The Advisors' Blog

Our recently released study of 2006 performance metrics at the top 300 public companies – now being updated for 2007 data – revealed that 37% of companies with long-term incentive plans used total shareholder return (TSR), a market measure. All but five of these companies based their payouts on TSR relative to a peer group. On the other hand, for the majority of plans using a performance-based or internal financial measure, relative designs were the exception. Indeed, of the performance-based long term incentive plans, less than 20% used relative measures. To be compliant with Item 402(e)(1)(iii), disclosure of the measures, including threshold, target and maximum values, would be required.

Short-term incentive plans rarely use relative measures. This same study estimated just 8% of companies with short-term incentive plans used relative measures as part of these plans. Moreover, the reporting of metrics in 2006 was woefully short of expectations with just 16% of these top companies providing complete information on short-term goals and accomplishments. Clearly, there was great hesitation in disclosing this information.

For companies that would prefer not to disclose this information for competitive reasons, an easy solution would be to base payouts on performance relative to a set of peer companies. As with a TSR design, payouts could be based on percentile performance over a multi-year period. Reporting would consist of listing the applicable measure(s) and the percentile performance that triggers vesting/payouts. Equity-based plans would retain all the features of any other performance-based plan such as fixed expense per share and reversible expense for sub-threshold performance.

Using a relative design is also a better way to measure performance. With a relative measure, changes in the economy and industry are reflected in the performance of comparator companies. Consequently, if a company is falling short of its EPS goal, it is possible that the company can outperform its competitors and be rewarded accordingly. Alternatively, if the company goal is more easily achieved as a result of external factors rather than astute management, a relative goal can prevent an unwarranted windfall.

Of course, one downside to relative measures is the potential payout of incentives in cases of poor company performance but strong relative performance. Having minimum financial hurdles can be designed to prevent ill-timed payments.

– Dave Schmidt, James F. Reda & Associates