By Katharine Turner and Tamsin Sridhara

There has been some discussion in the U.S. recently about the advantages of performance-based incentive plans that use relative total shareholder return (TSR) as the primary measure.

Some clients have asked us to model how such a program might work as a replacement for a more traditional mix of equity grants with other long-term performance measures. The results of these modeling exercises can be instructive in presenting the various strengths and weaknesses of relative TSR programs for each company’s specific industry and circumstances.

We wanted to share with you our experience in the U.K., where long-term incentive programs with relative TSR measures are very common.

First, however, it’s important to clarify what we are talking about. The way a relative TSR measure normally works is that (a) a company identifies a suitable comparator group and performance period; (b) a total return figure is calculated for each company at the start and at the end of the period; and (c) executives are rewarded depending on the extent to which the company’s TSR performance exceeds the median return of the comparator group over the performance period.

The UK perspective

Relative TSR is one of the most prevalent performance measures in the U.K. for executive long-term incentives (LTIs). For many years, it has been promoted by many institutional investors and in governance guidelines as a preferred measure because it appears to achieve the desired alignment with investors’ interests executives are rewarded only when they deliver returns at or above the norm for comparator companies, with general stock market performance being screened out. It is also deemed to be transparent and objective.

However, our experience after many years of working with relative TSR as a measure in the U.K. is that it is in practice flawed, for several reasons.

For example, outcomes can be at odds with long-term sustained performance. There is little incentive effect for executives. Small variations in calculation methodology can lead to significant differences in payouts.

Some of these shortcomings are controllable and there are companies that use relative TSR to great effect underline the company’s objective of superior performance for shareholders. But, some of the shortcomings are inherent, forcing remuneration committees to spend unnecessary time and resources managing the consequences.

Revealing examples

Company A operates in a niche market, with too few peers to form a meaningful comparator group of direct peers. How appropriate is it for this company to reward executives for relative TSR performance against a general market peer group?

Company B has enjoyed steady performance for a number of years while the performance of many of its peers has been more volatile. Is it appropriate for executives in the more volatile companies to be better rewarded than Company B’s executives because strong relative TSR performance over just a few performance cycles can lead to higher aggregate payouts than sustained steady performance?

Company C operates globally and competes with companies listed in a number of different markets around the world. How does company C’s remuneration committee reach a fair decision when the change in just one variable in calculating TSR (e.g., using local or a common currency) can lead to either no vesting or nearly full vesting?

As these shortcomings have become more apparent, investors and the governance guidelines in the U.K. have been more accepting of other financial or operational measures in their LTI plans.

In fact, the current situation in the U.K. is that, while TSR remains one of the most prevalent measures, its overall impact is declining as companies have added additional measures to their LTI arrangements and/ or have given their remuneration committees more discretion to override formulaic outcomes based on relative TSR measures if the results are inconsistent with a broader view of actual performance.

Katharine Turner is the leader of Towers Watson’s executive compensation practice in the U.K. Tamsin Sridhara is a senior executive compensation consultant of Towers Watson in the London office.
Towers Watson’s executive compensation blog, where all of its research is available and continuously updated. http://www.towerswatson.com/blog/executive-pay-matters