Is relative TSR still the performance metric of choice?

by Cydney Posner

According to a just-released report from Equilar, an executive compensation and corporate governance data firm, “relative total shareholder return” continues to be the most common performance measure used in long-term incentive plans for CEOs among S&P 500 companies.  However, after years of increasing prevalence among companies in this group, use of rTSR flattened out in 2015 as a performance metric for CEO pay. At the same time, use of return on capital and earnings per share as performance metrics each “saw a bump,” the related press release indicated. Does this data portend a change?

The report showed that rTSR has increased by a relatively steady five to six percentage points year over year from 41.6% in 2011 to 57.4% in 2014, until it leveled off at 57.4% in 2015.  (Apparently, 2015 was the most recent year when comprehensive data was available.) Why the flattening? Could the break in TSR’s ascent reflect recent criticism of the “tyranny of TSR”? For example, a study in 2015 showed no real correlation between use of TSR and improvements in company performance.  (See this PubCo post.) Similarly, a report by Organizational Capital Partners and the Investor Responsibility Research Center Institute contended that, by relying on TSR, companies are tying compensation to short-term market returns rather than using metrics related to creating sustainable, long-term value. That report, which studied companies in the S&P 1500, asserted that the “best measure of economic value creation is economic profit, i.e. net operating profit minus a capital charge for invested capital. Moreover, the report maintained, tying compensation to share price appreciation through TSR is deeply misguided because factors that affect share price, such as “fund flows, central bank policies, macroeconomics, geo-political risks and regulatory changes are all beyond the control of executive management.” Other compensation consultants have observed that, although TSR might be a useful tool for some purposes,  “it is not particularly helpful in short-term compensation decisions. Many firms, for instance, use three-year-TSR performance, but it’s common for three-year TSR to often be a lagging or leading indicator of future performance. That can lead to low pay before strong performance and elevated pay before business heads south.” (See this PubCo post.) Other compensation consultants, relying on behavioral economics, have contended that CEOs should be paid with more short-term incentives that have been designed in a way to improve long-term performance. (See this PubCo post.) Others have taken the opposite approach altogether, contending that no type of performance-based pay for CEOs makes sense because the types of work performed by CEOs require deep analysis or creative problem-solving, tasks that are typically not susceptible to performance incentives. Instead, some have proposed paying top executives with a fixed salary only. (See this PubCo post. and this PubCo post.)

Equilar appears to share some of those views. According to the press release, plan designers recognize that TSR “represents shareholder value over time, but have begun to question its ability to incentivize CEO behavior and performance. Executives can engage in activities they believe will influence TSR, but they cannot directly control all the factors that influence the outcome.” Consequently, other measures, such as ROC and, to a much lesser extent, EPS, have gained renewed acceptance as performance measures: “[o]nly ROC consistently increased every year in the Equilar study, rising from 26.1% in 2011 to 30.6% in 2015 for CEOs. While EPS declined each year between 2011 and 2014, usage of this metric in 2015 increased from 27.3% of companies to 29.2% in 2015, though still below its high in 2011 of 34.6%.” In that regard, the managing editor at Equilar observed that “[t]hough TSR helps balance executive pay with shareholder returns, profits and return on company investments have emerged as consensus picks for tying day-to-day operations to long-term value creation.” Variables associated with rTSR can also create challenges: for example, selecting a peer group against which to compare company shareholder returns can be complex, as can determining the correct time period for measurement. Nevertheless, the prevalence of rTSR in 2015 was still almost twice that of ROC.

As a result, companies now often employ more than one metric when using rTSR. For companies in the S&P 100, Equilar “found that more often than not, rTSR was included alongside at least one other metric to achieve performance awards. The study found that 35.9% of the time rTSR appeared in CEO incentive plans, meeting target goal accounted for half of the payout. Meanwhile, when ROC or EPS were included as a performance award metric, they were most commonly weighted 100%.” In addition, the managing editor noted, “Even when an incentive is tied to one weighted metric, ROC for example, it doesn’t preclude a committee from adjusting the award’s payout based on TSR performance. Sometimes there is more than meets the eye.”

Other key findings in the report included the following:

  • “S&P 500 long-term incentives were most commonly measured over a three-year performance period, with nearly eight in 10 companies utilizing this measurement timeframe
  • In the S&P 100, threshold performance levels for CEO long-term incentives were most often set between 91% and 99% of target performance, while maximum performance was most commonly between 101% and 110% of target
  • Threshold payout of S&P 100 CEO long-term incentives was most commonly 50% of target payout, while maximum payout was most frequently 200% of target”

 

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