5% or more below	0%
At Threshold	2.5%–5% below	50%
At Target	2.5% below–2.5% above	100%
At Maximum	2.5%–5% above	150%
Above Maximum	>5% above	150%

Key Questions for Committee Members to Ask:

• Do we have a credible basis for establishing long-term performance goals? Is there a risk that we will overpay or underpay if we do a poor job of projecting market conditions?
• Is the preferred measure readily used for relative performance comparisons?
• Is there a good group of companies or a market index available to use for relative performance comparisons?
• Should we use the same peer group for performance comparisons that is used for pay comparisons?

b. Absolute Performance Goals: Performance Calibration

The challenges faced in setting performance goals for a multi-year performance plan are similar to those for an annual plan but are complicated by the heightened degree of difficulty in projecting business conditions over a multi-year period. Depending on the business environment, making projections for business performance for one year may be difficult, let alone three. Still, the clear message that multi-year business objectives send to management about what the company is trying to achieve is so compelling that a majority of companies with performance plans set multi-year financial goals.

When looking at performance over a multi-year period, there are two main ways to assess performance:

• Point-to-Point Growth: The company will establish a growth goal for the three-year period. For example, if EPS in 2022 was $1.50, the company may say that they want to grow EPS by $0.15 per year to $1.95 by 2025. This approach effectively puts all of the focus on the final year of the performance period and implicitly assumes that performance in the intermediate years of 2023 and 2024 will be progressing toward the 2025 level. The downside of this approach is that performance in 2023 and 2024 could be poor, but the plan will pay out well so long as 2025 performance is strong.
• Cumulative Performance: In contrast to point-to-point growth, setting a cumulative performance goal requires summing the goals for each period in the plan to come up with a three-year total level of EPS (e.g., $1.65 + $1.80 + $1.95 = $5.40). In this structure, each year of the performance period matters in evaluating three-year performance — not just the final year of the performance period. The downside of this approach is that there may appear to be a pay-for-performance disconnect if performance is strong in the first two years of the performance period and then declines in the third year. In this situation, there could be a meaningful plan payout, even though performance looks average in the final year.

Similarly, for multi-year measurement of a return measure (e.g., return on equity), performance can either be assessed based on the level of attainment in the final year of the three-year performance period or on the basis of the average result on the performance metric over the full period.

Key Question for Committee Members to Ask:

• Is it better to focus management on getting to an aspirational level of performance by the end of the performance period or should we assess management based on their performance throughout the entire performance period?

c. Examples of Performance Share Designs

• Financial Metric Performance Share Plan: Shares are earned based on level of performance relative to pre-established financial goals over a three-year period (e.g., three-year return on invested capital (ROIC)):

  Performance Level	3-Year Average ROIC	Payout vs. Target Shares
  < Threshold	<7.5%	0% of target
  Threshold	7.5%	50% of target
  Target	10%	100% of target
  Maximum	≥12.5%	200% of target

* Shares interpolated for performance between threshold and target, and target and maximum.

• Relative TSR Performance Share Plan: Shares are earned based on relative TSR performance vs. an index (e.g., S&P 500 index) or a custom peer group:

  Performance Level	Performance Requirement	Payout vs. Target Shares
  < Threshold	<25th percentile	0% of target
  Threshold	25th percentile	50% of target
  Target	50th percentile	100% of target
  Maximum	≥75th percentile	200% of target

* Shares interpolated for performance between threshold and target, and target and maximum.