Over the last few months, several exasperated clients have expressed difficulty determining new grants for their Long-Term Incentive Schemes (“LTI”) and/or are questioning the effectiveness of the current LTI given the financial uncertainties relating to Covid-19 and post pandemic financial landscape.
Without being inane and stating the obvious, LTI is a vital component of your Employee Value Proposition (“EVP”) and influences the company’s ability to attract and retain talented individuals, introduce a high-performance culture and ensuring the attainment of the company’s strategy- ultimately resulting in increased profitability.
Let’s examine a few truths about current LTI schemes extracted from behavioral psychology:
- The most important observation from behavior psychology is that executives are prone to hyperbolic discounting. Assume I was to receive $100 in 3 years. The present value (the value today) should simply be the future value discounted by the risk-free rate applicable in that country – as a global average this would probably be around 5% per annum. $100 would then be worth $86.38 today – a discount of 14%. Executives however discount the $100 by almost 50%.
- Executives are risk adverse and prefer a smaller guaranteed amount to a possible bonus of higher value.
- Inclusivity Recognition Need – in various surveys, only 50% of executives state that an LTI is an effective incentive but 66% stated that they valued the opportunity to participate in such a scheme.
- LTI’s have always been proposed as the ideal vehicle to address Agency Theory which states that by bridging the divide between the executive and company, this will ensure that both are working towards a common goal and the implication is that both will strive to increase the long-term value of the company.
However, various studies have shown that there is LITTLE correlation between LTI schemes which are designed on the Agency Theory methodology and/or incorporate the agency philosophy, and the share price. If shareholders do not receive the benefit of a higher share price, why have an LTI, in its current format, at all?
Professor Alexander Pepper in his article, “The Case against Long-Term Incentive Plans” which was published in the Harvard Business Review, October 2016 issue states:
”My research suggests, somewhat perversely, that companies would be better off paying larger salaries and using annual cash bonuses to incentivize desired actions and behaviors. Additionally, they should require leaders to invest those bonuses in company stock (or should pay the bonuses in the form of restricted stock) until a certain share of leaders’ net worth, or some multiple of their annual salary, is invested”
We would contend that the following incentive scheme design could be an option: