Three Key TSR Incentive Design Considerations

As proxy advisors and shareholders continue to focus on improving the relationship between compensation and shareholder returns, and new pay for performance rules are finalized by the U.S. Securities and Exchange Commission, it is likely that more companies will consider adapting incentives based on Total Shareholder Return (TSR) principles. Ultimately, companies need to balance shareholder value creation with executive motivation and retention when deciding whether a TSR-based incentive plan is appropriate and aligns with the company’s compensation philosophy.

If TSR is utilized in a performance-based award package, companies need to consider the following three factors: whether TSR should be measured on an absolute or relative basis, the appropriate TSR performance hurdle, and whether there will be a cap on payouts based on absolute TSR performance.

1. Absolute versus Relative TSR. Absolute TSR requires the company to set stock price targets that must be achieved to earn a payout. Establishing an absolute stock price level at the beginning of a performance period can be challenging, as a declining stock market could make goal achievement difficult to achieve, while a “buoyant” stock market could make the absolute goal relatively easy to achieve. The challenge with relative TSR is that it requires the company to select a peer group or index that is appropriate for relative TSR performance comparisons. Identifying an appropriate comparator can be particularly challenging for companies in unique markets or industries with just a few competitors.

A well-designed TSR plan might provide that when a company achieves both low absolute TSR and relative TSR, little to no payouts would be allowed (Figure 1, box C); similarly, when absolute TSR and relative TSR performance are high, payouts would be sizable (Figure 1, box B).

In cases of high absolute TSR with low relative performance (Figure 1, box A), some type of reduction in payouts might be appropriate, as the company underperformed the stock market. Similarly, in cases of low absolute TSR and high relative TSR performance (Figure 1, box D), management could be rewarded for out-performing a down stock market.

Competitive practice, however, does not often combine these two concepts. Most plans are based on relative TSR, with no adjustment for absolute performance. The few companies that set absolute stock price (or TSR) goals do not consider relative performance. A few large companies have introduced payout caps when absolute performance is negative, a concept which is discussed below.

2.TSR Performance Hurdle. If absolute TSR is utilized, a company will need to decide a minimum stock price level that must be achieved to trigger a payout (e.g., the current stock price is $15, and a trigger price of $30 is established before a payout can be earned). Determining an absolute stock price, or TSR hurdle, should stretch the executive’s efforts, but should not be demotivating. That said, the performance of the overall stock market or the stock performance of the company’s industry sector can make the $30 target in the example either impossible or easy to achieve, which may not create the intended incentive.

For relative TSR, the company must decide the minimum level of relative performance compared to a peer group or market index that begins to provide a payout. This approach allows companies to avoid the need to set a specific stock price. However, it is important to remember that a relative TSR goal may not provide the intended motivation, as the goal is not as clear cut as the absolute stock price target (and, presumably, the underlying earnings or cash flow that must be achieved to support the target stock price).

A typical relative TSR performance curve for a US-based company is illustrated in Figure 2. The threshold level is often the most debated payout level on the performance curve, although competitive market practice suggests the 25^th percentile is the most common threshold performance level. By way of contrast, a UK-based company would typically start payouts at 50^thpercentile relative performance.