The success of any organization largely depends on its employees, and incentives are vital in attracting, retaining, and motivating employees. In the past five years, companies have been rapidly reforming their incentive policies to promote employee compensation packages being paid out over multiple years. This accelerated trend of providing long-term incentives over short-term incentives and bonuses is a means to retain top-performing employees for longer periods. This transition to long-term incentives is attributed to the growing recognition of their advantages over traditional short-term incentives.
Long-term incentives (LTIs) are a type of incentive that is usually reserved for highly valuable employees who are invested in the organization’s success. It is one of the most effective ways to align and reward key employees for tenure and achieving long-term goals and objectives linked with the company’s overall performance.
In this blog, we will provide a comprehensive guide to long-term incentive management, covering everything from defining the objectives and best practices for your LTI program to leveraging technology for long-term incentive plan management.
What is LTIP?
Long-term incentive plan (LTIP) is a type of employee compensation plan designed to recognize, reward, and motivate employees for fulfilling the company’s long-term goals or objectives. This company policy is part of a deferred compensation strategy important to retain valued talent and maximize shareholder value. LTIPs, like any other bonus and incentive plan, are based on the employees’ performance in addition to fixed income. It typically consists of performance-based awards, such as stock options or restricted stock units, that vest over a period of years.
Importance of long-term incentives
Long-term incentives (LTIs) though designed to motivate employees but are a win-win for both employers and employees alike. LTIPs can help reduce employee turnover by incentivizing top-performing employees to remain with the company for an extended period, reducing the need for costly hiring and training processes. Additionally, by focusing on sustainable growth, LTIPs can align the interests of the company and its employees, promoting a culture of accountability and continuous improvement.
WorldatWork research shows that 94% of publicly traded companies offer LTI to maintain a balance between performance orientation, retention, and share-conservation objectives.
Who receives LTIP?
LTIP by nature is disbursed to employees whose performance is crucial to the future of the company. In the majority of cases, LTIPs are exclusively offered to upper management and senior leaders, both in privately held companies and publicly traded firms. However, there is a growing trend in various industries, particularly in Europe where bonuses are not as prevalent, of providing equity-type programs to all full-time employees. This approach is aimed at fostering a culture of ownership and incentivizing top performers to remain motivated and committed to the organization. To learn more about this shift, visit our blog on compensation trends.
How does LTIP work?
The LTI component of the compensation is earned at present but is paid out (deferred) over a period of time, usually after an initial performance period. The vesting schedule i.e., the time span for LTIP payout is pre-determined and mutually agreed upon. This period typically lasts for three to five years, during which the employee must remain with the company. In case of termination or an employee leaving the organization before the vesting schedule, typically they forfeit this bonus.
There are also companies that payout awards post five or more years of service. In essence, the LTIP only becomes vested after the predetermined time period. The specifics of LTIPs, including the frequency, amount, and percentage of awards, vary widely among companies. It is up to each company to design a program that aligns with its goals and values while also making sense of its unique circumstances.
Types of long-term incentives
There are essentially various types of long-term incentives, called LTI vehicles, which can be categorized into four buckets – appreciation-based awards, time-based awards, performance-based awards, and cash-based awards:
- Appreciation-based awards: The value of these types of awards is tied to the increase in the company’s value over time. Gaining from the company’s growth and profitability, employees with stock options and stock appreciation rights (SARs), can yield substantial financial gains if the company’s stock price appreciates/rises. These awards give flexibility to companies for customizing the vesting period and deciding when and how often employees receive these awards. SARs are typically available to employees without any upfront payment after vesting, while employees need to pay the pre-set exercise price for stock options upon exercise. This structure allows employees to profit from buying low and selling high, but it also entails the risk of being worthless if the value falls below the exercise price, resulting in underwater stock options. Around 40% of organizations grant stock options, typically reserved for companies with higher growth trajectories.
- Time-based awards: These are granted to employees after a specified period of time in the company and require no upfront payment from employees and are therefore considered less risky than stock options. With time-based full-value awards like Restricted Stock Units (RSUs), the vesting period can be customized to suit the company’s needs. The timing of taxation for RSUs is also predetermined, with ordinary income tax being due once the awards vest. In contrast, with stock options, tax is only due when employees decide to exercise their options. RSUs typically require employees to remain with the company for a certain period of time before they can be sold. Typically, LTI participation is restricted to executive officers and above, however, restricted stock units (RSUs) remain the most popular vehicle used and are most commonly granted (89%) even to managers.
- Performance-based awards: Designed to reward employees based on achieving specific performance targets, rather than based on their tenure or growth of the company. Performance Share Units (PSUs) are an attractive option for companies to motivate employees to strive for higher and achievable performance levels. At least 50% of LTI awards are based on performance metrics. This is due to the persistent demands of proxy advisors and significant investors who prioritize performance-based compensation
- Cash-based award: Cash-based LTIs are awards of cash that vest over time. These awards may be based on company performance or individual performance and do not cause any ownership dilution issues as there are no shares involved. This makes it a popular long-term incentive for private companies as the valuation of their shares is complex. Employees who receive cash-based awards may not feel as invested in the company as those who receive stock-based awards.
LTIP payout is mostly in a portfolio approach given in a combination of LTI vehicles such as RSUs, PSUs, stock options, and cash. Each type of LTI has its own benefits and drawbacks, and companies may choose to use one or a combination of these plans to align employee incentives. Before starting the LTIP program the assessment is crucial in determining the right mix of LTI, percentage distribution, and vesting mechanics. It primarily depends on the overall culture, strategy, and long-term goals of the organization.
Variations in LTIP among Executive Compensation Structures
Given the executive compensation structure, long-term incentive plans (LTIP) form a huge part of their compensation. The percentage distribution between base salary, annual bonus, and long-term incentives can vary amongst different factors such as private or publicly listed companies, enterprise size, industry standards, and region-specific economy requirements.
For CEOs in the Americas, LTI levels are significantly higher than annual bonus levels when compared to that from Europe and Australia. LTI comprises 906% of salary at the median, compared to the annual bonus as 175% of salary in the Americas whereas it is 135% of salary and 100% of salary at the median, for LTI and annual bonus respectively in Europe and Australia. An exception is – Asia – where LTI programs are not as common as in other regions. Companies that do grant LTI, do on a sporadic basis linked to strategic events such as initial public offerings, five-year plans, or with a change in leadership team.
Best practices for designing long-term incentives
To ensure the effectiveness of long-term incentives, companies should follow these best practices when designing their programs:
- Align incentives with company goals: The first step in designing effective long-term incentives is to have a clear philosophy guiding the plan’s design and implementation. Factors such as the company’s stage of growth, industry benchmarks, and competitive landscape are to be considered that allow supporting business objectives with their values. This will help ensure that employees are motivated to work towards the company’s long-term success, rather than just short-term gains.
- Determine eligibility and performance metrics: Eligibility for long-term incentives is often based on job function, level of responsibility, and overall contribution to the company’s success. Defining key performance metrics such as revenue growth, total shareholder return, or earnings per share will drive the LTI program’s success. Establishing clear measurable performance metrics with transparent communication, ensures employees understand how their performance contributes to the program’s success.
- Set the Vesting Schedule: The vesting schedule determines the timeline for when employees can exercise their LTI awards. Typically, vesting periods range from three to five years, with a portion of the long-term incentives becoming available each year. Vesting schedules should be established to ensure that employees are motivated to stay with the company over the long term.
- Develop a comprehensive equity compensation plan: Companies should consider offering a variety of equity-based awards, including RSUs, PSUs, and ESOPs. This allows employees to choose the award that best aligns with their personal preferences and financial goals. Firms should also consider including provisions for equity plan administration, including governance, compliance, and communication.
- Communicate equity compensation clearly and frequently: Clear communication of the long-term incentive program is as important as establishing the program. This ensures employees understand how the program works, what performance metrics are being used, and what they need to do to earn their awards. Also include details on the number of shares available for grant, the vesting schedule, and the exercise price, as well as provisions for change of control and termination. This helps in building trust and engagement among employees, which can lead to increased retention and motivation.
- Use peer benchmarking: Benchmarking long-term incentives against other companies in the same industry can help ensure that the incentives are competitive and attractive to top-performing employees. This can help attract and retain top talent, particularly in competitive industries.
- Ensure Compliance with Regulatory Requirements: Organizations must comply with geography-specific regulatory requirements and rules for executive compensation disclosure to comply at legal and financial levels.
- Monitor and update the program regularly: Long-term incentive programs should be regularly reviewed and updated to align with company goals, compensation philosophy, and employee engagement levels. Companies should track key metrics such as equity grant utilization rates, vesting schedules, and employee retention rates. They should also conduct regular surveys to gather employee feedback on the equity compensation plan and use that feedback for future plan design and administration.
Leveraging technology for long-term incentive plan administration
LTIP administration can be complex and time-consuming, especially as companies grow and their equity compensation plans become more complex. To manage these plans effectively, organizations should leverage technology solutions that can:
- Automate key processes such as grant approvals, vesting schedules, and equity plan reporting.
- Improve accuracy and efficiency while reducing the risk of errors or compliance issues.
- Be flexible in accommodating and customizing different types of equity awards, performance metrics, and vesting schedules.
- User-friendly interface for both HR and employees to understand and track LTIP awards and metrics.
- Forecast the required accruals for deferred compensation.
- Integrate with other HR processes and systems such as performance management, compensation planning, and employee data management ensuring data security and compliance.
Key takeaway: Long-term incentive programs can be a powerful tool for retaining and motivating talent by promoting loyalty and a sense of ownership. A successful LTI program must be well-designed, effectively implemented, and regularly monitored and adjusted.
Following the modern approach of extending LTI to all employees and considering individual preferences, it can be a very effective tool in attracting and retaining key employees. Continuous updates in maintaining a robust LTIP program can help align overall compensation strategy and promote long-term growth.