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5 min to readMonday, November 29, 2021

Understanding Long-Term Incentives

Written by: Jeff YoderReviewed by: Naoufal Fillali

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Not everyone gets Long-Term Incentives (LTIs) as part of their rewards package, but those who do are usually considered crucial to the success of the company. A well-designed LTIP (Long Term Incentive Plan) can help a company to lure and keep top executive talent, and to align company leaders with the long-term goals and performance of the organization. They can also engender loyalty and a sense of ownership amongst the rank and file employees. LTIPs generally offer the opportunity for equity or deferred compensation over and above salary.

Yet with all the criteria and controls required for LTI awards and the complexity of managing multiple plans and vesting schedules, LTIPs can be a real headache to administer and are often beyond the capabilities of basic compensation management tools. 

Are you able to automate your LTI process and run it smoothly? Can you create all the types of stock and deferred comp plans you need? Do you have the transparency and reporting required to manage the programs in a compliant way? Let’s look at what it takes to manage LTI plans effectively, and make your life as a compensation administrator easier.

Long-Term Incentives (LTIs) are a form of variable compensation that is earned in the present but whose payment is deferred and spread over time. This can be cash compensation but often is in the form of stock or stock options. Their purpose is to give employees a financial incentive to stay with the organization and to have a long-term stake in company performance. LTI awards are often an important component of executive compensation.

Ownership creates loyalty and responsibility

Stock-based LTIs award shares according to a designated set of criteria. There are many ways for companies to grant equity and create employee ownership, but two of the most common include: 

  1. An Employee Stock Ownership Plan (ESOP), grants shares to participating employees according to the plan’s parameters, usually allocated by managers or, in the case of senior executives, by the board of directors. 
  2. An Employee Stock Purchase Plan (ESPP) enables employees to purchase shares at a discounted price. There is an immediate benefit because the market value of the shares is higher than the purchase price, and a long-term benefit because it makes employees into owners, with reason to care about the overall performance of the company.
  3. RSUs (Restricted Stock Units), used as an executive incentive plan vehicle, are a form of long-term compensation that grants executives the right to receive shares of company stock at a future date, subject to certain vesting conditions.

Vesting aids retention but adds complexity

Unless the equity is granted outright, the plans include a vesting schedule, such that the shares or options are not actually owned by the employee until a specific period has passed. With vesting schedules, employees are incentivized to stay with the firm, since they would generally forfeit their assets if they decided to leave the company early.

Typical vesting periods are 3 to 5 years, during which the asset gradually becomes fully owned. For example, an award of 90 shares may vest over 3 years, with 30 shares being earned per year.

An array of options — no pun intended

Stock option plans work similarly to stock plans, but what is awarded is the option, or right, to buy the stock at a set price. Known as an Incentive Stock Option Plan (ISOP), this method may offer options at a discounted price or market price. Still, in either case, the goal is to encourage employees to remain with the company and contribute to its growth in value and share price.

Another LTI approach is profit sharing, typically implemented as a Deferred Profit-Sharing Plan (DPSP). This is an incentive plan in which eligible employees are granted a payment based on company profits during a given period, awarded as cash or company stock. 

Keep in mind that if the LTI is deferred cash compensation, the projected amounts must be accrued, as the company must have cash on hand to pay out the incentive at the designated time. So, as with other variable compensation, forecasting these amounts is important to the Finance team.

A cash-based deferred compensation arrangement may also include clawback mechanisms. If performance does not meet certain pre-established criteria over time, or if there is some sort of misconduct, the company may be able to retract some or all of the payment.

Data-driven rewards for a performance-based culture

To support a pay-for-performance culture, any type of LTI plan may be driven by company and/or individual performance. The system should be able to apply business rules that take performance metrics and use them to calculate proposed incentive awards. For example, there may be a company multiplier applied depending on the achievement of revenue or other objectives or targets. This requires the ability to tap into the data sources that can provide the relevant KPIs, and a rules engine to use those metrics to drive the award of incentives.

Rules-based and performance-driven, but with discretion

Companies may allow managers to enter incentive grants for their teams on a spreadsheet or via their internal system or may allow the system to suggest grants based on employee data and business rules. Even though the system can propose the awards, management can override them at their discretion. That override should, however, be accompanied by a rationale or explanation. It is important for governance and compliance reasons to track all the calculations and approvals that go into determining the incentives awarded.

An automated compensation system will be synced with the core HR platform such that the employment status of the participants is constantly updated. Thus if the recipient of an LTI plan leaves the company, it may cancel the plan but may also trigger a transaction to pay out from the plan. This may be prorated depending on the reason for leaving (retirement, layoff, firing, etc.) and the rules of the plan. The compensation system will automatically apply the predefined business rules to deal with the event appropriately.

Key system capabilities for LTI management

Keeping your LTI plans under control requires versatile compensation technology. A few of the capabilities your system needs include the ability to:

  • Track and report incentive grants and approvals
  • Manage vesting schedules for multiple concurrent plans
  • Provide a rules engine to handle eligibility, awards, and exercising of options
  • Incorporate KPI data sources to use in calculating proposed awards
  • Perform clawbacks and adjustments
  • Calculate/forecast accruals needed for deferred compensation 

Long-term incentive success

Whatever your use of long-term incentives—to attract top executives, reward success, motivate star employees, or encourage long-term thinking and value creation—it is important to have a robust compensation system that will allow you to manage the plans effectively. If you are still managing your LTI plans in spreadsheets, consider that now may be the time to move to an automated total compensation platform to simplify the administration of the plans, integrate LTIPs with total compensation, and improve compliance.

If any terms in this article are unfamiliar to you, don’t worry. We have a resource that will help you navigate this and other compensation management terminology. Bookmark our Compensation Glossary or download a copy to access it offline.