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Three Key Considerations for TSR Awards

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June 06, 2017 | Terry Adamson, Aon Hewitt

Three Key Considerations for TSR Awards

For today’s blog, we have a special guest entry from Terry Adamson of Aon Hewitt on three key considerations for relative TSR awards. Terry also invites readers to participate in Aon's new Global Relative TSR Survey to find out how their plans compare to their peers'.

Three Factors That Impact Relative TSR Award Performance

By Terry Adamson of Aon Hewitt

I just finished reading over the March/April edition of The NASPP Advisor, and enjoyed reading the Q&A with Nell Minow, who will be the keynote address at the upcoming NASPP conference in October. One of her responses wished for more “indexed option grants so that they would only be in the money if the company outperforms its peers.” I love the idea and completely agree with the overarching philosophy of treating LTI as a profit sharing agreement between the employee and the investors. Unfortunately due to the tax code, indexed option grants create challenges. However, a similar payout function can be replicated with performance shares contingent on relative total shareholder return (RTSR), which is shares that vest based on the company’s stock price growth as compared to the stock price growth of defined peer companies.

RTSR has become a hot button with strong opinions weighing in from all sides. Some of the frequent criticisms are that relative TSR performance is not within management’s control, it is a “lottery ticket,” and simply rewards volatility. These criticisms are often misplaced to the discussion of whether relative TSR should be part of LTI. We know that relative TSR plans create incredibly strong shareholder alignment when properly designed, are completely transparent, and allow for objective multi-year performance measurement without the difficulty of long-term goal setting. The real challenge with relative TSR programs is designing a plan that is right for your organization and competes against a relevant group of comparators.

I’ve been thinking about these issues recently because Aon just formally launched our first ever Global Relative TSR Survey including firms from the United States, Europe, and Australia. I want to provide three recent thoughts that I have been playing with in my head:

  1. Averaging Period—Our preliminary data show 92% of companies have averaging periods on TSR calculations ranging from 20 trading days to 90 calendar days. However, early returns show 41% of companies use a 20-trading day. I continue to think that a 90-calendar day is appealing as it would continue to smooth out short-term stock price aberrations, and also ensures that an SEC regulatory filing is always included within the averaging period.
  2. Index vs. Custom Peers—A recent academic study, Relative Performance Benchmarks: Do Boards Follow the Informativeness Principle?, concluded that index-based peer groups perform 14% worse in their ability to explain performance than a customized peer group set. Interestingly enough, the study also has evidence that firms with poor governance are more likely to use an index rather than a bespoke group of peers. Our preliminary data show 56% of companies use an index for peer comparison within their relative TSR plans.
  3. Percentile Rank Plans vs. Outperform Plans—Percentile rank plans currently make up 86% of the market in our preliminary data. For larger peer groups, percentile rank plans work great. However, for smaller peer groups, percentile rank plans can create situations that see small changes in TSR produce large changes in payout—which I would label as a governance risk. In these situations, I believe an outperform plan is an elegant way of mitigating risk and graduating the earnout. Learn more about percentile/outperform plans at www.RelativeTSR.com.

I’ve brought up these issues because there needs to be much more research on relative TSR designs. It is challenging to determine specific plan design nuances as the public disclosures from award agreements, proxies, and other regulatory filings are vague. For the good of the industry, we urge issuers to participate in this ten-minute survey at www.RTSRSurvey.com, in which all participants will be provided results, so we can all better understand what creates better alignment with pay and performance in your equity plans. Further, cross-correlated against our PeerTracker plan certifications, we may be able to determine what plan designs have strongest TSR performance. Look for the results to be discussed thoroughly at the 25th Annual NASPP Conference in DC!

Radford-Terry2Terry oversees Aon’s global Equity Consulting practice, with specific domain expertise in equity accounting, performance certification, and share management. Between consulting gigs though, Terry proudly serves on both the CEP Advisory Board and the NASPP Executive Advisory Board. Further, Terry was on the FASB Round Table on Employee Share Options, and is the Chairman of the Society of Actuaries task force on stock option valuation. The NASPP Conference is returning to Terry’s college town (let’s go Georgetown!), so he hopes to see you there.

 

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