Understanding the Nuances of Relative TSR Awards

Relative TSR awards are awards in which vesting is fully or partially contingent upon the granting corporation’s total shareholder return as compared to its peers. As use of performance-based equity at public companies has steadily increased over the past two decades (since the adoption of ASC 718), companies have increasingly added TSR awards to their equity plan portfolio.

In the most recent Equity Incentives Design Survey, administered by the NASPP and Deloitte Tax, 64% of companies that grant performance-based awards tie vesting to relative TSR, up from only 30% in 2007.

Relative TSR is the only metric utilized by a majority of respondents to the survey. The next most commonly used performance metric, revenue, is utilized by only 31% of companies that grant performance awards. Moreover, TSR is popular regardless of industry sector: 61% of tech/life science companies and 66% of companies in other sectors grant TSR awards.

Given the prevalence of relative TSR awards, it’s worth taking a close look at some of the nuances of how these awards work. The NASPP webinar Smart TSR Award Design: Trends and Best Practices does just that. Here are some highlights.

TSR Peer Groups

One advantage of relative TSR awards is the simplicity of goal setting. Companies don’t have to predict company financial performance several years out to establish appropriate targets, they just have to determine how they want the company to perform against its peers.

But companies do have to decide on a peer group that the company will be measured against. This could be the same peers the company benchmarks its executive compensation against (38% of respondents to the 2024 survey use this approach), an index (35% of respondents), or a custom group of peers that the company selects (22% of respondents).

Payouts for Negative TSR Performance

Something that might surprise you about relative TSR awards is that they can pay out even when the company has experienced negative performance. This is because relative TSR awards measure companies against their peers, rather than against absolute metrics. If the entire peer group experiences a decline in absolute TSR, but the company’s decline is less than that of its peers, executives may still be eligible for a payout.

Although investors usually take a dim view of payouts in this circumstance (particularly if they aren’t capped), 80% of respondents to the 2024 survey indicate that their awards can pay out even when TSR has declined.

The webinar panelists explain that limiting award payouts when TSR is negative can help reduce award fair value. This can result in larger grants, an outcome that will likely be welcomed by executives (especially if the executives expect TSR performance to be positive). Thus, limiting payouts when TSR performance is negative could be a win for both shareholders and executives.

TSR as a Modifier vs. a Standalone Metric

Some companies use relative TSR as a standalone metric and others use it as simply a modifier to their other metrics. In the modifier approach, vesting might be tied to an operational metric, like revenue or earnings per share, but the payout is adjusted—or modified—up or down based on the company’s relative TSR performance.

This can be a good way to tie payouts to TSR, which appeases shareholders, while also tying payouts to a metric that executives feel they have more control over.

Percentile, Ranking, and Outperformance Plans

There are several approaches that can be used to measure relative TSR performance. The approach I’m most familiar with is a percentile calculation. The target is usually for the company’s TSR to be at the median or 50^th percentile of its peers. If the company exceeds this target, the payout is increased, usually maxing out once the company reaches around the 75th percentile. If the company’s TSR is below the median, the payout is reduced, usually with no payout for performance below, say, the 25^th percentile.

Another approach is to tie payouts to the company’s numerical ranking. If the company is first among its peers, the awards pay out at the maximum; the payout is reduced as the company’s ranking falls.

The last approach is an outperformance model, in which payouts are tied to the percentage by which the company’s TSR exceeds or falls short of the median. For example, the plan might specify that for every 1% (or 100 basis points) that the company exceeds the median TSR of its peers, an additional 5% of the award will vest. 

In a scenario where a company and its peers all have TSRs that are clustered closely together, this ensures that the company doesn’t have a significantly outsized (or undersized) payout for performance that is only marginally better (or worse) than its peers.

Learn More

Check out my short video 3 Types of TSR Awards to learn more about percentile, outperformance, and modifier plans.

Check out the NASPP webinar Smart TSR Award Design: Trends and Best Practices to learn more about how to design and implement TSR awards, including case studies illustrating the plans at PSEG and Akamai.