Human Capital & Careers

Use of TSR as Incentive Pay Metric Flattens Out

Total shareholder return is still the leading metric for calculating long-term compensation, but companies' thinking may be starting to shift.
David McCannMarch 30, 2017
Use of TSR as Incentive Pay Metric Flattens Out

In response to regulations that took effect following the passage of the Dodd-Frank Act, as well as pressure from proxy advisers and investors, it became common practice for executive compensation to be based on company performance.

Relative total shareholder return (rTSR) — a measure of TSR compared with that of other companies, usually a peer group of some kind — emerged as the leading metric for determining long-term incentive payouts for named executive officers.

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That remains true. But after several years of rising influence for rTSR, usage of the metric in setting executive pay is flattening out, according to Equilar, an executive compensation research firm.

Equilar and E*Trade Financial Corporate Services examined the pay practices among S&P 500 companies from 2011 — the year after Dodd-Frank passed — through 2015, the most recent year for which complete data was available.

In the case of CEOs, the number of companies using rTSR as a factor in determining executive pay packages rose five to six percentage points each year from 2012 to 2014, reaching 57.4%. But in 2015 there was no gain at all, with the prevalence remaining at 57.4%

At the same time, return on capital (ROC), which in 2014 surpassed earnings per share (EPS) as the second-most-used performance metric for CEOs, inched forward for a fourth consecutive year, to 30.6%.

EPS, which had declined from 34.6% to 27.3% between 2011 and 2014, reversed the trend the following year, climbing up to 29.2%. Among other leading metrics, both revenue and operating income/margin remained mostly flat over the five-year period and registered 22.3% and 15.2% usage, respectively, in 2015.

With regard to CFO compensation, rTSR did continue to rise in 2015, but only by 1.2 percentage points (to 56.6%), significantly trailing the gains seen in the prior three years. Usage percentages for the other leading metrics closely mirrored the CEO patterns.

Why the slowdown in the usage of total shareholder return? According to Equilar, while incentive-plan designers recognize that it represents shareholder value over time, some have begun to question its ability to incentivize CEO behavior and performance. “Executives can engage in activities they believe will influence TSR, but they cannot control all the factors that influence the outcome,” the firm said in its report.

Selecting a peer group of companies for purposes of calculating rTSR may also be problematic. “Many companies are challenged with defining how to measure their success and who they will measure themselves against, as peer groups are not always easily defined based solely on size and/or industry sector,” said Craig Rubino, director of corporate services for E*Trade Financial Corporate Services, in a release.

Additionally, while fewer companies use ROC and EPS than rTSR, those that do use one of those metrics are more likely to use it as the sole basis for long-term incentive awards. By comparison, rTSR is more often used to calculate 50% of such awards. (See chart below.)

In another key finding of the research, long-term incentives were most commonly measured over a three-year performance period; 77% of S&P 500 companies did so in 2015, compared with 56.1% in 2011.