The last two editions of KBA Insights drew on the results of a Monte Carlo Simulation to demonstrate the lottery-like nature of LTI Plans that vest based on ranked relative TSR.
In this month’s edition, we provide a deeper understanding of the results of the simulation. In doing so, we reveal who wins and who loses in what we have decided to call ‘the LTI lottery’. We also look at one particularly surprising vesting outcome related to Unilever Plc.
In a departure from our normal practices, this month we have provided links to three documents.
The first is the December edition of KBA Insights.
The second is to a paper entitled The Misunderstanding Behind all the Angst Around Executive Reward. This paper is a collaborative effort by Denis Kilroy and Marvin Schneider of KBA, and John Colvin of the Colvin Consulting Group. It was written to provide Non-Executive Directors with a summary of what our research has revealed about the way wealth is created over time in successful listed companies, and how the product and service market performance produce by management, translates into the capital market outcomes experienced by shareholders. This paper also shows that there is a fundamental misunderstanding in relation to both these matters embedded in the performance measurement frameworks and executive reward plan designs used in most ASX and LSE-listed companies.
The third is a comprehensive technical paper that provides a more detailed coverage of the topics addressed in the other two documents.
Returning to this month’s edition, the lottery-like nature of LTI plans that use ranked relative TSR as a vesting metric has been evident for years. Many have commented on this in the past, including BlackRock, Macquarie Equities and leading proxy advisor CGI Glass Lewis. However, its use has persisted.
These days, ranked relative TSR is generally augmented with an accounting metric like EPS, ROC or ROE in a well-intentioned effort to mitigate its lottery-like impact on vesting outcomes. Unfortunately, this ‘solution’ created another problem – the risk of encouraging short-termism – which we discussed in October.
Having once again highlighted the shortcomings of ranked relative TSR over the past few months, we were asked if we could provide some indication of the magnitude of the problem. There were two key findings.
Firstly, the lottery-like vesting outcomes produced by ranked relative TSR arise entirely as a consequence of the probabilistic nature the metric, and the way vesting thresholds are expressed in statistical terms (as percentile levels in a comparator group).
Secondly, vesting based on ranked relative TSR can be expected to produce an incorrect outcome in the form of a ‘false positive’ where executives benefit at the expense of their company and its shareholders; or a ‘false negative’ where the company and its shareholders benefit at the expense of executives; a little over half the time. There are slightly more ‘false positives’ than ‘false negatives’.
Of particular interest is the example of Unilever Plc which was a clear case of a ‘false negative’. Unilever delivered outstanding capital market performance over the five years to 31 December 2016, as well as over each of the rolling three-year periods contained within that five-year period. But the component of its LTI Plan related to capital market performance assessed using ranked relative TSR, delivered zero vesting to executives over the three years to 31 December 2016 – clearly an incongruous result.
ASX and LSE listed companies need a better approach to LTI Plan design. Moving away from the use of ranked relative TSR as a vesting criterion will be step in the right direction.
However, the move to hybrid plans with much larger short-term incentives (STIs) that has emerged over the past twelve months needs to be approached with some caution, as it may further encourage short-termism. It appears to have embedded the same misunderstanding that we address in The Misunderstanding Behind all the Angst Around Executive Reward.
To read the full article in this month’s KBA Insights, click here
To download a copy of KBA Insights in a print ready form click here
To download a copy of The Misunderstanding Behind all the Angst Around Executive Reward, click here
Top download a copy of a comprehensive technical paper entitled Getting Executive Reward Right, click here
To access GRG Remuneration Insights 100 click here
To access previous editions of KBA Insights click here
To watch a video of an address to the Governance Institute annual conference that provides a holistic response to the challenge of short-termism, click here
To purchase a copy of Customer Value, Shareholder Wealth, Community Wellbeing, Click Here