Top managers’ incentives

This chapter focuses on the various incentives offered to executives, including annual bonus arrangements, share options and long-term incentive plans. Trends in executive incentives are discussed and the performance conditions attached to the different schemes documented. We also examine the company philosophies underpinning each approach.

KEY POINTS

  • the surge in popularity of variable pay systems has resulted in most UK businesses operating an annual executive bonus scheme, and growing numbers offering top managers share-based incentives - either share options or a long-term incentive plan, or both;

  • executive incentives generally are a mix of short-term and long-term arrangements. Annual bonuses reward performance, typically operating profit, over a 12-month period, while share-based schemes focus executives' attention on longer-term corporate objectives and strategic goals;

  • annual incentives tend to reinforce a better understanding of the business and greater accountability for corporate performance, and they generally tie the reward to financial success, such as profitability, and/or specific operational goals;

  • financial and operational objectives usually inform the level of bonus opportunity - the overall amount from which individual payouts are made. Whereas the actual level of bonus payment is often determined by individual performance, normally assessed through a formal appraisal process;

  • Management Review's analysis shows that individual contribution is a key determinant of bonus in 45% of cases;

  • financial performance, however, is the most common basis for determining the annual executive bonus among our sample, with the most popular financial measures being profitability and earnings per share;

  • the median annual bonus award, as a percentage of annual salary, is 41%;

  • though some UK companies have used share options for a considerable length of time, the key change in recent years has been the greater propensity to attach performance conditions to such arrangements;

  • most new executive share option plans apply some measure of performance to the award of options, whereas their previous schemes were generally free of performance targets;

  • employees cannot lose with share options: if the shares increase in value, the employee can realise a gain; if not, the employee loses nothing. Also, executives have a number of years in which to decide whether to exercise their options;

  • under an Ltip scheme, executives receive a notional allocation of shares paid for by the company. The proportion of the award that vests is dependent on satisfying certain performance conditions over a specified performance period, usually three years;

  • the typical performance criteria for Ltips is total shareholder return, with TSR commonly ranked against a comparator group of companies, such as the FTSE 100 or against a selected peer group from within the company's own sector;

  • Ltip payouts are often expressed as a percentage of salary, though the actual benefit will depend on the share value at the end of the performance period;

  • our analysis of 39 companies shows that more than 38% operate both share options and Ltips, while the proportion using only share options or Ltips was 31% each;

  • Ltips are most suitable in UK-based companies with fairly close-knit management groups, whereas share options are more appropriate in international and diversified enterprises where management structures are looser;

  • EPS is readily available and widely understood, and allows external performance comparison among companies using the same standard. However, it is susceptible to manipulation; and

  • TSR is a transparent metric and therefore a good company benchmark against which to make comparisons. It is also less open to manipulation. However, factors outside the control of the company can substantially affect its share value.
  • There is a long tradition of companies offering incentives to improve performance for employees below senior management level. Even at the higher level, profit sharing and share options have been a key feature of executive compensation for many years. The US steel company Bethlehem Steel established the first executive incentive plan, a bonus arrangement, in 1902, while General Motors won shareholder approval for its first bonus plan in 1918.1 By 1928, a study estimated that 64% of US companies had introduced bonus and profit-sharing schemes.

    The surge in popularity of variable pay systems has resulted in most UK businesses operating an annual bonus scheme for senior staff, and growing numbers offering executives a share-based incentive - either share options or a long-term incentive plan, or both. The Monks Partnership's 1999 examination of board earnings in the FTSE 100 found that only five companies in the index do not have an annual bonus plan.3 IDS Management Pay Review's 1998 survey of the FTSE 350 revealed that around 90% of companies had an annual bonus scheme; more than 52% had established a long-term incentive plan (Ltip) and almost two-thirds (65%) offered share options.4

    Executive incentives generally are a mix of short-term and long-term arrangements. The variable pay elements balance the importance of short-term and long-term executive decision making. Annual bonuses reward performance, typically operating profit, over a 12-month period. "They bridge the gap between the base salaries paid for day-to-day roles and responsibilities and awards paid as long-term performance incentives," according to remuneration consultants Towers Perrin.5 By contrast, share-based schemes focus executives' attention on longer-term corporate objectives and strategic goals.

    It is important to construct the right balance between incentives that reward short-term needs and those that support the achievement of long-term objectives. Rob Collinge, director of compensation and HRIS at SmithKline Beecham (SB), makes this point. He says that it is important to ensure that total compensation rewards both short-term and long-term financial and other objectives: "We can't allow them [executives] to take their minds off the now to achieve the future." Different elements of SB's programme are therefore deliberately designed to achieve both annual targets and longer-term business success and goals (see case study 4, Case studies ).

    SHORT-TERM INCENTIVES

    The annual bonus - normally a cash payout - is an important feature of most executive compensation programmes. Its main aim is to focus attention on immediate business goals. Under SB's 10>3/1 business strategy and corporate planning process, the 3/1 element focuses on the specific short-term actions required to achieve the longer-term objectives, and the annual bonus scheme aims to support this activity.

    At Abbey National, the annual performance-related bonus is "designed to provide a direct link between each individual's remuneration and the performance of the company in the short term".6

    While rewarding short-term success, companies may also link some of the incentive to long-term business performance by paying part of the bonus in shares which must be retained for a specified period. This is the case at Tomkins, which explains its position thus: "The aim of incentive compensation is to link a significant part of future compensation to the creation of long-term value for shareholders, evidenced by the fact that part is paid in the form of shares which have to be retained for not less than three years."7 Alliance & Leicester also awards a proportion (up to a maximum of 25%) of the annual executive bonus in deferred shares, which cannot be exercised for at least three years (see Ltips).

    In some cases, executives receive additional shares at the end of the investment period. The National Grid operates such a system. Company directors must invest 25% of their annual bonus in equity. After three years, and provided the director is still employed, the company awards additional shares equal to the pre-tax value of the invested shares.

    Performance measures

    Annual incentives tend to reinforce a better understanding of the business and greater accountability for corporate performance. They typically tie the reward to financial success, such as profitability, and/or specific operational goals. The key factors determining 1997/98 bonus levels at National Power illustrate the typical mix of financial and non-financial metrics attached to annual performance-related schemes:

  • a TSR in the upper quartile of the agreed international peer group of companies;

  • achievement of the forecast contribution to earnings by international assets;

  • successful investment in international projects to secure long-term growth;

  • continuing good safety and environmental performance; and

  • progress in IT infrastructure renewal and millennium compliance.8

    Enterprise Oil provides a further example of the various performance conditions attached to annual bonus arrangements for executives. The company generally refers to factors such as: relative share price performance; cost of sales; portfolio management; production performance; replacement oil and gas reserves; and finding costs.9 Reuters' annual bonus targets reflect the company's objectives for the coming year. For 1998, directors' bonuses depended on the extent to which three key targets, designed to align directors' interests with shareholders, were met. These were: millennium compliance and euro conversion; the growth in operating profit at constant exchange rates; an the growth in earnings per share (see case study 3, Case studies ).

    In addition to the basic financial metric earnings per share to determine the annual bonus level, Compass, the catering business, has applied Richard Kaplan and David Norton's balanced scorecard concept to assess factors important to the company's long-term success. Compass' balanced scorecard items include: customer/client satisfaction, market leadership, preferred employer status and operational excellence.10

    Financial and operational goals usually inform the level of bonus opportunity - the overall amount from which individual payouts are made. Whereas, the actual level of bonus payment is often determined by individual performance, normally assessed through a formal appraisal process. It is the "how" an individual has performed rather than the "what" he or she has achieved. However, at the top end, the annual bonuses paid to the chair, CEO and finance director will normally be based wholly on corporate performance. The bonus levels of divisional heads will commonly depend, at least in part, on business unit performance.

    A study by the Monks Partnership found that personal target was the most common performance measure attached to the annual bonus in 90 companies in the FTSE 100 (see figure 4.1 ). It was closely followed by group profit. Figure 4.2 illustrates the performance criteria attached to annual executive bonuses in 40 UK companies. It shows that, where specified, individual contribution is a key determinant of bonus in 45% of cases.

    Figure 4.1: Performance conditions attached to annual incentive plans: FTSE 100

    Metric

    Number

    %

    Eps

    29

    32

    Group profit

    38

    42

    Unit profit

    3

    3

    Personal target

    39

    43

    Cash flow

    7

    8

    Discretionary

    15

    17

    ROCE

    4

    4

    Based on 90 plans; typically more than one measure applied.

    Source: Board earnings in FTSE 100 companies, Monks Partnership 1999, p34

    Figure 4.2:Annual bonus arrangements for executives in 40 companies

    Company

    Cash award

    Option of shares? (where specified)

    Latest performance criteria

    Maximum amount
    (% of salary)

    3i

    Yes

    Yes

    Profit

    n/a

    Abbey National

    Yes

    Individual; company - budgeted levels of operating expenses and income; market share targets for key products; specified measure of shareholder value. In addition, customer service and product quality also assessed

    30

    Alliance & Leicester

    Yes

    Yes

    Individual; profit

    70 (100 for Group CEO)

    Amvescap

    Yes

    Yes

    Individual

    -

    BAT

    Yes

    Financial, including profit, cash flow and EPS; business - related to strategic goals

    50 (75 for chair)

    British Aerospace

    Yes

    Yes

    EPS, budgeted cash performance

    -

    Cable & Wireless

    Yes

    Profit, cash flow, turnover and EPS

    60

    Cadbury Schweppes

    Yes

    Yes

    Profit

    90

    Compass

    Yes

    Yes50

    EPS; balanced scorecard items (customer/client satisfaction, market leadership, preferred employer status, operational excellence and financial performance); divisional profit

    50 (100 for CEO of US division)

    De La Rue

    Yes

    Financial

    80

    Enterprise Oil

    Yes

    Individual; share price; cost of sales; portfolio management; production performance; replacement of oil and gas reserves

    50

    Halifax

    Yes

    Yes

    Profit

    60

    Hillsdown

    Yes

    Share price

    -

    Invensys

    Yes

    Financial, including profit, ROCE, cash flow, EPS

    100 (CEO, CFO, CO)

    Kingfisher

    Yes

    EPS. Also, financial and non-financial performance indicators for executives responsible for major businesses

    -

    Ladbroke

    Yes

    Individual performance against key objectives

    50 (60 for CEO)

    Lasmo

    Yes

    Business and personal objectives, including profit and/or cash goals

    40

    National Grid

    Yes

    Financial, personal and quality of service targets

    40

    Northern Foods

    Yes

    Achievement of targets which take account of current business plans

    -

    Norwich Union

    Yes

    Yes

    Profit; individual

    -

    Nycomed Amersham

    Yes

    Financial performance, including success in delivering merger synergies, cash flow, EPS; individual

    50

    Orange

    Yes

    Financial targets

    75

    Pearson

    Yes

    Yes

    EPS, revenue growth, margin improvement and cash generation

    100

    Pizza Express

    Yes

    Yes

    EPS

    -

    PowerGen

    Yes

    Yes

    EPS; individual

    40

    Railtrack

    Yes

    Shareholder value, train performance, asset condition and quality of investment. Also, individual performance

    45

    Reckitt & Colman

    Yes

    EPS, sales growth and achievement of specific business objectives

    40 (50 for CEO)

    Reuters

    Yes

    Millennium compliance and euro conversion; growth in operating profit and EPS

    50

    Royal Bank of Scotland

    Yes

    Yes

    Profit; financial and other targets

    40-60

    J Sainsbury

    Yes

    Business and individual targets

    50

    Scottish Power

    Yes

    EPS and ROCE; individual achievement of key strategic objectives

    50

    Severn Trent

    Yes

    Financial, including profit; non-financial, including quality, service and environmental performance targets

    40

    Shell Transport and Trading Company

    Yes

    Financial, operational, social and environmental objectives

    50

    SmithKline Beecham

    Yes

    Yes

    Grade and personal performance plus business unit performance against bonus targets

    70

    Sun Life and Provincial

    Yes

    Individual performance based on measurable criteria. Also, relates to group and Axa performance

    -

    Tomkins

    Yes

    Yes

    Financial, including growth in earnings and dividends a share, and increase in the ordinary share price throughout the year

    -

    Unilever

    Yes

    Yes

    Achievement of corporate (EPS) and individual targets (key objectives)

    40

    United Assurance

    Yes

    Corporate and individual objectives

    40 (50 for CEO)

    United Biscuits

    Yes

    Profit, sales growth

    60

    WPP

    Yes

    Operating profit, profit margin, staff costs to revenue, revenue growth and conversion, level of cooperation among operating companies and other strategic goals

    75 (100 for CEO)

    Key: EPS = earnings per share; ROCE = return-on-capital-employed.

    For example, annual bonus payments at the leisure business Ladbroke as based on "achievement of the annual profit plan together with personal performance against key objectives that are established in line with the company's strategic priorities".11 Similarly, at Sun Life and Provincial, partly owned by the French financial services company Axa, the annual bonus is largely determined by the "individual performance of each executive director, based on achievement of measurable performance criteria. These criteria predominantly relate to the personal performance of the director and the company or function for which he [sic] is responsible. An element, however, also relates to group performance and Axa performance."12

    Our case studies also provide examples of bonus levels that are greatly influenced by personal contribution. BASF, for example, operates a short-term bonus scheme that is related to both individual and company performance. The individual element is dependent on the attainment of agreed goals or targets which are set jointly by the manager in question and his or her immediate superior on an annual basis at the beginning of each year. These goals are related to the performance of the individual's unit and can include developing new markets and achieving cost targets (see case study 1, Case studies).

    Individual performance is a key element for deciding the annual bonus at SmithKline Beecham. Its remuneration committee uses a matrix containing definitions of individual performance levels to guide it in awarding payouts (see case study 4, Case studies).

    Financial performance of the company, however, is the most common basis for determining the annual executive bonus among our sample. The most popular financial measures were profitability (mentioned by more than 37% of companies which specify which financial metrics apply) and earnings per share (also cited by over 37% of our sample).

    Whatever performance metrics are applied to annual bonuses, they should, according to schedule A of the combined code, be "relevant, stretching and designed to enhance business". In addition, the code suggests that upper limits should always be applied (see figure 4.4). In our sample, the most common upper limits were 40% to 50% of base salary. BAT, for example, puts a 50% salary limit on bonus payments for all executives except the chair, whose maximum bonus value is 75% of salary. Alliance & Leicester, Compass, Invensys, Pearson and WPP are the only companies in Management Review's sample to offer bonuses up to 100% of salary for one (usually the CEO) or more top managers.

    Figure 4.4: Combined Code - Schedule A

    Schedule A: Provisions on the design of performance-related remuneration

    1        Remuneration committees should consider whether the directors should be eligible for annual bonuses. If so, performance conditions should be relevant, stretching and designed to enhance the business. Upper limits should always be considered. There may be a case for part payment in shares to be held for a significant period.

    2        Remuneration committees should consider whether the directors should be eligible for benefits under long-term incentive schemes. Traditional share option schemes should be weighed against other kinds of long-term incentive scheme. In normal circumstances, shares granted or other forms of deferred remuneration should not vest, and options should not be exercisable, in under three years. Directors should be encouraged to hold their shares for a further period after vesting or exercise, subject to the need to finance any costs of acquisition and associated tax liability.

    3        Any new long-term incentive schemes which are proposed should be approved by share-holders and should preferably replace existing schemes or at least form part of a well considered overall plan, incorporating existing schemes. The total rewards potentially available should not be excessive.

    4        Payouts or grants under all incentive schemes, including new grants under existing share option schemes, should be subject to challenging performance criteria reflecting the company's objectives. Consideration should be given to criteria which reflect the company's performance relative to a group of comparator companies in some key variables such as total shareholder return.

    5        Grants under executive share option and other long-term incentive schemes should normally be phased rather than awarded in one large block.

    6        Remuneration committees should consider the pension consequences and associated costs to the company of basic salary increases and other changes in remuneration, especially for directors close to retirement.

    7        In general, neither annual bonuses nor benefits in kind should be pensionable.

    Source: The Combined Code, June 1998 (Gee Publishing Ltd)

    What's it worth?

    Short-term incentives provide participants with the opportunity to significantly enhance their overall compensation each year, and, where deferred, the potential to realise even greater future rewards. The Monks Partnership found in 1999 that the value of the annual bonus for CEO in FTSE 100 companies varied between 21.5% (lower quartile) and 55% (upper quartile) of salary. The level of award as a proportion of salary for finance directors was just under 20% (bottom quartile) and 51.5% (top quartile).13

    Figure 4.3 illustrates the highest executive bonus payment in 30 companies, based on figures from their latest annual reports. The median award, as a percentage of annual salary, is 41%. Excluding the largest bonus paid at BAT, which includes a deferred payment, the biggest payout as a proportion of annual salary was the £638,000 award to Kingfisher chief executive Sir Geoffrey Mulcahy. This was worth 91% of his salary. At the other end of the scale, the largest bonus at Enterprise Oil, which was £25,900, amounted to just 7% of salary.

    Figure 4.3: Annual bonus payouts in 30 companies

    Company

    Bonus payment (£)51

    % of salary

    3i

    212,000

    72

    Abbey National

    67,500

    18

    Alliance & Leicester

    344,000

    78.5

    Amvescap

    2,415,000

    86

    BAT

    474,233

    12752

    British Aerospace

    175,000

    35

    Cable & Wireless

    190,130

    41

    Compass

    138,000

    32

    De La Rue

    61,000

    36

    Enterprise Oil

    25,900

    7

    Halifax

    198,000

    45.5

    Invensys

    109,238

    19.5

    Kingfisher

    638,000

    91

    Ladbroke

    205,000

    53

    National Grid

    108,000

    36

    Northern Foods

    40,700

    19

    Norwich Union

    124,000

    31

    Nycomed Amersham

    144,625

    44.5

    Orange

    241,000

    48

    Pizza Express

    17,000

    17

    PowerGen

    159,000

    50

    Railtrack

    61,000

    18

    Reuters

    255,000

    49

    Scottish Power

    109,200

    28

    Severn Trent

    65,600

    24

    Sun Life and Provincial

    127,500

    42.5

    Tomkins

    645,000

    68

    Unilever

    435,41953

    49

    United Biscuits

    81,000

    32

    WPP

    605,000

    85

    Elsewhere, at Marks & Spencer, which introduced an annual bonus scheme in 1988, the level of payout has averaged 14.7% each year. In 1998, the now former-chair Sir Richard Greenbury's £117,000 bonus was worth 12% of his total cash remuneration.14

    While bonuses can be large when performance conditions are met, below par corporate performance can reduce to zero the level of award. The Shell Transport and Trading Company, for example, paid its executive an annual bonus worth 25% of salary in 1997. In 1998, no bonuses were payable.15 Reckitt & Colman, too, made no bonus payment in 1998, stating that: "In 1998, a minimum profit before tax threshold had to be achieved for any incentive payment to be made; this was not achieved and no payments were made."16

    LONG-TERM INCENTIVES

    Share options

    Share options give the recipient the opportunity to buy shares at the pre-set price at some future date. Inland Revenue-approved schemes, which place a £30,000 ceiling on the number of shares an individual can hold at any one time, attract certain tax advantages.

    Relatively few UK companies had established share option schemes prior to the 1984 Finance Act. This legislation, which encouraged executives to stay in position to benefit from the most favourable tax treatment on their options (hence their retention benefit, see below), was followed by an explosion of executive share option schemes. A survey of FTSE 100 companies found that almost a quarter (22%) of share option schemes were established in 1985.17 Proshare found that the biggest percentage of executive share option schemes were set up in the second half of the 1980s.18 This was also the finding of a survey of 374 companies by KPMG.19 By 1998, Proshare estimated that 84% of UK listed companies operated an executive share option scheme, including 57% of those in financial services and 77% of utilities.20

    Several companies in Management Review's sample indicate that share options were first used from the mid-1980s. Cadbury Schweppes is one such company, having introduced its first share option scheme for executives in 1984. By contrast, the Shell Transport and Trading Company first established its Global executive share option scheme in 1967. Elsewhere, Marks & Spencer won shareholder approval for its first option plan in 1977.

    Performance conditions?

    Though some UK companies have used share options for a considerable length of time, the key change in recent years has been the greater propensity to attach performance conditions to such arrangements.

    ABI first issued performance guidelines for share options in 1987 - stipulating that all new schemes should allow options to be exercised only if EPS growth exceeded the increase in the RPI - but its recommendations were largely ignored. KPMG's research, conducted in August 1994, found that two-thirds of companies were operating schemes without performance targets - this was particularly true of smaller companies.21 According to KPMG the resistance at this time to attaching performance conditions indicated a "lack of popular support within companies for performance targets for share options".

    Today there is a wholly different picture. The Greenbury Committee's report on directors' remuneration pressed the point that higher-level rewards, such as share options, should be linked to performance indicators, suggesting in the published code of practice that "performance-related elements of remuneration should be designed to align the interests of directors and shareholders". The combined code also stresses the importance of performance conditions for long-term incentives, indicating that they should be "subject to challenging performance criteria reflecting the company's objectives" (see figure 4.4).

    Most new plans apply some measure of performance to the award of options, whereas previous schemes were generally free of performance targets. Building materials group RMC illustrates the addition of performance criteria to share options. The company's 1990 options scheme was not restricted by a performance condition, whereas shares granted under the 1996 plan can only be exercised "if the increase in the company's earnings per share exceeds the increase in the Retail Price Index by 6% over a period of three continuous years".22

    Also, some new arrangements are stipulating graduated performance criteria (see Pearson case study, for example, Case studies). Rio Tinto, which as chapter two pointed out eschewed share options for a time, now has a scheme with tiered vesting. As the company's latest annual report explained:

    "The exercise of options is subject to the satisfaction of a graduated performance condition set by the committee. Two-thirds of the grant will vest when growth in the group's earnings per share over a performance period of three consecutive years has been at least 9% in total higher than US inflation over the same three-year period, as measured by the Consumer Price Index. The balance of the grant will vest when growth of at least 12% higher than the Consumer Price Index has been achieved."23

    A further variation is the granting of so-called super options. These schemes grant options over shares worth more than the ABI previous recommended limit of four times salary. The growing popularity of such arrangements - GEC, Marks & Spencer, Standard Chartered and Rio Tinto have all adopted super options - has influenced the ABI's decision to relax its options-to-salary guidelines (see chapter two). Super options typically are exercisable only once stringent performance conditions have been met. For example, Standard Chartered's scheme grants supplemental share options if the following two performance targets are met:

  • the share price must increase by at least 50% plus RPI; and

  • earnings per share must increase by at least 25% plus RPI.

    In addition, executives become eligible for the supplemental options only if they hold at least 10,000 Standard Chartered shares purchased with their own money.24

    Options' value

    Employees cannot lose with share options: if the shares increase in value, the employee can realise a gain; if not, the employee loses nothing. Also, executives have a number of years in which to decide whether to exercise their options. If the share grant is exercised and the share price has risen, the executive has three options: to pay for them and receive an annual dividend; pay for them, sell some and retain some and receive an annual dividend; or sell them and realise a profit.

    The potential gains from share options are substantial. William M Mercer estimated in 1998 that UK chief executives were sitting on share options worth an average of £1.389 million, excluding those unexercised by SmithKline Beecham's Jan Leschly.25 However, this figure pales into insignificance compared with the gains from options realised by US CEOs. Mercer's report cites Sanford Weill, CEO of the Travellers Group, as having realised over $500 million from share options and shares. It also revealed that 10 US CEOs were sitting on potential share options worth over $100 million, and a further 47 chief executives with the possibility of option gains amounted to more than $50 million.

    Some examples from our sample of top UK companies illustrate the potential gains - the amount by which the market value of shares on the date of exercise exceeded the option price - to be made from exercising share options. Geoffrey Hutchings, chair of Tomkins, made a paper gain on exercised options amounting to £309,000 in 1998 and £730,000 in 1997. Tomkins' deputy chairman and managing director, Ian Duncan, exercised options in 1998 with a potential profit of £1.295 million.26 Abbey National's Ian Harley made a potential profit of £572,016 on exercised share options in 1998.27 David Sainsbury exercised three lots of share options in 1998 prior to his retirement form the board of J Sainsbury, and made a paper gain of £431,288.28 Shell Transport and Trading's Sir John Moody exercised 450,000 share options during 1998, realising a paper profit of £945,000.29

    Ltips

    As chapter two noted, Greenbury saw long-term incentive plans as the future of share-based executive reward programmes, believing they were potentially better at aligning management and shareholder interests than existing share option arrangements. Typically under a Ltip scheme, such as a Performance Share Plan (PSP) - also known as a restricted share plan linked to future performance - executives receive a notional allocation of shares paid for by the company. The proportion of the award that vests is dependent on satisfying certain performance conditions over a specified performance period, usually three years.

    New Bridge Street Consultants found in 1997 that a PSP was the most common form of Ltip, with 72% of the top 500 listed UK companies with a long-term scheme operating one.30 Among Management Review's sample, several companies, including Abbey National, British Aerospace, Halifax, Ladbroke, Norwich Union, PowerGen, J Sainsbury, Scottish Power and United Assurance, operate a PSP (see figure 4.5)

    Figure 4.5: Executive share plans and performance criteria in 39 companies

    Company

    Scheme(s)

    Performance criteria (where appropriate)

    3i

    Share options; Ltip

    Share options = individual performance. Ltip = TSR over three-year period.

    Abbey National

    Ltip

    Share price and TSR (against 11 FTSE 100 financial institutions).

    Alliance & Leicester

    Ltip

    EPS over three-year period exceeds RPI increase by at least 9%.

    Amvescap

    Share options

    Individual merit basis.

    BAT

    Share options

    EPS must exceed RPI increase by average of 3% for any three consecutive years in the 10-year life of options.

    British Aerospace

    Performance share plan (PSP)

    TSR against FTSE 100 (100% of conditional share if BAe TSR in top 20%; 10% vesting if company in top 50%; no awards if outside top 50%). Also, EPS over performance period must be no less than average value in proceeding three years.

    Cable & Wireless

    Share options; Ltip

    Share options = individual performance; key skills. Ltips = minimum award (10% of salary) if rolling EPS average is 2.5% a year over three-year period; maximum award (60% of salary) if rolling EPS average is at least 15% a year over three-year period.

    Cadbury Schweppes

    Share options; Ltip

    Share options = EPS growth must exceed RPI increase by at least 2% a year over a period of three consecutive financial years. Ltip (2 awards) = (1) TSR ranked against a peer group of UK and non-UK fast moving consumer goods companies. Also, subject to EPS growth over performance cycle exceeding RPI by at least 2%; (2) EPS growth must exceed RPI increase over the period by at least 4% a year.

    Compass

    Share options; Ltip

    Share options = EPS growth must exceed RPI increase by at least 3% a year over three-year period after options are granted. Ltip = TSR ranked against FTSE 100 (no award if TSR below 50th percentile) underpinned by requirement for EPS growth over three-year period to be greater than RPI.

    Enterprise Oil

    Share options; Ltip

    Share options = TSR must outperform % growth of average TSR of FTSE 100 over three-year period. Alternatively EPS must outperform RPI % growth plus 2% a year over the same period. Ltip = TSR ranked against FTSE 100 plus comparator group of oil and gas exploration and production companies, and integrated oil companies. Higher of two percentages determines level of award.

    Halifax

    Long-term bonus scheme

    TSR over three-year periods against the annualised weighted average TSR of a basket of 15 comparator companies. All designated shares released if TSR exceeds average by 3% a year; two-thirds granted if TSR exceeds average by 2% a year; one third granted if TSR matches average TSR.

    Hillsdown

    Share options

    EPS growth must exceed the RPI increase by 6% or more over three consecutive years.

    Invensys

    Share options

    EPS growth must exceed the RPI increase by at least 12% over three-year period.

    Kingfisher

    Share options; Ltip

    Share options = EPS growth must exceed the RPI increase by at least 6% over three years. Ltip = TSR measured against 15 retail companies. If TSR in top half of peer group, the reward ranges from 30% to 70% of salary.

    Ladbroke

    Share options; Performance share plan (PSP)

    Share options = EPS growth must exceed the RPI increase by 2% a year. PSP = TSR measured against FTSE 100 and EPS measured on an absolute basis.

    Lasmo

    Share options; Equity plan

    Share options = TSR measured against a comparator group of 10 international oil and gas exploration and production companies. 100% exercisable if TSR in the top 25%. Equity plan = share price growth must exceed the RPI increase by 2.5% a year over the award period. Also, TSR position against the comparator group will determine actual number of shares allocated.

    Lonrho

    Share options

    TSR over consecutive three-year period must be greater than total return on the FTSE All-Share Index.

    National Grid

    Share options

    EPS growth must exceed RPI increase by 3% a year over three-year period.

    Northern Foods

    Ltip

    TSR against that of a group of food producers.

    Norwich Union

    Ltip: share participation scheme (SPS) and restricted share plan (RSP)

    PS = TSR must be at or above the median point in the FTSE 100. Alternatively, EPS growth must exceed RPI. RSP = TSR ranked against FTSE 100 over three-year period.

    Nycomed Amersham

    Share options; Ltip

    Share options = EPS growth must exceed RPI increase by at least 6% in any three consecutive years. Ltip = share price measured against FTSE 100. No shares vest unless share price is in top 60%.

    Orange

    Share options; Ltip

    Share options = profit. Ltip = TSR ranked against FTSE 100. No shares vest unless share price is in top 60%.

    PowerGen

    Share options; Medium term bonus scheme (MTBS)

    Share options = TSR measured against comparator group of companies. MTBS = TSR ranked against a comparator group of FTSE 100 companies. No shares released unless company in top 50%.

    Railtrack

    Ltip

    EPS growth over three-year period and improvements in train performance.

    Reckitt & Colman

    Share options; Ltip

    Share options = share price growth over any three-year period between grant and exercise must exceed RPI increase by at least 4%. Ltip = TSR ranked against FTSE 100. No shares released unless TSR is better than the median of the comparator group.

    RMC

    Share options; Ltip

    Share options = EPS growth must exceed RPI increase by 6% over a period of three consecutive years. Ltip = TSR ranked against a comparator group of companies (FTSE Actuaries Building Materials and Merchants Index). Maximum number of shares released if TSR in top 25%.

    Royal Bank of Scotland

    Share options

    EPS growth must exceed RPI increase by an average of at least 2% a year over three-year period.

    J Sainsbury

    Share options; Performance share plan (PSP)

    Share options = EPS growth must average 3% a year over three years. Alternatively, EPS growth must average 3% a year over four years. PSP = TSR ranked against a sample of comparator companies.

    Scottish Power

    Ltip

    TSR ranked against FTSE 100 and electricity and water sectors over three-year period. 100% of shares released if TSR in top 10%.

    Severn Trent

    Ltip

    TSR ranked against privatised utilities over three-year period. Maximum award payable if TSR is in first, second or third place.

    Shell Transport and Trading Company

    Share options

    TSR ranked against comparator group of major integrated oil companies over three-year period and measured by the average weighted share price over a 10-day period at the start and end of the period.

    Sun Life and Provincial

    Share options

    EPS growth must exceed RPI increase by at least 6% over three-year period.

    Thistle Hotels

    Share options

    EPS growth must exceed RPI increase by at least 6% over three-year period.

    Tomkins

    Share options

    EPS growth must exceed RPI increase by an average of 2% a year over three-year period.

    Unilever

    Share options

    EPS growth over three-year period prior to grant must exceed RPI increase by at least 6%.

    United Assurance

    Share options; Performance share plan (PSP)

    Share options = TSR ranked against quoted life assurance companies or FTSE 250 (excluding investment trusts). PSP = TSR must be at least equal to average of comparator group.

    United Biscuits

    Ltip

    TSR ranked against a comparator group of the 15 largest companies in the food manufacturing sector. Maximum award payable if TSR ranked third or above; no award if TSR ranked 10th or below.

    United News & Media

    Ltip

    TSR ranked against FTSE 100 over three-year period. Maximum award if TSR in top quartile; no award if TSR is below 50th position.

    WPP

    Ltip (parent company)

    TSR ranked against seven major publicly traded marketing service companies. Maximum award if TSR ranked equal to second in peer group; no awards if TSR is below the median.

    Key: Ltip = long-term incentive plan; EPS = earnings per share;

    TSR = total shareholder return; RPI = Retail Price Index.

    Another type of Ltip, the so-called Bonus Deferral Plan, is linked to the annual bonus scheme. Under this arrangement some or all of the executive's bonus is deferred and paid in shares. A variation of this approach is the Equity Partnership Plan, in which executives invest part or all of their bonus in company shares, receiving a further tranche of equity after a specified period. Lasmo operates an equity plan in which the company matches the number of shares committed to the plan by an executive with a further notional allocation.

    Performance criteria

    The typical performance criteria for Ltips is total shareholder return. TSR is commonly ranked against a comparator group of companies, such as the FTSE 100. British Aerospace and the Compass Group both opt for this form of comparison. At BAe shares vest on a sliding scale, and become exercisable only if its TSR performance is in the top half of the index (see figure 4.5). The performance period is generally three years - the minimum expressed by institutional investors.

    Several companies compare TSR performance against a selected group of companies from within their own sector. Cadbury Schweppes bases its Ltip awards on the performance of its TSR against a peer group of UK and non-UK fast moving consumer goods companies. Lasmo uses a comparator group of 10 international oil and gas exploration and production companies. In 1998, this comparator group included: Apache Corporation; British-Borneo Petroleum Syndicate, Burlington Resources; Enterprise Oil, Monument Oil and Gas and Talisman Energy. The Halifax ranks its TSR performance against the annualised weighted average TSR of a basket of 15 comparator companies, while Kingfisher compares its TSR with 15 other retail companies. For the 1998-2000 performance period, Abbey National's comparator group consists of: Alliance & Leicester, Bank of Scotland, Barclays, Halifax, Legal & General, Lloyds TSB, NatWest, Northern Rock, Prudential, Royal Bank of Scotland and the Woolwich.

    EPS is the sole financial performance indicator for the Ltips operating at the Alliance & Leicester, Cable & Wireless and Railtrack. The latter also includes in its scheme improvements in train performance.

    Institutional investors have brought pressure on companies to use a combination of TSR and EPS for new long-term incentive schemes. This use of dual performance criteria is designed to ensure that plans do not pay out if the overall return to shareholders is negative.31 Among our sample, BAe, Cadbury Schweppes, Compass, Ladbroke and Norwich Union also include EPS growth in addition to TSR as a performance condition. The Monks Partnership's examination of the FTSE 100 found that 15% of Ltips include a second performance measure, usually EPS growth.32

    Ltips' worth

    Ltip payouts are often expressed as a percentage of salary, though the actual benefit will depend on the share value at the end of the performance period.

    Abbey National's scheme illustrates how executives receive their shares. The company's executives are awarded shares worth a maximum of 70% of basic salary at the outset of the performance period. These are held in trust and awarded as performance conditions are fulfilled. Performance is dependent on two measures: TSR against the FTSE 100; and TSR ranked against a comparator group of 11 financial services companies. A percentage of shares can be exercised separately on a sliding scale when each of the performance conditions is met. If the company's TSR is ranked in the top 25% of the relevant comparator group the full allocation will vest; if it is ranked at the median, 25% of the grant will vest; and pro rata between these points. No award will be made if Abbey National's TSR is below the that of the relevant comparator group.33

    As with share options, the potential gains from Ltips are substantial. Kingfisher was ranked first by TSR in its peer group at the end of the company's 1996-99 Ltip, having achieved a total shareholder return of more than 150% over the period. This resulted in a bonus worth 70% of salary to chief executive Sir Geoffrey Mulcahy (£224,000) and former director Roger Jones (£100,000), a third of which was paid in March 1999, with the remainder used to purchase shares. This equity will be realised in two parts: 50% in March 2000 and 50% in March 2001.34

    Options v Ltips

    It was noted in chapter two that the initial popularity of Ltips following Greenbury's endorsement has subsided. The latest figures from the Monks Partnership show that among the FTSE 100, 16 companies retain share options as their sole long-term executive incentive; 22 operate only an Ltip; and 22 use both share options and an Ltip.35 A study by New Bridge Street Consultants found that Ltips - which the authors believe generally have more demanding, longer-term performance measures than conventional option schemes - occur most frequently in FTSE 100 companies, whereas share options are more commonly found in the mid-250 companies (the next 250 largest quoted companies).36

    Our own examination of 39 long-term incentive schemes shows that more than 38% of companies operate both share options and Ltips, while the proportion using only share options or Ltips was 31% each (see figure 4.5).

    According to the Monks Partnership, share options remain the preferred long-term incentive in some companies because:

  • they are easily understood by participants;

  • they are well established in international remuneration packages; and

  • they are believed to align employee interests with those of the shareholders.37

    Hotels group Stakis has explained why its remuneration committee prefers share options to other long-term incentives:

    "The [remuneration] committee believes that there are significant advantages in using share options over other forms of Ltips. These include: their relative simplicity, the stringency of the proposed performance criteria, the harmonisation of management and shareholder interests, the golden hand-cuffs effect of annual grants, the non-diluting effect of options over existing shares and the automatic performance criterion of requiring the share price to increase before options have any value."38

    Ltips' greater link with corporate performance was - until option schemes began adopting their own performance criteria - their biggest advantage over share options. However, this is also their major problem: Ltips are often considered too complex. The performance formula attached to most Ltips, which generally compares company TSR against a comparator group, is something that cannot be assessed easily and regularly.

    It is believed by some remuneration consultants that Ltips are most suitable in UK-based companies with fairly close-knit management groups, whereas share options are more appropriate in international and diversified enterprises where management structures are looser. Indeed, options score over Ltips in companies with significant overseas interests because they are more common elsewhere, especially in the US, and are therefore a well-known and understood remuneration practice.

    Share options may also be a better long-term incentive in small companies because many top managers will already have a substantial equity holding and options can encourage further ownership as well as providing new recruits with a relatively quick shareholding. Figures for companies floating in 1998 show that options were considerably more popular than long-term plans. New Bridge Street Consultants found that 95% of newly floating companies had an executive share option scheme compared with only 19% operating an Ltip.39

    PERFORMANCE CONDITIONS

    If incentive schemes are to realise their expectations, remuneration committees need to attach the right measures and the right levels of performance. The two most popular performance conditions attached to long-term executive incentive schemes are earnings per share and total shareholder return. A survey of the UK's top 350 listed companies confirmed the popularity of EPS and TSR as performance measures for executive incentives:

  • almost 60% executive share option schemes used an earnings per share target of 3% above inflation (traditionally, the EPS growth target is 2% above inflation), while more than 20% had a more demanding target; and

  • 60% of Ltips adopted TSR as the main performance criterion.40

    Both EPS and TSR have advantages and disadvantages. On the plus side for EPS, accounting-based metrics, such as this, are readily available and widely understood. They also allow external performance comparison among companies using the same standard (though accounting standards vary from country to country). On the downside, they are internally focused and directly or indirectly linked to budget, which makes them susceptible to orchestration: executives play a major role in setting budgets and can therefore manipulate the figures to optimise incentive payments.

    TSR provides an indication of by how much the equity markets value the business. Generally, good past performance indicates future success and leads to a rise in share price. TSR is a transparent metric and therefore a good company benchmark against which to make comparisons. It is also less open to manipulation. However, factors outside the control of the company can substantially affect its share value. For example, a bear market (steadily falling share prices across the stock market) and its reverse, a bull market, are unrelated to individual company performance. As a result, there is some concern that a scheme based on TSR may pay out because of factors outside of the influence of management.

    Rob Collinge at SmithKline Beecham says the company's preference for TSR as a performance metric rather than earnings per share is because it provides a level playing field for companies and investors to make global performance comparisons, whereas EPS is less consistent measure of performance across national boundaries due to differing accounting standards.

    KEY ADVANTAGES

    Whatever the relative merits of options and Ltips and their respective performance conditions, the overall advantages of long-term incentives are mainly in two areas: aligning executive and shareholder interests; and encouraging loyalty.

    Aligning interests …

    Executive share schemes are generally designed to link the interests of the recipients with those of shareholders. Burmah Castrol, which introduced an executive share option scheme in 1995, states that the aim of offering options was:

    "to provide a community of interest with shareholders through the common objective of share price growth".41

    Figure 4.6 contains several examples of the company philosophies underpinning share options and Ltips. In line with the Burmah Castrol example, aligning the interests of executives and shareholders is the common rationale for establishing them. A 1996 survey of financial participation in FTSE 100 companies conducted for actuaries Bacon & Woodrow confirms this as a major reason behind scheme implementation. It reported that 41% of companies saw share options as a way of executives identifying with shareholder interests.42

    Figure 4.6: Long-term incentives policy in selected companies

    Company

    Statement

    Share options

    Hillsdown

    "Exercises of options granted to senior executives under the executive share option schemes should be subject to challenging performance criteria which reflect the interests of the company's shareholders."

    Marks & Spencer

    "Share options are readily understood by the participants, fit the culture of the business and have historically delivered an appropriate level of reward."

    The Royal Bank of Scotland

    "It is the company's policy that executive share options be awarded only to those executives who can genuinely influence the company's performance over the medium term."

    Shell Transport and Trading Company

    "Long-term incentives for managing directors are provided through the Group Stock Option Plans which have been in operation since 1967, and which are believed to create an effective method of aligning the interests of managing directors and other Group senior managers with those of shareholders."

    Tomkins

    The [remuneration] committee believes that the long-term performance of the company is an important consideration for shareholders and that share-based incentives are an important part of helping to align the interests of shareholders and employees."

    Long-term incentive plans

    Abbey National

    "A long-term incentive plan for senior executives was adopted at the 1997 annual general meeting. It is designed to enhance the link between the remuneration of executives and the company's medium and long-term performance and incorporates challenging performance targets, measured over a three-year period."

    Enterprise Oil

    "Long term performance-related share scheme: This scheme was introduced in 1995 for certain senior executives, including executive directors. Its object is to align more closely the interests of the executives with those of the shareholders over the long term through the allocation of ordinary shares in the company, conditional upon the company's performance."

    National Power

    "The [Performance Share] plan is designed to increase the emphasis on longer-term performance, appropriately matching the company's business, which increasingly involves long-term strategic investment in new markets. The plan more closely aligns the interests of senior executives with those of shareholders, through performance conditions based on the company's TSR compared with average TSR of FTSE 100 companies."

    Norwich Union

    "The SPS [Share Participation Plan] is designed to provide an opportunity for executive directors and certain senior managers to earn an additional reward which depends on personal commitment from participants and which is directly aligned with shareholders' interests."

    Scottish Power

    "The plan links the rewards closely between management and shareholders, and focuses on long-term corporate performance."

    … and encouraging loyalty

    The Bacon & Woodrow study highlighted a further important influence on corporate decisions to establish long-term incentives. More than a third (36%) of surveyed companies had developed share option arrangements to aid recruitment and retention. And 45% of companies said this issue was the main reason for implementing an Ltip. Mobile phone company Orange endorses the notion that share options can support recruitment and retention in its share option policy:

    "Executive share options are considered important for market-related retention and motivational purposes … The aim is to relate the ability to exercise options with sustained improvements in the underlying financial performance of the group."43

    It is widely acknowledged that in a competitive labour market, incentives, such as share schemes, that provide the opportunity to greatly enhance the level of reward can help to recruit and retain highly regarded individuals. Certainly this is a major reason why a growing number of businesses, including Asda, BAe and Safeway, are offering all-employee share schemes.44 Share schemes tend to have a positive effect on loyalty because the longer the employee stays, the "disproportionately greater will be the reward he [or she] ultimately receives."45

    Retailer Marks & Spencer made reference to the potential recruitment and retention benefits of share option schemes, as well as their incentive qualities, in its circular to shareholders seeking their approval for such an arrangement at the company's 1977 annual general meeting. It stated:

    "We also believe it is important that we continue to secure and reward management of high calibre, with the right attitudes and skills; we feel that our most senior UK employees, as well as the directors, should be given an added incentive to contribute to the growth of the company. We therefore propose to introduce a scheme which will enable such senior employees and directors to be granted options to purchase ordinary shares in the company."46

    Labour market factors, especially the stiff competition for talented senior executives, is believed to be behind the upward drift in overall executive remuneration in the US, including the exponential growth of stock options.47 According to one US consultancy, the offer of share options in tight labour markets "can make a significant difference as employers compete to recruit and to keep a high-quality workforce".48

    Other benefits

    One US remuneration specialist believes that share options also produce wider macro-economic benefits.49 It is his opinion that the recent success of the US economy compared with its European and Japanese counterparts is due to the prevalence of executive share options in America. Share options motivate top managers to run their companies better.

    1     Balkcom J and Brossy R (1997), "Executive pay - then, now and ahead", Directors & Boards, Fall, pp55-64

    2     Ibid

    3     Board earnings in FTSE 100 companies, Monks Partnership, 1999

    4     IDS (1998), "New FTSE 350 survey", IDS Management Pay Review 211, September, pp2-9

    5     Bannister R J and Gentry W (1999), "Aligning executive pay and company performance", in Risher H (editor), Aligning pay and results: compensation strategies that work from the boardroom to the shopfloor (AMACOM, New York), pp43-79

    6     Abbey National directors' report and accounts 1998

    7     Tomkins annual report 1998

    8     National Power report and accounts 1998, p14

    9     Enterprise Oil annual report and accounts 1998

    10    Compass Group annual report 1998

    11    Ladbroke Group annual report 1998, p54

    12    Sun Life and Provincial Holdings annual report and accounts 1998, p23

    13    Monks Partnership, see note 3, above

    14    Marks & Spencer annual report and financial statements 1998

    15    The Shell Transport and Trading Company annual report 1998

    16    Reckitt & Colman annual report and accounts 1998

    17    Sharing in success? Employee and executive financial participation in FTSE 100 companies (City University Business School/Bacon & Woodrow)

    18    Proshare (1998), Employee share ownership research (London)

    19    KPMG (1995), Executive share options and performance targets (London)

    20    Proshare, see note 18, above

    21    KPMG, see note 19, above

    22    RMC Group annual report and accounts 1998, p42

    23    Rio Tinto annual report to shareholders 1998

    24    Standard Chartered

    25    Is executive pay set to increase? Trends in the US/UK suggest it will, William M Mercer, 16 July 1998

    26    Tomkins, see note 7, above

    27    Abbey National, see note 6, above

    28    J Sainsbury annual report and accounts 1999

    29    The Shell Transport and Trading Company, see note 15, above

    30    Paying for performance: long-term incentives in the top 500 UK listed companies, New Bridge Street Consultants, February 1997

    31    Monks Partnership, see note 3, above

    32    Ibid

    33    Abbey National, see note 6, above

    34    Kingfisher annual report and accounts 1999

    35    Monks Partnership, see note 3, above

    36    Paying for performance - executive share incentives in the top 350 UK listed companies, New Bridge Street Consultants, March 1999

    37    Monks Partnership, see note 3, above

    38    Stakis 1998

    39    Survey of employee share schemes and executive incentives on flotation - 1998, New Bridge Street Consultants, February 1999

    40    New Bridge Street Consultants, see note 36, above

    41    Burmah Castrol annual report 1997, p7

    42    City University Business School/Bacon & Woodrow, see note 17, above

    43    Orange annual report/form 20-F/1998

    44    IRS (1998), Financial participation, IRS Management Review 11, October, pp24-32

    45    Pett D and Moss L (1994), Employee share schemes handbook (Longman, London), p3

    46    Marks & Spencer letter to shareholders, 9 June 1977

    47    Business Week, 20 April 1998

    48    William M Mercer, 1998

    49    Kay I T (1998), CEO pay and shareholder value: helping the US win the global economic war (St Lucie Press, Boca Raton)

    50    half bonus for CEO of US division is paid in shares;

    51    figure is the highest bonus paid;

    52    includes deferred bonus payment;

    53    highest £ bonus