Why are Long-Term Incentive Plans not effective?

According to research, executives prefer less risky choices as compared to LTIPs, tend to think about pay only in present terms, and place greater importance on non-monetary considerations, such as achievements and teamwork.

What are some types of LTIPs?

Examples of types of LTIPs are stock options, cash, restricted stock, 401(k) retirement plans, and phantom stocks.

How does a company track an employee's performance?

Employees in a long-term incentive plan are subject to quantifiable performance metrics, such as a market capitalization number or sales figure, or executive goals defined by the company’s board of directors that they must reach in order to be eligible for the award.

What are the two types of vesting schedules?

The first type of vesting is graduated, in which the award is transferred in batches over several years. Cliff vesting occurs at a certain point in the near future.

Long Term Incentive Plan (LTIP) | Definition | Types

Q: What is a Long-Term Incentive Plan?

Long-term incentive plans are plans to retain employees by rewarding them to reach certain performance targets or goals. The targets or goals differ based on the type of company (public or private) and the employee’s position.

Long Term Incentive Plans are plans to retain employees by rewarding them to reach certain performance targets or goals.

The targets or goals differ based on the type of company (public or private) and the employee’s position. For example, the chief executive officer may have incentives to increase a company’s market capitalization.

On the other hand, a junior employee may be incentivized to put in a certain number of years with the same company.

Proponents of LTIPs claim that such plans are effective tools to retain employees and encourage them to work towards its success. Critics of LTIPs say that other factors, besides incentives, play a more important role in employee retention and on their performance.

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Basics of LTIPs

LTIPs are chiefly targeted at executives and the case for such incentive plans rests on company culture.

Companies spend considerable effort and money in order to attract and retain executive talent. LTIPs ensure that these employees spend time and effort in order to familiarize themselves with the company’s operations and its culture.

In exchange, they offer handsome rewards to employees who meet the performance criteria specified in these plans.

The duration of an LTIP differs between companies but the average time that they last are generally around 3 to 5 years.

The LTIP beneficiary can only cash out the benefits after the time period requirements and goals, specified in their employment agreement, are met.

LTIP Components

The design of LTIPs differs based on the type of company and the executive position.

For example, publicly-listed companies may offer stock units as awards to senior executives for reaching performance targets while private companies may offer cash bonuses for the same position. Some common components of LTIPs are as follows:

Performance metrics or goals: Employees subject to the long-term incentive plan are subject to quantifiable performance metrics, such as a market capitalization number or sales figure, or executive goals defined by the company’s board of directors that they must reach in order to be eligible for the award.

Vesting schedule: Most LTIPs have vesting schedules during the course of which the ownership of the award is transferred to the beneficiary. There are two types of vesting schedules:

Graduated Vesting: In this type of vesting schedule, ownership of the award is transferred in batches, gradually over a period of several years, and may be based on achieving of interim performance targets defined in the LTIP agreement.

Cliff vesting: In this type of vesting schedule, ownership of the award is immediate and at a certain point in the future.

Types of LTIPs

The types of LTIPs are as follows:

Stock Options: In this type of LTIP, the plan’s beneficiary receives stock options that give the owner the right to buy shares of the company in public or private markets at a discounted cost.

Cash: In this type of LTIP, the plan’s beneficiary receives a lump sum cash payment from the company provided they achieve certain goals set by the company.

Restricted Stock: In this type of LTIP, the plan’s beneficiary receives a percentage of the stock promised to them each year until the plan is fully vested.

For example, an employee may receive 25% of the stock promised to them each year until the LTIP is fully vested after four years.

401(k) Retirement Plan: In this type of LTIP, organizations match or increase their contributions to an employee’s retirement plan based on the number of years of service.

Phantom Stocks: In this type of LTIP, phantom stocks, or mock stocks that mirror the price movements of their physical counterparts, are handed out to employees and exchanged for real stock after a period of time.

Example of LTIP

Consider the case of Alphabet CEO Sundar Pichai. In 2020, he had a base salary of $2 million and was awarded a $240 million stock package that vests over a period of three years. The stock package is a combination of performance stock and restricted stock.

Pichai will receive a total of $90 million stock based on Alphabet stock’s performance relative to the S&P 500.

He is also entitled to receive $150 million worth of restricted stock between 2020 and 2022, subject to his continued employment with the company during this period.

$120 million worth of restricted stock will vest at the 1/12th of the total amount each March and July until the total amount is reached.

The remaining $30 million will vest at the rate of 1/4th of the total amount each March and July until the total amount is reached.

Advantages and Disadvantages of LTIPs

Research about the effectiveness of LTIPs is conflicting. Many suggest that LTIPs can foster commitment and ownership to a company and provide employees with the necessary motivation to work harder for its success.

Others contend that LTIPs are not effective in retaining employees. Alexander Pepper, a management consultant, has identified four reasons why LTIPs are not effective. They are as follows:

Executives prefer less risky choices, like guaranteed payouts, as compared to taking on the risk of committing to an LTIP based on performance goals.
Executives think about pay in present terms, meaning they’d much rather get paid today for work they have already done than plan for a bumper payout based on a performance target.
Executives are swayed by relative pay, meaning they consider their salary in relation to the society they live in.
Executives place greater importance to nonmonetary considerations, such as achievements, teamwork, and status, than high salaries.

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