In an age when shareholders get an advisory vote on executive pay, there is an increased focus on pay-for-performance. As a result, more banks are using long-term performance plans. Unlike traditional restricted stock and stock option awards that vest solely over time, long-term performance plans also include pre-established performance goals that must be met for awards to be earned.
Meridian’s 2012 study of chief executive officer incentive plans at publicly traded banks with assets between $1 and $5 billion indicates that 34 percent include performance-based awards in their long-term incentive program, including more than half of the banks larger than $2 billion in the study.
We anticipate the use of long-term performance plans will continue to increase. Shareholders and proxy advisors (such as Institutional Shareholder Services) typically respond positively to the implementation of long-term performance plans. Additionally, well designed performance-based awards help provide balance and risk mitigation to incentive programs. Many companies have used performance plans in their long-term incentive program to replace stock options, which regulators have discouraged as a riskier way to reward performance. Following are some of the key design elements to be considered in designing a long-term performance plan:
- Award vehicle. Banks predominately use full value shares (restricted stock or restricted stock units) in their long-term performance plans. The number of shares ultimately awarded may vary based on different levels of achieved performance (e.g., threshold, target, and maximum). While less common, programs can also be cash-based.
- Performance period. Seventy-four percent of performance plans in Meridian’s study use three-year performance measurement periods. Typically, three-year performance objectives are established at the beginning of the performance period, and awards are paid out based on actual performance at the end of the three-year period. However, it can be challenging to establish appropriate three-year goals, particularly in an era of high economic uncertainty. To avoid this challenge, some plans are structured for annual goals to be set each year of the three-year vesting period, while others only establish one-year goals but require additional service before awards are paid out.
- Absolute and/or relative measurement. Performance criteria can be absolute goals based on internal expectations, or they can evaluate performance relative to a peer group of companies. Relative goals can make it easier to establish long-term performance goals, but provide less direct line-of-sight for executives and require a relevant group of companies to use for comparison. Practices among banks in Meridian’s study are mixed—35 percent use absolute goals, 35 percent use relative goals, and 30 percent use a combination of both.
- Performance measures. Measures should tie to key corporate objectives that will drive long-term shareholder value. Return measures (e.g., return on assets, return on equity) are most common among banks, followed by earnings measures such as earnings per share and net income. Some banks measure shareholder value directly, tying payouts to the company’s total shareholder return ranking relative to a comparator group. Most banks use two or three performance measures in their plans.
- Mix and match. While performance plans can be a critical part of a bank’s long-term incentive program, they may not meet all of the program’s objectives. Performance plans are often used in combination with time-based equity grants (e.g., stock options and restricted stock) to provide a balanced program and limit compensation risk. In most cases, the performance plans are used to deliver 50 percent or more of the target long-term incentive value for senior executives, but are often combined with other award vehicles such as time-based restricted stock.
Several other items must also be considered when designing a long-term performance plan, including: Who will be eligible, how will it be disclosed, what is the accounting expense, what are the tax consequences, and will shareholders approve of the plan? While performance-based long-term incentives require many decisions, they can enhance pay-for-performance and create a balance between short-term and long-term objectives. Banks that do not currently have long-term performance plans should consider whether introducing one would improve the effectiveness of their executive compensation program.