Three Objections to TSR Awards (and What You Can Do About Them)
More than half of all US companies have relative total shareholder return (TSR) awards in their executive long-term incentive programs (LTIPs). While we continue to work with outstanding companies adopting TSR for the first time, this trend is not without controversy. From academic research to commentary at industry conferences, we hear murmurs of an extreme positive and negative nature.
Who is right? Should companies consider abandoning TSR awards? Some of the arguments are better than others, but our view is that for most companies the answer is to keep the award but continue refining the design and execution to address specific shortcomings. We’ll discuss some of the main arguments against relative TSR awards in this blog post, along with ways to think through their merit and actionability.
Most of the criticism comes down to three basic points:
- Little, if any, connection exists between granting TSR awards and company performance.
- Executives don’t relate to market metrics the way they do operational metrics.
- Relative TSR awards are too susceptible to peer groups and the performance period to be a reliable measure of shareholder value creation.
Let’s examine these objections one by one.
Objection 1: Granting TSR Awards Does Not Correlate With Shareholder Value Creation
According to a recent academic paper from Cornell University, no statistical evidence exists to suggest that firms with TSR awards outperform their non-TSR issuing peers. After that paper was published, we received a number of inquiries from compensation professionals about how to interpret its conclusions in the context of their TSR programs.
Our take is that while TSR granters may not outperform non-TSR granting firms, this is different from proving that TSR awards fail to align executive and shareholder interests.
The relevant question is how well an instrument aligns incentives so that executives get paid when shareholders do, and so-called “pay for performance disconnects” do not erupt in the proxy. As much as we wish for an outcome in which compensation strategies drive outperformance in the market, at a minimum, compensation should auto-adjust in response to market performance.
Here, TSR awards shine. With their tighter pay for performance linkage, TSR awards offer a better story for shareholders (and say on pay results) because they more precisely tether executive pay to shareholder value creation and decline. TSR awards are not for every company, but the inclusion of TSR (even just as a modifier in a hybrid award) helps keep proxy and shareholder problems at bay.
Critiques of TSR often occur in a vacuum, but equity compensation instruments should be evaluated against one another, rather than against a perfect ideal. We applaud the use of non-TSR awards or hybrid awards that combine TSR with an operational metric, but are quick to note these instruments introduce their own challenges. Goal setting, for example, can be especially tough with operational metrics, giving rise to unfavorable situations in which shareholders have suffered losses and executives’ pay programs are paying out at maximum levels. We are especially excited to watch the ongoing growth in hybrid awards, which often can deliver the best of both worlds.
Beyond the high-level question of whether TSR is “in” or “out,” we recommend actively driving the upfront and ongoing messaging to participants, as well as reassessing the design each year for creative enhancements that will make the awards more meaningful to those receiving them. Whether TSR provisions make the cut or not, this is what puts them to the test. Below are some ideas on how to improve the ongoing execution of these awards.
First, help recipients understand how their awards work. Brochures, explainer videos, and FAQs are all essential to this goal. So is providing recurring updates on actual performance in order to keep awards top of mind.
A second best practice is using analytical rigor to pick suitable peers. Even today, we see numerous TSR awards where the comparison group consists of firms that are structurally different from the issuer. TSR awards are supposed to filter out uncontrollable market “noise,” but if the wrong peers are picked, the very opposite happens.
Third, understand how the accounting under ASC 718 can inadvertently undermine an equity granting strategy. We’ve discussed elsewhere how grant quantities are often set using the ASC 718 grant-date fair value, and that if the fair value is higher than expected, recipients will be disappointed in the number of awards they receive. Not using accounting values to set grant quantities creates proxy risk in the form of a potential pay-for-performance surprise.
At their core, TSR awards provide a means of rewarding outperformance within a broader corporate governance program. Equity compensation should influence behavior, but our experience is that this relates much less to the high-level design and much more to how companies make thoughtful micro-level design decisions and engage recipients via education. If it was so simple as just granting one flavor of performance award and watching the stock skyrocket, then everyone would flock to that design and everyone would outperform (which is impossible, since by definition only 50% of companies can outperform).
So, while we wish an academic study could find that the mere decision to grant TSR awards leads to outperformance, our experience tells us the devil is in the details. TSR awards simplify a number of tricky proxy and shareholder problems, but they don’t drive themselves. Careful upfront design planning plus ongoing communication to recipients are key.
Objection 2: TSR Awards Deliver Poor Line of Sight to Recipients
Executives tend to be preoccupied with revenue growth, cost containment, new product launches, and other operational goals. Few think about how to maximize relative TSR—not because they don’t care, but because it’s harder to act on. We call this the “line of sight” problem, and relative TSR awards arguably suffer from it more than other sorts of performance awards. It can lead to executives viewing their awards as lottery tickets they cannot control or influence. When this happens, recipients disengage.
On the flip side, targets that are very much within the control of the recipient might not be well correlated with shareholder value creation. This is why annual bonuses are usually based on more local goals whereas long-term incentive plans are structured around broad organizational-level goals (TSR, EPS, revenue, etc.). The question is whether the benefit of a true shareholder value-linked target like TSR outweighs the cost of potential disengagement among those receiving it.
To resolve this cost-benefit question, consider the following:
How relevant is the TSR peer group? Comparison companies that are not close competitors can amplify a line of sight problem. This is why TSR awards are less prevalent outside of industries like pharmaceuticals, oil and gas, and financial services where close peers usually exist. Analytics can test for peer groups that deliver reasonable line of sight.
What is the alternative? Awards with operational metrics have their own challenges. Three-year operational targets (set from the grant date) can quickly become too easy or too hard due to the many perils and imperfections of setting absolute hurdles far into the future. One-year targets (set at the beginning of each fiscal year) may fail to provide sufficient long-term incentive. When comparing the limitations of a TSR award to the many practical challenges of implementing operational metrics, you might find they’re equally problematic but for different reasons.
Could internal communication be improved? High-quality content, coupled with ongoing performance tracking and updating, can go a long way toward keeping an award top of mind.
What is the internal attitude toward relative TSR? Many companies are nudged into granting TSR awards for the message it sends to shareholders and the proxy advisors influencing their shareholders. Other companies have a key group of executives who vehemently oppose adopting TSR. The constraints, preferences, and pressures of stakeholders will often influence the final outcome.
Is there a way to do both? A hybrid award combines one or more operational metrics with a TSR provision. The general idea is to deliver an award based on operational metrics that recipients will understand, with TSR as a modifier to tighten the link between pay and shareholder value creation. We have seen countless companies across different industries very successfully execute hybrid awards.
Line of sight is a real issue, even for c-suite executives. By working through these five questions, you may discover ways for TSR awards to work better for your company.
Objection 3: TSR Awards Are Overly Influenced by Short-Run Factors
Recently, we ran an experiment on the S&P 500 to test whether payouts on a standard relative TSR award correspond to long-run shareholder value creation. We found that standard three-year TSR awards reward short-term stock price volatility (or other factors not tied to long-run shareholder value creation) more often than we may think. It’s reasonable to suppose that non-TSR operational awards suffer from the same problem to an even greater degree.
It appears that the transition from stock options to performance-based restricted stock has inadvertently led to a shorter-term focus. This troubling turn of events lacks a simple answer. But our thinking on the matter and conversations with clients suggests a few potential solutions:
Consider a longer performance period, especially for a new CEO grant or other special situation. A performance period of five years will do a much better job than one of three years in tracking long-run shareholder value creation.
Hold on to stock options. Their lengthy 10-year runway can create healthy incentives. What’s more, it’s easy to design an award that mimics the economics of a stock option but can be classified as “performance-based” by governance groups like ISS. Or, consider granting a stock option with a performance or market condition.
Be careful before you totally eliminate a relative metric. Even if you extend the performance period to five years and even if stock options yield a lengthy 10-year runway, the starting point and broad macroeconomic environment still substantially drive the eventual payout. Relative metrics elegantly filter out uncontrollable market events, which remain a major cause of participant disengagement.
Consider adding a post-vesting holding period. These provisions require recipients to hold the underlying shares for one or two years after the instruments vest and any performance contingencies are resolved. A similar benefit can be had from share ownership goals.
Evaluate other unique instrument designs. Pfizer and Exxon both offer creatively designed awards that assess performance over a longer time. Pfizer’s design is a mix of stock option and restricted stock unit. It’s an RSU, but absolute share price appreciation or depreciation over both a five-year and seven-year period governs how much of the RSU grant is delivered.
In short, we’re concerned about the shift from long-term incentives to mid-term incentives. This can drive a wedge between LTIP payouts and long-run shareholder value creation. TSR awards are a major improvement over non-TSR performance awards (where the link between target and shareholder value is even more tenuous), but their standard three-year form may not always be optimal.
Our goal in this article has not been to provide a blanket defense of TSR. We don’t think any award design is prima facie perfect. TSR awards are elegant for the following reasons:
- They deliver excellent alignment between executive compensation and shareholder value creation.
- Goals are easier to set.
- Proxy frameworks for evaluating pay in the context of performance lean on TSR models.
- The relative nature of TSR insulates recipients from uncontrollable market shocks.
But TSR awards also have their shortcomings. For example:
- They generally deliver worse line of sight than operational goals.
- Peers are not always easy to pick.
- The use of a short 3-year performance period may not match long-run shareholder outcomes.
While for many companies we think the benefits outweigh the costs, we’re much more interested in what companies do differently in an exceptional award design rollout versus an average one. First, they use analytics and detailed modeling to stress-test each design lever and customize the award to their particular situation. Second, they coordinate a thoughtful program for educating recipients both upfront and throughout the life of the award. These practices are what give the award wings. Execution is everything.
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