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Breakthrough Could Herald New Approach to Executive Reward

A recent breakthrough in understanding means many companies might now take quite a different approach in designing their executives’ long-term and short-term incentive plans.

Most LTI plans measure performance in a way that produces the wrong reward outcome just over half the time, with slightly more ‘false positives’ where executives benefit at the expense of the company, than ‘false negatives’ where the company and its shareholders benefit. 

This was one of the findings of a Monte Carlo Simulation conducted on a typical LTI plan by The KBA Consulting Group contained in a discussion paper written by Denis Kilroy and Marvin Schneider of KBA, and John Colvin of the Colvin Consulting Group.

The problem ultimately stems from the use of relative TSR to assess capital market performance. This metric assigns a percentile ranking to a company’s TSR within a group of peers. 

Relative TSR has attracted a lot of criticism over the years, and its continued use concerns Kilroy and Schneider, who did a comprehensive ‘take-down’ of the metric in a book released in August entitled Customer Value, Shareholder Wealth, Community Wellbeing (Palgrave Macmillan, 2017).  

The authors argue that relative TSR turns LTIs into lotteries.  The simulation they ran showed that when a company delivers capital market performance broadly in line with expectations, executives can expect zero vesting of their performance rights 45 percent of the time, full vesting 30 percent of the time, and partial vesting 25 percent of the time.

Lead author Denis Kilroy explained that most LTI plans are designed to deliver 50 percent vesting if a company’s TSR is at the median in the comparator group.  “This is supposed to be a proxy for matching market performance or meeting expectations.  But clearly it doesn’t work,” he said. “And the main reason it doesn’t is the probabilistic nature of relative TSR and the fact that vesting thresholds are expressed as percentile rankings in the comparator group.”

It gets worse.  When vesting outcomes from relative TSR were compared with the underlying capital market performance attributable to management, it was evident that relative TSR produced either a ‘false negative’ or a ‘false positive’ roughly half the time. 

“It’s a complete lottery” Mr Kilroy said.  “So, it’s no wonder many executives just focus on their short-term incentive (STI) and put their LTI in the bottom drawer.  But STIs are a problem too, because most involve the use of stretch targets.”

“Stretch targets in STI plans encourage management to try to beat expectations by extracting more performance from a business than its strategy was intended to deliver.  They are a major driver of short-termism, and their pursuit is more likely to destroy shareholder wealth than create it” he said.

When asked how this situation had come about, he explained it all stemmed from a widespread misunderstanding in relation to two things: how wealth is created over time in successful listed companies; and how the performance produced by management in the market for their company’s products and services, translates into the capital market outcomes experienced by shareholders. 

The paper draws on research covering 300 companies listed in Australia, the UK and the USA, to show how those which thrived and created the most wealth over time, didn’t do it beating short-term expectations.  They did it by creating capabilities and harnessing innovation leading to the establishment of new and higher performance expectations to be delivered in the future.  They then met, or went close to meeting, those new and higher expectations.  And they did it again and again. 

“These misunderstandings are a problem.  But they are cleared up in our book”, said Mr Kilroy, adding that “As my colleague John Colvin points out, unless there is a proper understanding in place in relation to these matters, and performance measurement and reward systems are aligned with that understanding, poorly designed incentives can lead to behaviours that can distort the settings the Board has put in place aimed at steering their company towards long-term success.”

A PDF version of this press release is available here.

Contacts for further information:    

Denis Kilroy, Managing Partner

The KBA Consulting Group

Denis.Kilroy@kba.com.au; +61 451 669 413

John Colvin, Principal

Colvin Consulting Group

jcolvin@johncolvin.com.au;  +61 409 183 174