What are the arguments for establishing long term incentive plan metrics that are different than those tied to the annual incentive plan?

Question:

What are the arguments for establishing long term incentive plan metrics that are different than those tied to the annual incentive plan?

Answer (by Dan Walter)

Great question!

There are several arguments for clear differentiation between the metrics used for annual incentive plans and LTI plans.

1)   The first concern is that overlapping metrics can create too much leverage for a specific objective, or tie too much risk to a potential goal.   Ex. When your short term goals are revenue and profit margin and your long term metric is EBITDA you are essentially incenting the same thing twice.  This may result in people no longer focusing on other critical factors.  And if there is a big swing up or down it may blow up your compensation strategy and budget.

2)   Another concern is that certain metrics are more valid and less volatile over several years. The wide swings in some metrics from year to year may be good when getting people to focus on the immediate horizon, but they may not align with a compensation philosophy that is intended to align employee or executives with shareholders.

3)   Some metrics are the result of a longer term cycle of Decision, Action, Behavior, Result. Focusing people on the entire cycle, rather rewarding each component individually may get them to see the big picture in a new way. Example: Company realizes its internal software for supporting the business is out of date and needs to be replaced.  The process requires finding the right replacement, getting it built or set up, rolling it out, then managing the tool and users to ensure they get the most out of it. Without a long-term program for the whole process you may get a series of results that take down a hole of failure.  Imagine: Decision to get new software is delayed because there is not short-term metric for it this year. The next year the decision to get new software controlled by a short-term budget goal that must be met, even though the software will be a long term investment.  The cheaper software requires far more work in year 2 or 3 to get installed correctly and it conflicts with the annual incentive plan in that year, so corners are cut to get a ”simpler” version put in place. The simpler version turns out to be less effective that the old software (which you are still using). A partial roll out occurs and is immediately followed by outcries that the new software is terrible. The team meets and decides to start all over again.  In the means time 4 or 5 years of annual incentive payments were made because each small piece seemed to be achieved, but no concept of the successful long-term deliverable was included in the pay program.

4)   Certain types of LTI programs (example:  equity plans) have a far different impact than short-term plans. These plans also rely on metrics like stock price that are built into the plan but not directly controllable by the individuals. Metrics for these programs need to account for the different “nature” of the plan and compensation instrument itself.