Relative total shareholder return survey: an opportunity to compare, assess and fine-tune plansBy: Stephen Zwicker, Bill Turner and Mark Daniels

Relative total shareholder return (TSR) remains the most popular performance metric for long-term incentive awards. These awards compare investment returns for a company against peer companies over a specific time period. Multiple surveys have shown that TSR is used by more than half of companies offering such performance-based awards, either as a single performance metric or as part of a suite of metrics. As such, our clients are interested in any plan design information and trends related to these plans.

A valuable tool

TSR’s popularity as a benchmark reflects dual demands faced by companies: the need to offer the proper incentives and rewards to covetable talent and the growing demand among shareholders to align long-term compensation with performance. It offers:

�� A transparent approach to tie pay to actual performance

�� An early alert to compensation levels that may either hurt say-on-pay support or reinforce the appropriateness of rewards

�� A way to measure whether the right talent is in place to achieve articulated strategies and goals

Figure 1: Form of settlement

0%

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90%Settlement vehicles

Cash Mix Stock

11.7% 7.0%

81.3%

Not surprisingly, most plans are stock-settled (Figure 1). This allows for fixed accounting. The fair value is determined as of the grant date using a pricing model such as Monte Carlo simulation, and the resulting expense is recognized over the required service period. It is not updated for actual performance. Cash-settled plans are marked to market.

InsightsJune 2018

What we found

This article provides insights into relative TSR design practices based on a recent survey of our clients’ plan provisions. It also presents an opportunity to evaluate how your company’s remuneration framework compares with others and whether any changes warrant consideration.

n=128

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1.8%

85.0%

13.3%

Less than 50th percentile

50th percentile

Greater than 50th percentile

Target levels

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Figure 2a: Threshold performance and vesting

Threshold performance (Figure 2a), the minimum performance required to warrant a payout, is most commonly set at the 25th percentile (i.e. 25% of peers have worse TSR performance), with a mix of companies above and below that level. Threshold vesting or payout (Figure 2b) is most commonly set at 50% of target. Other vesting percentages are almost entirely below this level.

Insights | June 2018

Figure 3a: Target performance and vesting

There is little variation in target performance levels and vesting (Figure 3a). They are almost always set at 50th percentile performance with target vesting at 100% (Figure 3b). A small number of companies require above median performance in order to earn target vesting. This can satisfy shareholder requirements that the company be better than average to earn target vesting.

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13.8%

56.0%

30.3%

Threshold levels

n= 109 n= 113

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6.4% 2.8%

19.3%

9.2%

59.6%

2.8%

0% 1% to 24% 25% 26% to 49% 50% >50%0%

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0.9%

99.1%

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Target payoutsFigure 2b Figure 3b

n= 109 n= 113

Insights 3

The most common maximum performance level is the 75th percentile (Figure 4a), but a significant number of plans establish higher levels. Maximum vesting is 200% of target (Figure 4b) about two-thirds of the time and 150% about a quarter of the time, with little variation.

A little more than a quarter of plans (Figure 5a) cap vesting at target (or something less) if the company’s absolute TSR is negative during the measurement period (or below some other threshold). Even if performance is above target relative to peers (i.e., negative TSR is better than the negative TSRs of peers), vesting is limited if shareholders don’t earn a positive return. In addition to satisfying shareholder concerns about negative returns, this feature will lower the fair value of the grant.

Overall payout caps (Figure 5b) are used by only 4% of our clients. These caps are used to limit the total amount that a participant can earn from the plan, including share price appreciation and vesting. For example, if the cap level is set at three times target value, the payout would be limited if the share price doubles over the performance period and 200% vesting is earned (for a total of four times target value). In this case, the number of shares delivered would be reduced. In addition to satisfying shareholder concerns about outsized payouts, this feature can significantly lower a grant’s fair value.

Figure 4a: Maximum performance and vesting

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45%Maximum levels

5.4%

38.4%

21.4%24.1%

10.7%

Less than75th percentile

75th percentile

76th to89th percentile

90th percentile

Greater than90th percentile

Insights | June 2018

n= 112

Maximum payouts

1.8%

23.2%

3.6%

68.8%

2.7%

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Figure 4b

n= 112

Figure 5a: Capped vesting and payouts

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71.9%

28.1%

No Yesn= 128

96.1%

3.9%

No Yes0%

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120%Overall payout cap

n= 128

Figure 5b

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Figure 6a: TSR measurement starting date and stock price averaging

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93.0%

7.0%

Year Grant

More than 90% of plans start measuring TSR at the beginning of the year (Figure 6a), either fiscal year or calendar year. However, the grant date for most plans is somewhere between one and three months into the year, when the board approves the awards. This requires that actual TSR performance between the beginning of the year and the grant date be reflected in the fair value. If the company is off to a good start relative to the peers, the fair value is higher and vice versa. This can add volatility from year to year in the fair value. Some companies have begun to manage this effect by starting the TSR measurement at the grant date.

Roughly 85% of plans use some kind of stock price averaging mechanism for calculating TSR (Figure 6b). This helps avoid short-term spikes or dips in the company’s stock price or peer company stock prices that could unduly impact the vesting result. A mix of averaging periods is used, but the most common is between 20 and 30 trading days (including one calendar month periods).

It is almost an even split between setting the peer group using a custom selected group of companies and using index constituents (Figure 7a). The index constituent category includes plans that use an industry subset of the index. Broad-based indices are often used when it is difficult to identify a custom peer group.

There is a wide range in the number of companies used as peers, but almost half of plans use between 10 and 25 companies (Figure 7b). There is a balance between percentile ranking issues with too few peers and the administrative effort for too many peers. The 10 – 25 range provides a good balance. Larger groups often indicate the use of an index.

Insights | June 2018

n= 128

15.0%

6.3%

44.9%

17.3%

4.7%

11.8%

None Less Thanone Month

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~ OneMonth

30 TradingDays

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Figure 6b

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Figure 7a: Peer company selectionPeer constituents

47.7%52.3%

Custom Index0%

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Number of peers

3.9%5.5%

47.7%

21.1%

8.6%13.3%

1 Less than 10 10 to 15 26 to 100 101 to 499 500 to more0%

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Figure 7b

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Insights 5

About one in six plans include peer companies whose main listing is outside the U.S. (Figure 7c). Non-U.S. peers create issues about how to measure TSR. Alternatives are to use American depositary receipts, if available; measure TSR in a peer’s home currency; or measure TSR using a peer’s main listing with conversion to U.S. dollars. These issues should be vetted at the outset of the plan to avoid any measurement uncertainty at the conclusion of the plan.

It is a pretty even split of companies that include themselves with the peers when calculating percentile rank (discrete) and companies that exclude themselves (continuous) (Figure 8). The discrete methodology slots the company into one of the fixed percentile outcomes regardless of how much they exceed the peer below them or trail the peer above them. The continuous methodology places the company in between two peers based on how much they exceed the peer below them or trail the peer above them. Differences between the two methodologies tend to shrink as the peer group grows.

About 10% of plans use TSR to modify the vesting outcome from another performance measure (Figure 9). Vesting is initially determined based on the other criteria and then adjusted upwards or downwards based on relative TSR performance. For these plans, the TSR modifier condition is subject to a fair value measurement (fixed if stock settled) and expense is only updated for the vesting outcome related to the non-market performance condition.

More than half of our clients offer dividend protection for their TSR based performance awards. This is generally in the form of dividend equivalents (Figure 10) that are accrued during the performance period and paid at the end based on the vesting outcome.

A fresh look

Whether a company has sponsored a relative TSR plan for a number of years or is just thinking about implementing one, a robust review of the plan features is encouraged to ensure a full understanding of the proper pay-for-performance alignment and accounting valuation implications. Many of the core features of these plans have not changed much over the years, but there are new features that have started to gain varying degrees of traction and may add value to companies’ plans.

Figure 8: Percentile ranking methodology

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83.6%

16.4%

No Yes

Use of non-US peers

52.8%47.2%

Continuous Discrete

Discrete vs. continuous ranking

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Figure 9: TSR as a modifier

No Yes

91.4%

8.6%

Modifier usage

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Figure 10: Dividend treatment

No Yes

37.6%

62.4%

Dividend equivalents

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Insights | June 2018

Figure 7c

n= 128

n= 123

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n= 101

About Willis Towers WatsonWillis Towers Watson (NASDAQ: WLTW) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson has over 40,000 employees serving more than 140 countries. We design and deliver solutions that manage risk, optimize benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas — the dynamic formula that drives business performance. Together, we unlock potential. Learn more at willistowerswatson.com.

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