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Pressure from shareholders and institutional investor advisory groups to include stock performance metrics in incentive compensation plans, balanced with demand for a simple, yet durable approach to performance-based equity, has led to continued interest in programs that measure relative total shareholder return (“TSR”). Over the past few years, some of the core design parameters have evolved to strengthen the alignment of executive pay and performance while other terms have remained the same. Most notably, software companies lead in adopting these enhancements among the technology industry sectors.
To ensure your relative TSR program remains aligned with market, this Alert highlights notable trends and key practices among our technology industry client base and the 103 technology industry companies in Compensia’s July 2023 Tech 200 Database that awarded executives performance-based stock units (“PSUs”) that included a relative TSR metric.
Background on Relative TSR PSUs
Relative TSR PSUs are simply RSUs that vest based on a company’s change in stock price, plus dividends (if applicable) paid, over a pre-established performance period, measured against an appropriate index/peer group.
While these PSUs provide direct alignment with shareholders with respect to stock price returns, they are often supplemented with PSUs earned based on financial, operational or strategic metrics, as well as time-based vesting options or RSUs.
Where both relative TSR and financial metrics are weighted components of the plan formula (85% of the companies including both types of metrics), TSR accounts for, on average, 45% of the payout. The other 15% of companies use relative TSR results as a modifier to adjust payouts determined using financial or absolute stock price metrics, generally +/- 25 percentage points. No company eliminated a relative TSR metric for the current year, while 10 companies introduced relative TSR PSUs for the first time.
Performance Levels
Performance requirements are becoming more rigorous, with companies raising the bar from the standard structure of setting threshold payout at the 25th percentile, target payout at the median/ 50th percentile and maximum payout at the 75th percentile.
In response to ISS’ and Glass Lewis’ belief that companies should “outperform the index” to earn target level awards, and Compensation Committees’ desires to strengthen the alignment between pay and performance, there has been a 70% increase in the number of companies targeting higher percentiles. Hardware and semiconductor industries are slower to embrace this trend; however, these industries provide for less upside payout opportunities. Among software companies, 94% set the maximum payout at or above 200% of target, as compared to 69% of hardware industry companies and 82% of semiconductor industry companies. Threshold payout for achieving 25th percentile TSR remains most common (70% – 80% among all industry sectors).
Payout Cap for Negative Absolute TSR
Capping payouts at target for negative absolute TSR is viewed favorably by advisory groups, serves as a risk mitigator and strengthens the alignment of plan payouts with company shareholders.
Measurement Approach
Each of these approaches comes with tradeoffs in terms of understandability and alignment. Three approaches used to determine relative TSR PSU payouts include:
With select indices becoming increasingly weighted toward a small group of highly-valued companies (i.e., top 10 constituents represent 30% of the S&P 500; Apple, Microsoft, Amazon, NVIDIA, Alphabet and Meta represent 40% of the NASDAQ), more companies are questioning the impact of using a percentile rank approach on the plan outcomes.
Comparator Index
A market index supports a transparent process, eases program communication and reduces year-over-year plan design changes. Despite shareholder requests to tailor the relative TSR benchmark to an industry or line-of-business focused index, most software and hardware companies continue to use the S&P 500 or Russell 2000/3000.
Performance Periods
Multiple performance periods are most often used at recently public companies or those adopting relative TSR PSUs for the first time. An overlapping 1-, 2- and 3-year performance period approach, all measured from the same starting point, is most common. In calculating TSR, an averaging period of between 30 and 90 days at the beginning and end of the performance period is typical practice to mitigate the impact of price volatility on outcomes.
Need Assistance?
Compensia has extensive experience in helping companies design performance-based equity programs aligned with the pay program objectives, market practices and shareholder preferences. If you would like assistance in reviewing your existing programs, developing a new performance-based equity program, or if you have any questions on the subjects addressed in this Thoughtful Pay Alert, please feel free to contact Jodie Dane at 415.462.1985 or jdane@compensia.com.
About Compensia
Compensia, Inc. is a management consulting firm that provides executive compensation advisory services to Compensation Committees and senior management.