Incentivizing outperformance: A global market perspective

How companies incentivize outperformance and appropriate risk-taking within reasonable bounds, is a critical aspect of effective executive compensation program design. While aligning pay with performance is a widely cited philosophical principle, its practical application varies across organizations depending on their listing location, lifecycle, industry and strategic goals.

Beyond the well-documented differences in quantum between Europe/U.K. and the U.S., variations in long-term incentive (LTI) vehicle selection and the calibration of total shareholder return (TSR) performance curves reflect contrasting regional approaches to incentivizing risk-taking and paying for performance. Given recent market volatility, such areas are of increasing relevance to the Remuneration Committee's agenda.

In this edition of Executive Pay Memo, we discuss some of these inherent differences across the U.K., Europe and the U.S.

Long-term incentive vehicles

LTI vehicles differ significantly between the U.S. and U.K./Europe, which is a function of contrasting performance philosophies on how to achieve pay-for-performance alignment, coupled with differences in accepted normative practices by investors and proxy advisors. In the U.S., companies typically adopt a portfolio incentive model, combining performance-based awards ('PBAs,' which can include performance shares, performance share units, performance stock options and performance cash), time-vested restricted shares ('RSPs', which can include restricted shares or restricted stock units), and/or time-vested stock options ("options"). Around 60% - 70% of U.S. companies use a combination of the two vehicles.

Note: Vehicle combinations reflect the top three most common combinations observed in the US.

In the U.S., while PBAs are typically the primary LTI delivery vehicle, RSPs serve as a backstop, ensuring executives receive some value even if performance targets aren't achieved. This helps companies achieve dual objectives of alignment with performance and retention of senior talent, while also balancing the challenges of effective performance target setting.

Options can further incentivize outperformance and the creation of sustainable shareholder value over the long term. This hypothesis is evidenced in WTW's enduring high-performing company research, which found sustained high-performing companies in the S&P 500 over the last decade are more likely to use stock options as one of their equity vehicles. Proponents of the U.S. portfolio model state that it balances retaining talent and performance alignment, by providing some downside protection with significant upside potential, which may ultimately encourage outperformance of strategic goals.

By contrast, European and U.K. companies rely predominantly on performance share plans, which reflect a philosophy of avoiding 'paying for failure.' However, driven by the debate on global pay competitiveness and the recent changes to the Investment Association ('IA') guidelines, attitudes to RSPs and hybrid arrangements (meaning the award of a combination of different vehicles to a single person) in the U.K. are evolving.

How are companies responding?

During the U.K. AGM season this year, we've seen a second wave of organizations adopting hybrid plans, with almost all organizations citing the need to compete with U.S. peers. For many of these companies, they were already using hybrid designs below the Board, and so an added benefit/objective was ensuring consistency across the executive leadership team.

While still a minority practice, this evolution signals a potential shift away from the traditional U.K. and, to a lesser extent, European philosophy of avoiding 'paying for failure' toward an incentive model that may balance globally competitive pay and paying for true performance delivered.

In the U.S., concerns over economic volatility are leading some companies to revisit their equity granting practices, including the use of options. For companies that have used options for several years, some are considering removing them from the mix due to their dilutive impact, the drag effect on share requests and concerns about the retention and engagement impact of having multiple consecutive awards underwater. Others are doubling down, believing that stock options, despite short-term market swings, remain crucial for incentivizing outperformance of ambitious growth strategies and fostering an ownership mentality.

Total shareholder return

Total shareholder return (TSR) is the most common long-term performance metric used in the U.S., U.K. and Europe and is seen as a clear mechanism to demonstrably align pay with performance. However, how companies use and calibrate TSR-based performance conditions varies notably across these regions.

The world of TSR modifiers

When used in the U.K. and Europe, the overwhelming majority practice is to use relative TSR as a discrete, weighted element in determining payouts. While this is also the majority practice in the U.S., just over a third of companies use relative TSR as a modifier to an internal financial goal. The design of these modifiers typically provides for no adjustment if the company is positioned between the 25th and 75th percentiles, with a 0.75-times modifier applied for below 25th percentile performance, and a 1.25-times modifier applied for above 75th percentile performance.

There are typically three reasons cited for using relative TSR as a performance modifier:

1. During periods of economic volatility, companies often prefer a relative TSR modifier over a standalone TSR metric. This enables companies to primarily incentivize and reward performance against internally set financial goals, with relative TSR serving as a crucial check to ensure payouts also reflect the company's performance relative to peers subject to similar economic factors. This mitigates for windfalls or undue penalties caused solely by broader market movements
2. A preference to use some form of market-based measure, but seek to minimize its impact (can't yield a zero outcome) due to lack of an appropriate performance peer group
3. To drive greater downside and upside in low- and high-performance scenarios respectively, and in these cases the upside may yield an even higher maximum (e.g., rather than 200% of target, an outcome of 250% or even 300% of target can be achieved). Interestingly, another finding from WTW's enduring high-performing company research was evidence of greater downside and upside in incentive payout curves

What does the 'typical' discrete relative TSR performance curve look like in each market?

U.S. companies typically align threshold vesting to 25th percentile performance; in contrast, U.K. companies overwhelmingly set threshold performance at the 50th percentile. While these performance expectations are markedly different, the level of payout on a percentage basis is often comparable, typically up to 25% of the maximum award available at threshold.

There's also some level of consistency in maximum performance standards, with 75th percentile performance triggering maximum payout in most instances. However, it's more common for U.S. companies to extend the maximum to the 80th, 85th or even 90th percentile. Across Europe, practices vary, with a relatively even split between the typical U.K. and U.S. payout curve, with more U.S.-style curves particularly common in Germany. To illustrate these differences, the chart below shows typical U.S. and U.K. TSR performance curves:

While establishing a lower performance standard threshold at the 25th percentile increases the perceived value of the incentive, it can also provide more incentive for outperformance. With a lower threshold, the emphasis of the incentive may shift to upside potential. This can drive a culture of high performance and a focus on exceeding expectations, particularly when the top end of the payout curve also extends beyond the 75th percentile. To balance investor concerns about "paying for failure," some plans will cap payouts at target (typically 50% of the maximum available payout) in the event absolute TSR is negative, even if relative TSR performance is above the 50th percentile.

From a U.K. perspective, the IA is the strongest voice in this area, who explicitly state that no TSR vesting should occur for performance below the 50th percentile. This is a stance that epitomizes the fundamental difference in philosophy between the U.K. and U.S. markets.

How are U.K. companies responding?

We're aware of several U.K. companies with global peer groups that have sought investor feedback on implementing a "U.S.-style" relative TSR payout curve. The response from shareholders in the U.K. has typically been overwhelmingly negative, with concerns primarily focused on the potential disconnect between pay and performance. Investors appear wary of the wider payout range and lower threshold stating they could lead to a disconnect between pay and performance.

What does the data tell us?

A more favorable calibration of TSR performance curves at threshold may be justified by the demonstrably stronger performance of U.S. companies compared to their U.K. and European counterparts. This is evidenced by an analysis of shareholder returns across three end-to-end performance periods in three markets:

This data shows that large-cap U.S. companies have consistently delivered much stronger TSR performance than their U.K. and European counterparts. Notably, FTSE 100 median TSR performance is more closely aligned to the lower quartile of the S&P 500 in two of the three periods analyzed. The picture in Europe is slightly more mixed.

While there are a multitude of independent and interconnected factors that influence TSR performance, taken in isolation, the data may indicate that there's a rationale for U.K. companies with a TSR peer group comprising a high proportion of U.S. companies to consider TSR performance curves that don't conform to the established U.K. model.

What next?

As companies continue to adopt more globally oriented peer groups, voices for adopting alternative LTI vehicle combinations and TSR performance curves may intensify in the U.K. and other parts of Europe. In respect of alternative TSR payout curves, even with a compelling and data-led case, we'd expect that many investors, citing the long-standing IA guidance in this area, will continue to strongly pushback on such arrangements.

Given the volatility in global stock markets, companies across all regions are assessing their use of relative TSR measures. While some view relative TSR as a self-calibrating measure that mitigates the need to set financial goals in uncertain environments, others are concerned it risks alienating participants as something further beyond their control than normal.

While we don't anticipate a reduction in the use of relative TSR metrics generally, we do expect companies to review their peer groups, seeking to focus on clear industry competitors rather than broad indices. Performance relative to a more comparable set of peers generally allows companies to more accurately assess management performance, as different sectors are impacted by market volatility to varying degrees.