Time to scrap long-term incentive plans

A new report says the schemes create 'perverse incentives' that can damage businesses.

by Jack Torrance
Last Updated: 06 Aug 2015

A lot of people are unhappy about the huge and escalating rewards raked in by Britain's top executives – in fact an Institute of Directors poll found that 52% of bosses agreed it was the biggest single threat to public trust in business. Base salaries for FTSE chiefs aren't exactly low, but it's the massive bonuses and other incentive windfalls that seem to really stick in people's craws.

While most big companies have moved away from a system where bosses are just rewarded for their short-term gains, by way of an annual bonus linked to profits, a new report today claims that long-term incentive plans (LTIPs) could be just as damaging.

Research by the High Pay Centre thinktank said that LTIPs create 'perverse incentives' by encouraging execs to to focus on gaming the system to maximise the amount they can earn. As they're based on performance over about 3-5 years, they still encourage behaviour that disregards long-term sustainability in favour of medium-term performance. They could, for instance, encourage cutting costs or buying back shares just for the sake of improving the share price, or discourage investment in long-term improvements to protect short-term profit margins. 

'Performance-related pay has failed on its own terms,' said the centre's director Deborah Hargreaves. 'It doesn’t encourage or reward good business performance. The only effect it has is to make executive pay packages more complex, less aligned with the interests of the company and much, much bigger.' 

The report found that LTIP payments to FTSE 350 directors increased by 250% between the years 2000 and 2013, five times faster than shareholder returns, and a negligible relationship between the two figures - suggesting the schemes aren't delivering on their purpose. 

So what does the High Pay Centre recommend instead? It wants to see LTIPs scrapped, but replaced with payouts based on wider objectives set out by the board. It suggests this could include productivity measures - not a bad idea, but one that could be based on slightly subjective criteria and could be a difficult metric for chief executives to understand how to improve.

The report also recommends that annual bonuses be paid in cash, not shares, to avoid effective pay inflation as a result of, for instance, a takeover bid, and for the scrapping of 'golden hellos' that can cause execs to disregard the importance of their LTIP.

Given the potential impact on its ability to hire the best performers, It would be a very bold move for any big company to shift away from the bonus and LTIP system to a rewards scheme based on less tangible metrics. But it usually takes a radical first-mover to bring about massive change and it's change British business could really do with considering.

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