Do you need both long-term and annual incentive plans for your executive team?

But first for the sake of definition, what is the difference between a long-term and an annual incentive plan? 

An annual incentive plan is a cash-based incentive or bonus plan that pays an executive (or other employee) for annual individual, group or enterprise performance. The value of the reward is generally based upon annual performance metrics and frequently measures results versus a goal or other standard. This is a concept and tool broadly applied in business.

Long-term incentive plans are less commonly used and represent a cash- or equity-based incentive or bonus that pays an executive for multi-year enterprise performance. The value of the reward is generally based upon the creation of measured enterprise value or achievement of pre-defined strategic objectives. Long-term incentives are used almost exclusively for senior executives, and then on a very selective basis. Stock options or restricted stock are common reward vehicles for publically-held firms, but most (or nearly all) privately-owned companies settle their plans in cash.

May 2012 Annual and Long-Term Incentives Chart

As noted above, the use of both types of incentives will vary, but typically annual incentives are nearly universally offered to executives. Long-term incentives are not. Look at the following table to see the differences amongst four typical senior-level executive positions. It shows differences in the frequency of use for reporting organizations taken from a recent Towers-Watson Data Services survey.

Three observations are obvious when you look at the above data:

  • 80-90% of executives receive annual incentives (or have the opportunity to earn them).
  • Long-term incentives are not frequently offered or paid by smaller companies (under 1,000 employees), but usage increases rapidly as company size grows.
  • Long-term incentives are less frequently offered or paid (by about 20% less) as the size and responsibility of the executive job is reduced from (say) CEO to a Vice President, in any sized company. 

In companies over 5,000 employees, it is very likely an executive will participate in an annual incentive plan and the majority (50-90% of participants) will have both an annual and long-term incentive. If you are the CEO, participation in both plans is nearly certain.

Why do smaller companies hesitate to use long-term incentives? In our experience, most of these firms are privately owned and the mere mention of terms like “phantom-stock” or “equity” will bring an immediate halt to any discussion of executive incentives (and groan from the owners). I have been in some of these meetings.

What is done by other companies in the marketplace provides an interesting benchmark for decision making, but do you need both a long-term and annual incentive for your executive team? Let’s briefly look at each in turn.

The case for paying a performance-based annual incentive for executives (and other key employees) has been long made. It is an effective and tested way to focus the attention of the executive team on the annual goals of the company and helps constantly reinforce its strategy. You should be using annual incentives for your executives. But what about long-term incentives, are they also needed?

That depends. Try this test to see. If you can answer the following four questions in the affirmative, generally you should also be considering a long-term incentive plan for the “pivotal” members of your executive team.

  1. Are there one or more members of your current executive team that are essential to the company over the next 5-10 years to assure success?
  2. Do you need to recruit key executive talent in a marketplace where competitors are offering long-term incentives in various formats like stock options?
  3. Can shareholders and other owners create a case for increasing shareholder value that involves “sharing” equity or future cash profits with the executive team and (in exchange) still coming out well ahead in terms of the increased value of their holdings? [i.e. – a value proposition]
  4. Can key members of your executive team be seen as having the ability to uniquely drive growth in company value? [How? Who?]

If your answer to all (or some) of the above questions is “yes”, you should be considering the addition of a long-term incentive plan. Unlike the market, the size of your company will have little to do with your ultimate decision. Smaller companies may also (and often do) apply.

It has been our experience that a well-designed long-term incentive plan can begin driving success and performance in as little as a single year and instantly put executives on the “same page” with owners in focusing on increasing shareholder value.

Looking for a way to sleep better at night? Then delegate ownership’s value-creation problems to the executive team with a long-term incentive plan, and get some rest.

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