An entire generation of investors has lobbied companies to use total shareholder return (TSR) as the barometer for executive pay. It has become commonplace mainly because investors believe TSR is a short-cut to align executives’ interests with their own. The problem is that this method of measuring success is almost always short-term in nature. By tying pay to stock prices over short periods of time, companies and investors are actually putting their long-term interests at risk.
Aligning incentives is important, but TSR misses the mark. Here’s why: according to Equilar, a corporate leadership data firm, over half of the largest US companies use a form of TSR in their compensation plans. But despite being called long-term incentive plans (LTIPs), almost 20% use 1 or 2-year terms, and less than 2% use terms of five years or longer. The use of short-term TSR in LTIPS pays executives for things outside of their control, like market sentiment, momentum, or the influence of public policy. And it encourages executives to be overly focused on short-term market movements rather than long-term value creation.
Simply extending the timeframe of TSR is appealing but challenging. We know from behavioral studies that executives dramatically discount deferred payments. Extending TSR to ten years to incorporate longer-term performance would devalue the incentive entirely for most executives.
So, if short-term TSR rewards the wrong thing, and long-term TSR is not practical, it cannot be the best metric to encourage CEOs to sustain the long-term success of a company or long-term returns for investors. What are some alternatives?
One is linking shareholders’ and executives’ fortunes through significant long-term shareholdings by corporate leaders. In fact, Norges Bank Investment Management, the Norwegian sovereign fund wealth and the largest in the world, has suggested that a substantial proportion of total compensation be paid in shares that are locked up for 5 to 10 years, regardless of resignation or retirement.
Another alternative that some companies have adopted is using relative total shareholder return (rTSR). But relativity is not the quick fix it appears to be. As the name suggests, executives paid in this way will receive more when their companies’ stock appreciates and pays out more than those of its “peers” and vice versa. In addition to the short-term nature of most of these metrics, peer groups are subject to interpretation – or even manipulation – with companies pursuing different strategies.
Furthermore, the use of short-term TSR or rTSR as a pay metric stands in stark contrast to the recent push for stakeholder capitalism. Paying executives only in terms of how short-term shareholders benefit is, at best, a distraction from the interests of the firm’s clients, employees, society, and the planet. At worst, it thwarts a focus on creating long-term value for shareholders and other stakeholders alike.
Tailored metrics can more practically gauge an executive’s performance in the interest of a company’s key stakeholders, including long-term shareholders. KPIs tied to a company’s core drivers of growth, like new product launches, diversity efforts or customer adoption, are helpful when included in long-term pay packages, and some of these can already be found in many public companies. Long-term objectives that show where the company stands and where it is headed – like market share, return on capital, carbon footprint, or operating cash flow – are better indicators of a company’s progress, are relevant for investors, and are consistent with sustainable growth over time.
Investors and companies cannot take a short cut to paying executives effectively. To point their organizations in the right direction, effective compensation committees reinforce key organizational goals and priorities such as building strong employees, loyal customers, effective suppliers, and good community relationships – all of which in turn build long-term shareholder value. Short-term TSR, on the other hand, reinforces a short-sighted obsession with market movements rather than a long-term mindset. Long-term investors would be wise to push for broader metrics than taking the short-cut of TSR – it is a dead end.
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March 10, 2021 at 09:00PM
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Why Basing CEO Pay On Stock Performance Rarely Works - Forbes
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