EVAluation Stern Stewart Europe Limited

Volume 1 Phani Solomou, +44 (0)171 399 3644, [email protected]

Issue 1 Fredrik Gustavsson + 44 (0)171 399 3645, [email protected]
March 1999

UK Remuneration Practices
Do UK Incentives Align
Managers With Shareholders?

• Owner-like remuneration strategies should balance three main

objectives: wealth gearing, retention and cost. We found little
evidence of companies weighing tradeoffs and balancing objectives.

• UK short-term incentive plans have problems:

Ø Incentives are based on too many measures with weak link to
value creation.
Ø Targets are based on negotiated budgets and reset each year.
Ø Payout caps minimise opportunity.
Ø Thresholds limit accountability.
Ø Rewards are not at risk over multiple years.

• Long term incentive plans are not aggressive enough.

• We propose innovative structures that overcome many of the

identified deficiencies.

Stern Stewart Europe Limited, 13 St. George Street, London, W1R 9DE
EVA® is a registered trademark of Stern Stewart & Co.
EVAluation is a series to be published monthly by Stern Stewart Europe Limited, drawing on the depth of our
experience and internal research, to cover issues of valuation, organisational design, decision making, remuneration,
and corporate governance. Our focus is to assist managers in understanding how their actions affect the value of
their organisations. We believe that all stakeholders benefit from the creation of value through both innovation and
efficiency.

“Executive remuneration should be structured to maximise NPV, not

minimise expense. The media should stop its harassment of so-called fat
cats. With incentives that better align the interests of managers and owners,
corporate governance would be greatly reinforced. If managers are paid
more like entrepreneurs, UK companies will be more aggressive, innovative
and competitive, while also being more sensitive to risk management. This is
vital for the success of the nation and its people.”

Greg Milano, Managing Director, Stern Stewart Europe Limited.

The views expressed in this report are based on Stern Stewart Europe’s general knowledge, analysis and
understanding of value, incentives and corporate governance issues. All estimates and opinions included in this
report constitute our judgement as of the date of the report and may be subject to change without notice. No
warranties are given and no liability is accepted in contract, tort (including negligence) or otherwise by Stern
Stewart Europe for any loss, or damage that may arise from actions based on any information, opinions,
recommendations or conclusions contained in this report. This report is being submitted to selected recipients
only. It may not be reproduced (in whole or in part) to any person without the prior written permission of Stern
Stewart Europe Limited.

Stern Stewart Europe Limited, 13 St. George Street, London, W1R 9DE
EVA® is a registered trademark of Stern Stewart & Co.
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Executive Summary
Most UK companies state a commitment to shareholder value in their annual reports. At
Alignment of UK a recent conference, we asked investors and security analysts how they distinguish the
incentives with companies that take this seriously from those that have good investor relations.
shareholders. Unanimously, they said you could tell by the remuneration. “If management commits
their pay to shareholder value, we know they are serious.”

We reviewed the remuneration practices of the FT30 to see whether UK executive

incentives really align with owners. Although our sample is small, only by combining
the remuneration data with our Market Value Added database1 we found effectively no
correlation between performance and pay 2, as shown in Exhibit 1.

Exhibit 1. Performance does not seem to count!

180%
160%

140%
Bonus as % of cap

120%

100%
80%

60%
40%

20%
0%
-0.5 0.0 0.5 1.0 1.5 2.0

Change in MVA/Capital

Source: Stern Stewart Research

Design, policies and We propose a framework for designing owner-like remuneration strategies, by balancing
compliance. the three main objectives of gearing, retention and cost. We found no evidence of
companies weighing the tradeoffs and balancing the remuneration objectives. Corporate
governance committees and Stock Exchange Listing Rules have led to a “the same plan
applies to all” situation.

Incentives are We found many flaws in UK short-term incentive plans. Rewards are based on too many
flawed. measures that do not directly link to value creation, targets are based on negotiated
budgets that are reset each year, payout caps minimise opportunity, thresholds limit
accountability, and rewards have no element of risk over multiple years. Long term
incentives are often not aggressive enough.

Our proposition. For short term plans we propose that multi-year targets are derived from investor
expectations, caps and thresholds are removed and rewards are held at risk over multiple
years. Long term plans should strengthen wealth gearing and alignment through the use
of more aggressive equity structures and granting policies.

1
Stern Stewart calculates annually the MVA (Market Value Added) of the top 500 UK companies. The FT200 MVA 1997 Ranking was published
in the Sunday Times on 27 September 1998.
2
We considered the relationship between actual bonuses declared and upper limits for highest paid director for 1997/8 as an indication of level of
performance. If the maximum bonus had been declared then performance would have been considered exceptional.

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Introduction
Over 90% of the FT30 companies (Exhibit 2) state in their annual reports their
Shareholder value commitment to maximising shareholder value. But how can we distinguish those that
and management are committed to this paradigm from those that just talk about it as part of their investor
incentives go hand in relation strategy? The obvious place to look is in the remuneration reports. Managers
hand. with remuneration packages that poorly align with shareholders’ interests can take
actions that help themselves but hurt the value of the company. Or managers that have
the success of the company at heart may be faced with a reduced personal remuneration
to do what is right for the owners. Only when incentive systems fully align managers
and shareholders’interests will such problems be overcome.

Exhibit 2. FT 30 companies for 1997/8(ranking based on market capitalisation).

Glaxo Welcome Prudential B Sky B

British Petroleum GEC Rio Tinto
British Telecommunications Marks & Spencer Bank of Scotland
Lloyds TSB HSBC Holdings Granada
Shell CGU Royal Bank of Scotland
Vodafone Sainsbury National Power
Barclays Tesco Orange
Nat West Bank Boots Company PLC Scottish Power
Cable & Wireless Royal Sun Alliance Standard Chartered
Abbey National PLC Cadbury Schweppes Pearson

Effective incentive An incentive plan should achieve alignment by balancing three main objectives: gearing,
plan design depends retention and cost (Exhibit 3). Wealth gearing measures the strength of an incentive
upon balancing three concept in aligning the reward to shareholders with that of managers (ie. wealth gearing
main objectives… measures the sensitivity of management’s expected wealth from employment to changes
in shareholder wealth). Alignment deals with what financial economists call agency
costs. As agents, managers will often pursue their own interests which, if not aligned
with shareholders’, may lead to poor company performance. Full alignment is achieved
when managers and shareholders fortunes are moving in the same direction.

Exhibit 3. Balancing of remuneration objectives.

Gearing

High Risk High Cost

Conflicts!

Retention Cost
Competitive Practice

Source: Stern Stewart Europe Research.

... an exercise which Balancing these remuneration objectives entails difficult trade-offs. If we choose high
entails difficult gearing to provide strong motivation while keeping costs low, we create substantial
tradeoffs. management retention risk during business downturns. If we maintain higher gearing
and protect against retention risk, the average expected cost of the incentive plan rises.
If we instead choose to emphasise cost containment and retention risk, the gearing drops
to levels that are not truly motivating. Each company must understand its own needs
well enough to ensure that the desired outcome is achieved.

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All components of Remuneration packages normally have three main components. Base salary (including
remuneration benefits and pension), short-term bonuses and long-term incentives. From the employees
package ... perspective base salaries can be characterised as fixed income, resembling debt
payments. As long as the company is a going concern and the executive remains
employed, these payments are made. Short-term bonuses should be performance-based
and should align with shareholders over the medium term. Long-term incentive plans
further extend the time horizon and have the potential of shaping the overall wealth
gearing of the remuneration package.

... should simulate The remuneration package should encourage managers to have a multi-year perspective
ownership and and pursue strategies that create sustainable value. They should think and act as owners
encourage multi-year because they are faced with both the accountability and opportunity of owners. We
value creation. evaluate the wealth gearing of remuneration packages by using a remuneration risk map
as shown in Exhibit 4.

Exhibit 4. Remuneration risk map.

Debt Equity

Salary Bonus
Benefits LTIP
Pension Overall
Wealth
Gearing
Source: Stern Stewart Europe Research.

Designing effective Designing effective remuneration packages entails evaluating the company specific
remuneration dynamics, defining the scope and boundaries of a desired remuneration strategy,
packages is a multi- understanding the relevant trade-offs of alternative structures, selecting the most
step process. appropriate package and communicating that both internally and externally. The “same
value” of remuneration can be provided with vastly different levels of risk and reward, as
illustrated in Exhibit 5.

Exhibit 5. Alternative same value packages entail different trade-offs.

More Reward

Cumulative
Management
Reward

More Risk

Cumulative Shareholder Gains

Source: Stern Stewart Europe Research.

Individual elements The individual elements of remuneration should not be viewed in isolation nor be
should not be viewed evaluated over a single period horizon. Management’s expected wealth is comprised of
in isolation or over a current income (including existing stock and option holdings) as well as the present
single period horizon. value of expected future compensation (including salary, benefits, pension, bonuses and
long-term incentive gains). The desired reward profile of the remuneration package over
the longer-term can be achieved by blending the individual elements of remuneration.

This report will analyse the current executive remuneration practices in the UK, focusing
on the FT 30, with respect to policy, salary, short-term bonuses and long-term incentive
plans. We also propose alternatives that overcome many of the identified deficiencies.

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Remuneration Policies & Compliance

Corporate Remuneration committees have been influenced by the publication of corporate
governance governance reports3 and the best practice provisions (Sections A & B) annexed to the
committees and Stock London Stock Exchange Listing Rules. Despite the overwhelming “commitment” of
Exchange Listing FT30 companies to shareholder value creation, in more than half of the companies did
Rules have influenced not identify the link between value creation and incentive plans that align manager and
current practices. shareholder interests4 as shown in Exhibit 6.

Exhibit 6: Stated remuneration policies and objectives of FT30 companies.

Claiming alignment 47%

Mentioning gearing 0%
Focusing on retention 100%
Focusing on minimising shareholder cost 0%
Source: Stern Stewart Europe Research and 1997/8 Annual Reports

Public corporations This is alarming as most investors and academics consider alignment with shareholders
have not been as one of the most effective corporate governance mechanisms. Michael Jensen of
“eclipsed” as Harvard Business School publicised these issues in Harvard Business Review5, where he
predicted by Michael argued that the incentive problems of large publicly traded corporations were so
Jensen … significant that they would become extinct. He claimed that they would be “eclipsed” by
LBO type organisations. LBO’s, that replace equity with debt, encourage management
… because discipline through the need to service debt and through greater equity stakes by
remuneration management6. However, LBO organisations have not replaced traditional corporations
practices have because remuneration structures and governance practices have changed. Ways of
changed. replicating the motivation inherent in LBO’s, without the high risk and lack of flexibility
caused by high debt equity ratios have been developed and proven.

Returning to the practices of FT30 companies, we find that there are little differences in
the remuneration practices between companies that declare their commitment to
alignment and those who do not. Exhibit 7 summarises the remuneration plans of
companies that are claiming alignment and those that do not. In fact, by offering more
equity-based incentives, the companies that are not claiming alignment are marginally
better.

Exhibit 7. Summary of remuneration plans of FT30 companies.

Short term incentive plan Long term incentive plan

Bonus shares
if cash
Cash Shares invested in Cash Shares Options
company's
shares
Companies claiming
alignment of directors’and
89% 11% 20% 4% 54% 43%
Shareholders’interests
Companies not claiming
alignment of directors’and
81% 20% 20% 0% 50% 50%
Shareholder’s interests

Source: Stern Stewart Europe Research & FT30 1997/8 Annual Reports.

3
“The financial aspects of corporate governance”, December 1992. Committee was chaired by Adrian Cadbury. “Directors Remuneration, report
of a Study Group chaired by Sir Richard Greenbury” July 1995. “Committee on corporate governance: Final report”, January 1998. Committee
was chaired by Ronnie Hampel.
4
This was assumed to be the case given that only 47% of the companies included any mention of the fact in their remuneration reports.
5
“Eclipse of the public corporation” Michael Jensen, Harvard Business Review Sep-Oct 1989.
6
“Performance pay and top management incentives” Michael Jensen and Kevin Murphy, Journal of political economy, 1990.

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No evidence of The remuneration policy statements should give investors clear insights on remuneration
companies weighing objectives. Unfortunately this is not the case. For example, all companies, whether
tradeoffs and clearly stated or implied, claim as one of their main objectives to “pay competitive
balancing objectives. salaries in order to attract, motivate and retain high calibre executives”. This statement
implies that attraction, retention and motivation are largely a function of base salary,
which is not the case. From our experience, managers frequently accept jobs with lower
salaries but more upside potential in an attempt to maximise their wealth.

Policy statements are not customised to the specific circumstances of each company and
There is evidence of
the specific desired behaviours. There is also great similarity of incentives across
“the same plan
companies in different industries. This might be because of compliance with listing rules
applies to all”.
and corporate governance guidelines. But it seems that companies with different
dynamics, opportunities and management objectives should have different incentive
policies. For example, one of the Stock Exchange Recommendations7 states that
“performance conditions should be relevant … and designed to enhance the business”.
For 70% of the companies this is translated as a generic statement such as “it is our
policy to offer performance based rewards on the achievement of business
objectives...”8. This does not provide investors with any useful information.

Guidelines require The listing rules recommend that performance conditions should be stretching and total
that performance potential rewards should not be excessive 9. The objective of these clauses is aimed at
conditions be giving a perception of ethical reasonableness and control of shareholder costs. We
stretching. looked for evidence of these “stretch targets” and found none.

We tested the relationship between actual bonuses declared10 and upper limits, or bonus
payout ratios during the financial years 1996/7 and 1997/98. We considered the payout
ratio as an indication of the evaluation of the CEO’s performance. If the maximum
bonus had been declared, then the CEO’s performance would have been considered
exceptional. Exhibit 8 shows the results of this analysis.

Exhibit 8. Evaluation of CEO performance - Distribution of actual bonus paid as a

percentage of upper limits.

30%
25% 1997
% of companies

20%
1996

15%
10%

5%
0%
0% 20% 40% 60% 80% 100% 120% 140% 160%

Bonus as % of upper limit

Source: Stern Stewart Europe Research & FT30 1996/7 and 1997/8 Annual Reports.

We looked for We would expect the distribution to be bell shaped, (ie. normally distributed). This is
evidence of these not the case, especially for 1997. The clustering between 50% and 100% indicates that
“stretch targets” … . the cap is not deemed to be a “significant award for over-performance” but rather the
high end of the target or expectation. Therefore, there is little evidence of the existence
7
Stock Exchange Listing Rules, Schedule A: Provisions on the Design of Performance Related Remuneration, Point 1.
8
The final report of the Committee on Corporate Governance, January 1998 reached the same conclusions. Section V 4.15. “A number of
companies have met the letter of this requirement with anodyne references to the need to “recruit, retain and motivate” or to pay “market rates”.
We consider that a policy statement is potentially helpful, to set the context for the more detailed information; we hope that companies will
provide more informative statements, drawing attention to factors specific to the company.”
9
Stock Exchange Listing Rules, Schedule A: Provisions on the Design of Performance Related Remuneration.
10
Analysis is based on annual bonus of the CEO or highest paid executive (including executive chairmen).

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of stretch targets. There also is a shift towards the right, year on year (ie. higher
percentages of upper limits were paid in 1997/8 than in 1996/7 – 80% and 73%
respectively). One reason for this is value creation in terms of MVA (Market Value
Added) which increased more in 1997/8 than in 1996/711. Another reason is that 18% of
the remuneration committees in 1997/8 used their discretion to authorise bonus payments
in excess of the stated maximums. Although rewarding exceptional performance for a
“job well done” is not a practice we disagree with, the fact that rewarding for “over
achievement or beating expectations” is left at the discretion of the remuneration
… and found none. committee (despite measured performance) is.

In the UK, there is a perception that base salary and benefits are an adequate reward for
expected performance and bonuses are for exceeding expectations. We do not agree
with this philosophy. Average performance should yield average bonuses with built in
mechanisms that allow risk on the downside and opportunity on the upside. The bonus
should be motivating across a wide range of performance possibilities. Unfortunately,
given that bonuses are clustered between 50% and 100% of maximum, neither of these
philosophies is evident in practice.

In summary, effective policy generation and incentive system design goes beyond
compliance or a “following the leader” approach. It requires balancing remuneration
objectives and making difficult tradeoffs taking the needs of each company into account.

Base Salaries
It is common practice to review base salaries annually by reference to external surveys of
Levels of base
peer companies. Indeed, the base package of over 50% of the FT30 is within the
salaries are based on
£400,000-500,000 range (Exhibit 9). The final salary is adjusted at the discretion of the
surveys and director
remuneration committee according to the individual’s experience, performance and
market value.
market value. There is no evidence that company size alone influences salary, which is
good.

Exhibit 9. Distribution of FT30 CEO’s base salaries and benefits.

35%
30%
% of companies

25%
20%
15%
10%
5%
0%
0

0
50

00

50

50

50

50

50

00
00

00
50

60
1-3

1-4

1-4

1-5

1-6

1-7

1-8

1-9
1-7

1-8
1-

1-
45

55
30

35

40

50

60

70

80

85
65

75

Salary & benefits (£1,000)

Source: Stern Stewart Europe Research & FT30 1997/8 Annual Reports

Although we found no relationship between level of base pay and performance over a
one or two-year horizon, one might argue that it is the aggregate performance or “market
value” of the CEO over his/her career that counts. This is difficult to test.

Short-Term Incentive Plans

93% of the FT30 companies had short-term plans with a one-year horizon. Although
long-term plans better encourage owner-like behaviour, short-term bonuses are important
because as Professor Michael Jensen12 of Harvard Business School puts it “if you pay
people in terms of large equity positions… what will happen is because of imperfections
11
The change in MVA between 1995/6 is £29bn and between 1996/7 is £108 bn. The FT200 MVA 1997 Ranking was published in the Sunday
Times on 27 September 1998.
12
Evangelist Magazine Volume II Issue III, 1998.

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in the human brain, managers will actually lose focus on the day-to-day and year-to-year
basis”. Therefore, it is important that short-term plans incorporate owner-like
characteristics as well.

Design of short-term Designing effective short-term incentives is essentially a three-step process. The first
incentives involves step is selecting a performance measure that has a high correlation to value creation, that
three steps. encourages owner-like behaviour and can be applied for decision-making at all levels of
the organisation. The second is identifying a target setting mechanism that is robust and
applicable over time. The third is designing a reward mechanism that encourages
sustainable value creating behaviour and better aligns with shareholder interests over the
medium term.

Performance Measure Selection

Multiple measures In general, companies use too many measures and often measures that encourage
cause confusion and undesired behaviours. The actual number of measures mentioned by individual
companies is shown in Exhibit 10. Using a variety of measures for day-to-day decision
conflicts.
making, capital budgeting, planning, benchmarking and other important processes
creates conflicts and confusion for managers. The system becomes fragmented with a
loss of understandability and accountability.

Exhibit 10. Distribution of performance measures used by FT30 companies13.

40%
35%
% of companies

30%
25%
20%
15%
10%
5%
0%
1 2 3 4 5 6 7

Number of measures

Source: Stern Stewart Europe Research & FT30 1997/8 Annual Reports.

Although companies tend to disclose only a sample of the measures used, Exhibit 11
gives a flavour of the wide range stated.

Exhibit 11. Performance measures used by FT30 companies.

• Achievement of individual performance objectives
• Achievement of strategic milestones/goals
• Achievement of financial plans/annual budgets
• Budgeted levels of operating expenses and income
• Return on capital employed
• Profit margins
• Growth in profit after tax, growth in trading profit
• Growth in sales
• Market share targets for key products
• Economic profit, Shareholder value added
• EPS growth, inflation adjusted EPS growth
• TSR
• Non-financial qualitative measures such as customer services, product
quality, safety and environmental performance, millennium compliance
etc.
• ETC… ..
Source: Stern Stewart Europe Research & FT30 1997/8 Annual Reports.

13
The actual observations of this table should be taken as guidance only as companies tend to disclose examples or more significant measures used
rather than complete lists.

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The performance measures used for reward can be summarised in five main categories.

1. non-financial measures.
2. some form of accounting income-based measure (eg. operating earnings14.)
3. growth-based measures (eg. EPS & revenue growth)
4. rate of return measures (eg. return on capital, TSR)
5. economic profit

Non-financial measures
Non financial Approximately 30% of the companies mention non-financial measures ranging from
measures are too ethical guidelines to customer satisfaction. Non-financial measures could be useful for
vague and the desired some businesses, especially if such measures capture information missed by financial
behaviour is not measures (eg. compliance with ethical guidelines). This is particularly relevant when
obvious. the non-financial measure is a leading indicator of future financial performance such as
customer satisfaction where infrequent purchases occur.

Our experience is that such measures are often too vague, the desired behaviour is not
obvious and there is no clear trade-off versus other factors. Consider an extreme
example. Suppose Kodak wished to increase customer satisfaction, and decided to
include a £20 note with each roll of film. The exceptional satisfaction of customers
would not stop the company from going out of business. Managers should consider the
trade-offs between the cost of improving customer satisfaction and the benefits in terms
of volume or prices.

Accounting income-based measures

67% of the companies use operating earnings. Accounting based income (like operating
Accounting based earnings, net income or EPS) is a poor measure of performance for shareholders. These
measures are a poor measures ignore the cost of capital, or at best only consider the cost of debt. If investors
measure of earn any return at all, even below investor expectations, earnings increase and bonuses
performance… benefit. As a consequence, managers are encouraged to over-invest and use more of the
“free” resource - capital. Accounting profits are also distorted by accounting
conventions such as expensing of research and development, despite the long term
expected benefits15. Investment in the future is thus discouraged. Finally, accounting
measures do not reflect the overall risk of the profit stream. As a result, accounting
based profit measures do not correlate well with share prices16 and may encourage
undesirable behaviour.

Growth-based measures
21% of the companies use EPS growth and 18% use revenue growth measures. Both
… and so are growth
EPS and revenue growth have negligible correlation to value creation17. Like accounting
based measures. earnings measures, earnings growth measures also encourage over-investment.

Using growth measures can be systematically misleading. Any company that has
experienced a “bad” year can easily show phenomenal EPS growth the following year
while the actual results might well be below market expectations. In such a case,
managers will receive rewards even if they destroyed value.

14
Operating earnings are normally defined as earnings before extraordinary items, interest and tax.
15
Stern Stewart research on 400 companies in 12 sectors concluded that in sectors like pharmaceuticals, chemicals and engineering share prices
rise upon announcement of intention to increase R&D. This is because of investors’ expectations of future rewards.
16
Stern Stewart research of the 1997 FT500 companies has concluded that standardised EBIT has an explanatory power of standardised enterprise
value of only 29% (ie. only 29% of the variations in enterprise value can be explained by operating earnings).
17
Stern Stewart research of the 1997 FT500 companies has concluded that revenue growth had a 3% correlation between the firm’s standardised
MVA multiple and EPS had a 0% correlation. There is also negligible correlation between operating profits growth. Investment analysts at
Credit Swiss First Boston have also reached the same conclusions.

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Return measures
Return measures 10% of the companies use return measures such as return on capital employed, return on
have an inadequate sales (profit margin) and total shareholder returns. Reward is normally tied to increasing
correlation to value the measure18. Although this is an improvement over EPS or revenue growth because
creation. capital investment is considered, return measures also have an inadequate correlation to
value creation19. Basing reward and decision making on maximising such measures
encourages over-investment in weak businesses and stifles growth in strong businesses
as we will demonstrate below.

The basic rule of modern corporate finance states that value is created if returns are in
Return measures can excess of the cost of capital and value is destroyed when returns are below the cost of
be misleading for capital. Maximising the rate of return does not support this. Consider a successful
decision-making and company that is evaluating a value creating investment, as shown in Exhibit 12. If
reward the wrong rewards are based on maximising the return on capital, management would not be
behaviour. rewarded for this investment since the return on capital would drop from 25% to 23%.

Exhibit 12. Rewarding on maximising the return on capital encourages under-

investment in successful businesses.
Existing New After
business investment investment
Income 250 100 350
Capital (Assets) 1,000 500 1,500
Return on Capital (R) 25% 20% 23%
Cost of Capital 10% 10% 10%

Alternatively, consider a business earning returns below the cost of capital, as in Exhibit
13. A new investment, which will also earn returns below the cost of capital and thus
destroy value, will be rewarded because it improves the returns.

Exhibit 13. Rewarding on maximising the return on capital encourages over-investment

in underperforming businesses.
Existing New After
business investment investment
Income 50 40 90
Capital (Assets) 1,000 500 1,500
Return on Capital (R) 5% 8% 6%
Cost of Capital 10% 10% 10%

Short-term TSR is a 3% of the companies use Total Shareholder Return20 (TSR) for annual bonuses. Over
noisy measure of multi-year periods, TSR is an excellent measure of performance for shareholders. Given
performance. the share price volatility over a single year, this is problematic and it is questionable
whether it would encourage any desired behaviour. TSR is a noisy measure and is
influenced heavily by external factors. Managers might be more concerned with investor
relations than managing the business itself.

Economic profit
7% of the companies listed economic profit as a performance measure. This is a shift in
the right direction but unfortunately the lack of disclosure on how economic profit is
calculated does not allow us to comment on either alignment with value creation or with
respect to the behaviour it encourages.
18
Return on asset measures were mentioned by 7% of the companies and profit margins by 3%.
19
Stern Stewart research of the 1997 FT500 companies has concluded that return on equity had a 10% correlation with MVA.
20
Total shareholder return is defined as the theoretical capital growth that would have been achieved by a shareholder over a pre-determined period
assuming all dividends were reinvested and adjustments for rights issues and other changes to share capital are made.

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Target Setting Mechanism

All but one company set target performance levels based on annually negotiated
Annual targets are
targets21. These targets determine the level of reward at the end of the year. Such
negotiated and reset
practice encourages the management of expectations rather than performance and the
each year…
concealment of information about opportunities. The time horizon and focus becomes
the next 12 months and how this is best justified since “we can negotiate next year later”.
By resetting targets every year the emphasis on continuous improvement is undermined.

… creating numerous This also reduces wealth gearing because actual cumulative results over time do not
problems… really matter. Exceptional performance could result in higher targets and less future
opportunity, while poor performance could result in more future opportunity. In either
case, managers are not encouraged to ensure that actual performance is enhanced over
time.

Focusing on the short-term might limit long-term potential. Good ideas that have
… like focusing on the
negative short-term impact and benefits in the future are penalised now and merely built
short term might
into future budgets, taking away the reward to the manager. This creates conflicts and
limit long-term
dilemmas. Managers might make decisions that are beneficial for the company with a
potential. reduction in annual remuneration. We believe this has a big impact on the lower level of
R&D spending by UK companies versus their foreign peers particularly in the U.S.

Reward Mechanism
Caps and thresholds on performance
Caps and thresholds There are normally caps on annual bonuses set as percentages of base salaries22. The
on performance are caps for the FT30 companies range from 25% - 150% of base salaries, with the average
observed. around 60%. We found no evidence that low salaries are reinforced by higher bonus
potential or vice versa.

There is also normally an under-performance threshold, below which no bonus is earned.

Disclosure is weak as companies imply the existence of a threshold but do not state the
actual levels. A graphic representation of a typical short-term incentive plan is shown in
Exhibit 14.

Exhibit 14. Typical short-term incentive plan.

Bonus %
“Go golfing point”

Unrewarded performance
“Take a big bath”

Target
Threshold
Unpenalised under-performance Performance measure
Source: Stern Stewart Europe Research & 1997/8 Annual Reports.

Shareholders do not One might expect such a plan to be attractive to shareholders as both a minimum level of
have caps and performance and a maximum level of bonus (shareholder cost) is established. When
thresholds so why viewed in terms of the behaviour it encourages, it is not attractive as it promotes a “take
should managers. a big bath” or “go golfing” mentality! Once a manager expects performance to be below
the threshold, the incentive would be to pull cost in from next year, and to “build
reserves”. This is often the time to restructure under-performing operations since it has
no effect on the manager. Once the “deemed” maximum level of performance is reached
21
The only exception is one FT30 Company, which distributes a fixed percentage of its earnings before tax to its board members at pre-agreed
rates.
22
7% of the companies do not disclose the actual mechanism and 4% distribute a fixed percentage of annual earnings before tax to board members
at pre-agreed rates.

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Stern Stewart Europe Limited

the incentive is to “pull back” and again incur extra costs and “build reserves”. In either
case, there is no incentive for the manager to turn a good year into an excellent year or to
limit the negative effects of a bad year.

Of course, the above are mere guidelines as all actual bonus payments are at the
discretion of the remuneration committees. We believe this in itself demonstrates a lack
of confidence in the formal bonus structure.

Effects of not having rewards at risk over multiple years

Paying bonuses Paying declared bonuses immediately in cash and not holding part of the bonuses at risk
immediately discourages long-term accountability. Managers are encouraged to engage in value
encourages near-term destroying actions without the risk of losing their bonuses in the future. For example, to
actions without long- boost the current year profits and bonuses, managers may reduce marketing or
term accountability… maintenance costs.

No company in our sample offers rewards that are truly at risk subject to sustainability of
the performance measure over multiple years. 75% of the companies pay the declared
annual bonus awards in cash, 18% pay a blend of cash and shares (normally 50:50 split),
… since rewards are 3.5% offer exclusively company shares and 3.5% give the option of cash or shares. Cash
not at risk over payments are either made upon declaration (93% of companies) or with a one-year delay
multiple years… (7%).

Of the companies offering shares, such shares must be held for 2-3 years. 43% of such
companies23 offer bonus shares at the end of the cycle. In addition, 22% of the
companies offering 100% cash payment of bonuses declared also offer bonus shares at
the end of the cycle in order to encourage equity shareholdings. Although the practice of
… although the offering bonus shares might be deemed to increase shareholder costs this is not
encouragement of necessarily a bad investment. Bonus shares are compensation for non-diversifiable risk24
share ownership is a (arising due to owning large holdings in one stock). Such practices encourage share
positive step. ownership that adds another equity-based component, reduces retention risk and
increases wealth gearing.

Can Short -Term Incentive Plans be Improved?

The current systems of performance measurement and reward have significant flaws that
do not always encourage value-creating behaviour. In the following section we will
propose a superior and proven design that overcomes the deficiencies discussed above.

Performance Measure Selection

Base rewards on Economic Value Added, EVA .
EVA has the highest EVA is the measure that best aligns manager interests with those of owners25. EVA26 is
correlation with simply the net operating profit after tax less a charge for the capital invested in the
value creation… business.

A few simple adjustments to operating profit and capital are made to greatly improve the
relationship between EVA and share price. An example is the capitalisation and
amortisation of research & development to better match costs and benefits, improve the
relation to share price and encourage a longer-term view.

23
In certain cases cash bonuses need to be additionally invested in company shares for the bonus shares to be vested.
24
There have been a number of academic studies of the way that unique or diversifiable risk is reduced by diversification, including: M. Statman:
“How many stocks make a diversified portfolio”. Journal of Financial and Quantitative Analysis, 22:353-364 (September 1987).
25
Stern Stewart and other independent studies have indicated that EVA is a far superior measure of wealth creation. Our regressions of FT500
1997 data have indicated that standardised capitalised EVA has a 61% predictive power of market value. Inferior measures include return on
equity, cash flow growth, EPS growth, dividend growth, sales growth. The results on an industry by industry basis are even more
overwhelming. For example, a study of the global pharmaceutical industry by Credit Swiss First Boston has demonstrated a correlation of 87%.
A Stern Stewart study of the UK retail sector indicated a correlation of 86%.
26
EVA NOPAT – c * Capital
NOPAT Operating profit (1-tax rate)
C Weighted average cost of capital
Capital Net investment of debt and equity holders
Tax rate Cash tax rate before the tax benefit of interest expense

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Stern Stewart Europe Limited

… and encourages Reintroducing the earlier examples27, EVA provides the right signals to management all
the right behaviour the time. In Exhibit 15, despite the decline in return on capital, the new investment
all the time. would be accepted as it adds to EVA. Since the investment beats the cost of capital, it
adds value.

Exhibit 15. EVA always sends the right signal for successful companies.
Existing New After
business investment investment
Income 250 100 350
Capital (Assets) 1,000 500 1,500
Return on Capital (R) 25% 20% 23%
Cost of Capital 10% 10% 10%
Capital Charge (100) (50) (150)
EVA 150 50 200

In Exhibit 16, the investment would be rejected as it has a negative EVA, even though
both profits and return on capital increase. Since the investment falls short of the cost of
capital, it destroys value. Only EVA shows both and quantity and quality of earnings,
thus providing an unambiguous signal of value creation.

Exhibit 16. EVA always provides the right signal for under-performing companies.
Existing New After
business investment investment
Income 50 40 90
Capital (Assets) 1,000 500 1,500
Return on Capital (R) 5% 8% 6%
Cost of Capital 10% 10% 10%
Capital Charge (100) (50) (150)
EVA (50) (10) (60)

EVA encourages managers to do four things that increase value.

EVA encourages
managers to do four 1. Increase the returns from the assets already in the business
things to create value. 2. Invest additional capital and aggressively build the business as long as the
returns on new investments exceed the cost of capital.
3. Release capital from existing operations where the returns are inadequate
4. Reduce the cost of capital.

Basing remuneration on a single measure that encourages the right behaviour and has a
high correlation to value creation sends a strong signal to the market that the company is
committed to value creation.

Target Setting Mechanism

Derive definitive multi-year performance targets from investor expectations.
Investor expectations of future EVA improvements are implicit in share prices. Share
prices rise and value is created when managers exceed these expectations and vice versa.
It is our practice to translate these market expectations into definitive multi-year
performance targets, thus avoiding the need for annual negotiation. Exhibit 17
demonstrates how this provides rewards for cumulative success and penalties for
shortfalls.

27
Exhibits 12 and 13.

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Stern Stewart Europe Limited

Exhibit 17. Multi-year definitive targets.

EVA Actual

Target
Target

N oow
w

Y eeaarrss
Source: Stern Stewart Europe Research

In some industries (eg. petrochemicals and mining) people might argue that external
Our experience has factors influence performance more heavily than management. It would be nice to
been that this separate the performance of managers from the influence of external factors.
approach is Unfortunately, as soon as we accept this, it creates a tremendous incentive to waste time
applicable to all explaining why the outside world caused all problems and managers created all
industries. opportunities. Superior value is created when executives better manage all business
opportunities and risks, including external factors. If we want managers to behave as
owners, they must be paid as owners.

Reward Mechanism
Remove caps and thresholds.
Once caps and Managers face more opportunity and accountability, without gaming opportunities, once
thresholds are the caps and thresholds are removed (Exhibit 18). The unlimited upside promotes
removed, managers entrepreneurship and the unlimited downside, which allows for negative awards,
face more discourages excessive risk taking. Whatever the performance is currently, there is
opportunity and always the same incentive to generate more EVA. This provides full alignment by
accountability. simulating equity like payoffs.

Exhibit 18. EVA bonus plan.

Bonus %

Payoff line
Target Bonus

E V A Improvement

Source: Stern Stewart Europe Research

The slope determines The slope of the payoff line determines the overall gearing of the plan. This is
the gearing. determined relative to the expected variability of business performance and the desire for
a specific risk and reward profile among managers.

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Stern Stewart Europe Limited

Place rewards at risk over multiple years.

An innovative way of ensuring that performance is sustainable before significant rewards
are paid is through the use of a “bonus bank”. Each year, a bonus is declared depending
on the EVA improvement versus the target. The declared bonus is deposited in a bonus
bank with only part of the total balance paid. Exhibit 19 illustrates how the bonus bank
works. Year 5 is an outstanding year but a substantial portion of the award is held at
risk. When performance declines, as in year 6, the bank allows negative payoffs and
absorbs a portion. A bonus payment is made although the bonus bank balance is reduced
substantially.

Exhibit 19. EVA Bonus Bank.

Year 4 Year 5 Year 6 Year 7

Opening balance 120 120 180 100
Declared bonus 60 150 (30) 80
Available bonus 180 270 150 180
Cash payout (33%) 60 90 50 60
Carried forward 120 180 100 120

Source: Stern Stewart Europe Research

There are many different bonus bank structures providing varying degrees of risk, time
A “bonus banking” horizons and dynamics. Overall the bonus bank discourages short-term gaming,
mechanism ensures smoothes through downturns, lengthens decision horizons for managers, and holds
that rewards are at managers accountable for delivering expected returns year on year. This greatly
risk over multiple enhances the simulation of ownership.
years.
Due to the added risk and the possibility of negative declared bonuses, the average target
bonus must be increased to compensate managers for the extra risk they bear. However,
this is a worthwhile investment for shareholders as the behaviour that is motivated will
be far superior to a conventional bonus plan.

Long-Term Incentive Plans

For remuneration in the UK, long-term is normally defined to be 3 years or more. There
Long term incentive are many different types of long-term incentive plans. They differ with respect to the
plans strengthen equity vehicle used (restricted share or share options28), the performance tests used to
wealth gearing and vest awards and the grant guidelines (level of grant, timing and management
alignment. investment). The objective is to strengthen the wealth gearing and the alignment of
interests between managers and shareholders.

Most companies state in their remuneration reports their aim to achieve alignment of
directors’ and shareholders’ interests through the encouragement of share ownership.
This approach is also supported by numerous academic studies29. Although long-term
incentives are aligned with shareholders, the potential share ownership offered is often
too small to encourage true entrepreneurial behaviour.

Disclosure
It is our opinion that the disclosure on long-term incentive plans is generally poor,
Disclosure is especially with share option plans. Investors would like to know the rationale in
generally selecting an equity instrument; the justification of the performance tests used; the goal of
disappointing. the granting mechanism and the details of such mechanism; the boundaries of the
remuneration committee’s discretion; the interaction created by the various plans in
place; and the details of all restricted shares and share options. Disclosures on options
should include the date granted, level of grant, time horizon, value, exercise prices,
performance test targets, expiry date, extension periods if any, and the policy with
28
Surprisingly 3% of the companies pay out long-term incentive plan rewards in cash.
29
For example Bud Crystal has found that shareholder value increases in large capitalisation companies as the CEO’s shareholdings increase.
Professors Moon Song of San Diego State University and Ralph Walking of Ohio State University have concluded that significant managerial
share ownership related to above market returns of 23.4% in successful takeovers. This is because managers only considered value creating
acquisition activities due to the impact that had on their personal wealth.

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Stern Stewart Europe Limited

respect to director departure or dismissal. The lack of consistent disclosure has limited
our analysis and conclusions.

Equity Instruments
Restricted shares
Restricted share Companies with restricted share plans annually award shares that are held in trust for a
plans provide a period of 3-4 years. This provides a strong retention incentive. The shares are released
strong retention at the end of the cycle subject to restrictions, such as continued employment and
incentive. satisfaction of performance tests30. Currently, 53% of companies have restricted share
plans with an additional 10% having a restricted share plan combined with an option
plan. Normally, share option and restricted share plans are mutually exclusive rather
than supplementary.

Short-term plan The practice of combining short-term bonuses with equity incentives enhances alignment
restricted shares and reduces retention risk. Over 25% of the companies combine their short-term
enhance alignment incentive plans with time based restricted shares. In particular, 55% of such companies
make it compulsory for all or part of the annual bonus to be paid in restricted shares that
and improve
are held for a period of 2-3 years. The percentage of the annual bonus paid in shares
retention risk.
varies from 30% to 100% with the average being around 50%. Almost 90% of the
companies that have compulsory restricted shares offer extra rewards of bonus shares.
Normally the only restriction with respect to the bonus shares is time, although 10%
have a performance test restriction (eg. target EPS growth). The remaining 45% of the
companies have a voluntary investment in restricted shares. Bonus shares are offered to
encourage managers to take up the offer. Although disclosure is often vague, bonus
shares are normally forfeited if the individual director leaves the company. The same
applies to director dismissal.

Share options
Should plain “at the It is common in the UK to grant “at the money options"31 which are exercisable three
money options” years after grant. Currently 36% of the FT30 companies have option plans in place. An
common in the UK… additional 10% have option plans in combination with restricted share plans. To comply
with the Greenbury report, companies have attached performance criteria to the options.
This is desirable, as without a performance test, the option holders would benefit from
any increase in the share price even if too small to provide an acceptable return.

There is a number of more aggressive option plans available, which are currently not in
place at any of the companies reviewed. Options of such plans are not normally granted
at the money. For example, the exercise price of indexed options tracks a specified index
or peer group. Premium options are granted at a pre-set percentage out of the money.
Leveraged options are granted at a discount and the exercise price grows at a
predetermined rate (normally the cost of equity less the dividend yield with an
adjustment for the inability of managers to diversify their risk). These leveraged options
… be substituted simulate the reward profile of an LBO without putting the company at risk with
with more aggressive excessive debt. The fact that these are either out of the money or at a rising exercise
plans? price ensures that managers do not benefit unless shareholders get a desirable return first.

Why would managers want to subscribe to these tougher standards? To deliver the same
remuneration value, substantially more options are granted. But once performance
exceeds the standard, the manager’s participation in each additional increase in value is
much more highly geared. Managers are less likely to get a reward, but if they do
… we think so. perform well, their rewards can grow much faster.
30
7% of the companies have a plan, which is not typical in the sense that shares are not awarded unless the performance criteria have been fulfilled.
Once awarded, shares need to be held in trust for the required period of 3 years, subject to continued employment.
31
Share options provide the owner with the right to purchase common shares at a pre-determined price over a fixed time period. Exercise prices
can be “in the money” (ie. below current market price), “at the money” (ei. equal to current market price), or “out of the money” (ie. above
current market price). The option holder receives a gain only if the market price during the term exceeds the exercise price and does not
normally receive dividends on unexercised options.

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Stern Stewart Europe Limited

Wealth Gearing
Wealth gearing is It is important to emphasise the difference between income and wealth. Managers, like
very difficult to shareholders, try to maximise their wealth, as opposed to current income. The true
measure of the incentive strength is the sensitivity of management wealth from
calculate.
employment to changes in shareholder wealth. For example, assume that a manager
holds 60% of his wealth in company shares and 40% as the present value of future base
salary and benefits. As a 10% change in shareholders’ wealth induces a 6% change in
the managers wealth, the total wealth gearing would be 0.60. The total wealth gearing of
a “pure entrepreneur” is 1.0.

Calculating the total wealth gearing of an executive can be a difficult process using the
externally published information in the UK. However, we can examine the factors that
influence wealth gearing. Exhibit 20 compares the wealth gearing of various equity
instruments. Although restricted share plans provide strong retention incentives they are
weaker than options in inducing wealth gearing. Since a substantial portion of
remuneration is base salary and equivalents, which have a wealth gearing close to zero,
options can be used to enhance the overall wealth gearing of the remuneration package.

Exhibit 20. Comparison of equity incentive securities.

Restricted shares Restricted shares Share options Share options

with time based with performance “at the money” “premium/indexed
restrictions based restrictions /leveraged”

Increasing Wealth Gearing

Source: Stern Stewart Europe Research

Options have higher The gearing of an option is always greater than one while the gearing of a share is
gearing than shares. always one. In fact, the gearing of an option changes as the share price changes and as
the option comes closer to expiration. To demonstrate, consider an executive who is
granted a 10-year option at the current market price of £10. Using the Black-Scholes
model with a volatility of 30%, a dividend yield of 3%, and risk free rate of 5%, the
value of the option is £3.12. If the share price jumps by 50% from £10 to £15 the option
value increases from £3.12 to £6.12 – an increase of 96%. If the share price drops by
50% from £10 to £5 the option price declines by 75% to £0.80. Exhibit 21 shows that
the gearing of an option declines as the option comes into the money and increases as the
option falls out of the money32 as well as how gearing increases as the option approaches
expiration.

Exhibit 21. Wealth gearing of an option with a £10 exercise price.

12 12

10
Share Price = £6
10 Exercise Price £5

Share Price = £10 Exercise Price £10

Option Gearing
Option gearing

8 8
Exercise Price £15
Share Price = £14
6 6

4 4

2 2

0 0
0 1 2 3 4 5 6 7 8 9 10 2 4 6 8 10 12 14 16 18 20
Time to expiry (years) Share Price
Source: Stern Stewart Europe Research

32
Graphs are based on the assumption that a 10-year option with a £10 exercise price is granted at the money.

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Stern Stewart Europe Limited

The higher gearing of stock options versus shares is reinforced by a study carried out by
Academic research
Brian Hall, Associate Professor at the Harvard Business School and Jeffrey Liebman,
verifies that granting
Assistant professor at Harvard’s Kennedy School of Government33. They found that
options is more
shares and options provided a much stronger link to shareholder value than traditional
efficient in aligning
base salary and annual bonus did. On average, a 10% increase in a company’s value
CEO incentives with
produced an increase in salary and bonus of only 2.4%. This shows how poor most
shareholders.
bonus plans are at rewarding value creation. But when changes in the value of shares
and options were considered, compensation went up by 50%. “If you look at the link
between total pay and performance, you find that about 98% of that link is attributable to
changes in the value of stock and option holdings, and only 2% comes from salary and
bonus changes”, says Hall. “And because options are much more sensitive to stock price
swings – both positive and negative – than stock itself, the granting of options appears to
be the most efficient means of bringing CEO incentives in line with the interests of
company owners”.

Hall34 went further to review the link between pay and performance for different types of
options. He analysed shares, “at the money” options, “out of the money” options and
“indexed” options. He demonstrated that indexed options are more sensitive to share
price than out of the money options, which are in turn more sensitive to share price than
at the money options.

It is unclear whether remuneration committees consider the most appropriate vehicle of

Are UK attaining the desired wealth gearing or even whether they consider wealth gearing at all.
remuneration The current trend of replacing traditional stock option plans with performance based
committees going a restricted share plans could be considered as a step “backwards”. This is moving
“step backwards”? remuneration packages away from simulating ownership and will lead to less innovation,
less accountability and poorer performance over time.

Although options provide a strong performance incentive for executive directors they are
not an effective tool for lower level managers who have a modest impact on share price.
The line-of-sight is just not adequate. However they are sometimes used at these levels
because of the illusion that stock options are a “free form of compensation”35. We
should not let accounting conventions mislead us on such important issues. It would be
much better to design an EVA incentive system for these managers with a close line-of-
sight and forget about shares and options altogether.

Performance Tests
The practice of using performance tests in the UK is a big improvement over the gifted
The practice of using
equity vehicles used in the US. The most common performance test measures are TSR36
performance tests as
and EPS37. TSR tests are predominately used for restricted shares while EPS tests are
a vesting vehicle is a
more common for share options (Exhibit 22).
big improvement.
Exhibit 22. Performance criteria of restricted share and option plans.
TSR EPS Unspecified
Restricted shares 87% 13% 0%
Options 29% 57% 14%

Source: Stern Stewart Europe Research & 1997/8 Annual Reports.

33
“Compensation: Refining CEO stock options” Harvard Business Review; Boston; Sep/Oct 1998. Hall and Leibman used Black-Scholes method
of option valuation to assess the correlation between CEO compensation and stock market valuations for 478 large US companies during the
1980’s and early 1990’s.
34
“The pay to performance incentives of executive stock option plans” Working Paper Brian Hall. 1998
35
Examples include the approved employee share ownership plans in the UK.
36
TSR tests normally involve comparisons between the individual company’s three-year TSR with those of either peers or the index.
37
EPS tests normally refer to estimating whether the individual company’s EPS growth exceeded the Retail Price Index (RPI) plus an additional
pre-specified percentage (normally 2-3%).

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Due to shortcomings Due to the shortcomings of measures like EPS, companies have begun to turn to TSR
of measures like EPS tests. These tests effectively eliminate market movements and reward managers when
companies have they do well versus the market, not because of the market. Restricted share plans with
begun to turn to TSR tests have become increasingly popular (Exhibit 23).
TSR…
Exhibit 23. Increased popularity of restricted share plans with TSR performance tests.

70%
60%

% of companies
50%
40%
30%
20%
10%
0%
1990 1991 1992 1993 1994 1995 1996 1997
Year

Source: Stern Stewart Europe Research & 1997/8 Annual Reports.

… which causes At the end of the cycle, the restricted shares are released to the executive according to
problems if you the performance test results. This increases gearing. What concerns investors is that
compare yourself to many companies are comparing themselves to the FT100, as shown in Exhibit 24. Over
the wrong group. 50% of TSRs are explained by external factors and there is evidence that TSRs are
predominately sector driven (eg. IT and Pharmaceuticals). Ideally, a company would
select a list of peer companies whose operations reasonably resemble its own.

Exhibit 24. TSR tests of restricted share plans.

70% 63%
60%
% of companies

50%
40% 32%
30%
20%
10% 5%
0%
Peers FT50 FT100

Reference group
Source: Stern Stewart Europe Research & 1997/8 Annual Reports.

It raises concerns With respect to share options, it is concerning that EPS growth still remains the most
that EPS is still used common performance measure. The weak correlation between EPS and value creation
for options. as well as the behavioural issues discussed above, render this measure inappropriate.

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Grant Guidelines
Equity incentives can be granted to executives through several processes, which have a
hidden but significant impact on wealth gearing.

UK practices
Although in general 31% of the companies with restricted share plans do not disclose what determines the
disclosure is poor for level of the award each year while 6% disclose that the award and level is at the
both restricted shares discretion of the remuneration committee. The remaining companies disclose the fixed
and… value of the award, which ranges between 25%-100% of base salary. This shows that
the award of at least 63% of the companies is not tied to current performance.

Disclosure of grant guidelines for share options is very poor. 61% of the FT30
… share options, companies either do not disclose the details or imply that the award is discretionary
based on the evaluation of the remuneration committee. The remaining companies
disclose a “fixed value” award whereby the value of shares underlying the options
granted is determined by a fixed percentage of a director’s annual base salary (ie.
number of options is total value divided by exercise price). The most common value is
… current practices an annual grant of 100% of base salary up to a maximum of 400% for all outstanding
may diminish options. Ironically, if management is successful, they are penalised by receiving options
gearing. on fewer shares in the future. The gearing is diminished the better a manager performs.

Alternative grant methods

Alternative grant methods include fixed share grants where the number of shares or
Althernative grant options to be granted each year is set in advance for multiple years (ie. the total value
methods like varies with the share price) as well as front loaded grants (ie. five years worth of grant at
purchasing the begining of the period). Overall, fixed share grants have higher wealth gearing than
equity incentives can fixed value grants, since the fixed number means executives are rewarded for good
shift risk from performance with a larger value of grants.
shareholders to
managers. In addition to grants that are offered for “free”, equity incentives can be purchased by
executives through deferring a portion of their annual bonuses, through forfeiting a
portion of salary or future salary increases, through purchasing equity incentives directly,
or through a combination of recourse and non-recourse loans. As shown in Exhibit 25,
grants shift risk to shareholders while purchases shift risk to managers.

Exhibit 25 . Compensation risk of alternative grant mechanisms.

Fixed Fixed share/ Cash purchases

multiple front loaded Bonus/salary/merit ownership
grant grant purchases guidelines
guidelines guidlines

Compensation Risk

More risk borne More risk borne

by shareholders by managers

Source: Stern Stewart Europe Research

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Stern Stewart Europe Limited

Can Long-Term Incentive Plans be Improved?

There is no single We cannot suggest a “single structure” that is superior to what we observe today. This is
structure that is because the nature of long term incentives is to shape the alignment and gearing while
applicable to all balancing retention and cost objectives. We have suggested various mechanisms that
companies although would “improve” current practices. We discussed the selection of equity instrument,
current plans can be performance tests on vesting award and grant guidelines. Integrating the elements is
improved. unique for each company.

US based engine producer Briggs & Stratton has chosen leveraged share options (LSOs)
Briggs & Stratton and linked the long-term incentive plan to the company EVA bonus plan. The value of
demonstrate one way LSOs granted in a given year is directly related to the EVA bonus payout for that year.
of creating an In addition to the cash bonus, each executive receives an out-of-the money option (with a
effective long-term five-year term) on shares with market value equal to 10 times the EVA bonus payout.
incentive plan. These LSOs become exercisable at the end of three years. In effect, the executives
receive double the EVA bonus payout with the requirement that half be invested in a 10-
to1 leveraged stock investment. The principle is to reward only exceptional
performance. The exercise price rises at the cost of capital return for the five year option
period. With the EVA plan, performance determines the number of LSOs granted.
Since the LSO programme is structured to require a cost of capital return before the
options are in the money, the plan also rewards growth in EVA. Without developing a
high value growth strategy, management can have little expectation for a payoff. The
plan recognises that growth without capital discipline destroys value and it rewards only
value creating growth. The LSO incentives are structured in such a way to reward the
maximisation of both current and long-term performance. Linking EVA with LSOs is a
very strong means of aligning managers and owners.

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 STERN STEWART EUROPE LIMITED

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