While Australian large-cap CEOs often have short-term incentive (STI) and long-term incentive (LTI) opportunities of identical quantum, executives frequently view STIs as significantly more valuable than LTIs. This sentiment is so commonly expressed during our corporate engagements that we consider it nearly universal within the ASX-listed executive community.

The imbalance between STI and LTI presents key concern for long-term orientated investors as it risks fostering an excessive focus on annual STI scorecard assessments, leading to short-term decision making. It also diminishes the role of LTIs as a vehicle for executive equity exposure.

Yet some of reasons that executives put more emphasis on STI appear to be the unintended consequences of investor-preferred safeguards, which protect against unmerited payouts but distort the risk profile of long-term awards.

In this article, we explore the issue of incentive weighting within the typical remuneration structure, and consider constraints placed on LTIs that contribute to a short-term focus.

An Illustrative Example

To describe the issue of STI and LTI imbalance, we use an illustrative example of three-pronged remuneration structure comprising: fixed remuneration (FR), an STI with a maximum opportunity of 150% of FR and a target opportunity of 100% of FR, and an LTI with a maximum opportunity of 150% of FR by face value.

At a glance, the STI and LTI opportunities are equal. However, executives are well versed at applying risk adjustment, and will consider the expected value of the award rather than the maximum opportunity.

Typical STI Assessment

The STI opportunity is assessed at the end of each year, often through a balanced scorecard. Typically, the intended level of challenge in the scorecard is set so that achieving target opportunity is the expected outcome. A threshold level of performance (below target) is also usually set out for each of the scorecard measures, below which no award is given in relation to that measure.

Better than expected performance and below expected performance results in outcomes above or below the target amount, subject to the maximum opportunity.

Typical LTI Assessment and RTSR Thresholds

LTI opportunities are commonly made through annual grants of performance rights, which are tested against a performance condition after three or four years. Relative total shareholder (RTSR) is the most common condition, used by approximately 68% of the S&P/ASX 300 companies.

Under the typical RTSR condition, no vesting occurs below median performance, 50% vests at median performance, 100% vests at upper quartile performance, and straight-line vesting applies between median and upper quartile performance.

The Expected Value Problem

With a neutral view of a company’s ability to perform against its peer group, the expected value of an LTI with this structure is 43.75% of the face value, or 65.6% of FR given the face value in our example is 150% of FR. This is based on a probability weighting of the below outcomes:

There is a 25% chance of top quartile performance, with 100% vesting.
There is a 25% chance of second quartile performance, with 75% vesting at the mid-point of that range.
There is a 50% chance of third or fourth quartile performance, with nil vesting.

This is further illustrated in the below chart. Note that the area underneath the line represents 43.75% of the total area.

By contrast, the expected value of the STI opportunity is the target opportunity, or 100% of FR — over twice as large as the expected value of the LTI opportunity. This disparity is driven largely by a cliff on LTI vesting that occurs immediately below median performance.

Forecast Risk and Uncertainty

Another factor that depresses the perceived value of LTIs for executives is forecast risk. While RTSR is typically assessed against the standard targets set out above, for other common LTI metrics, such as earnings or absolute TSR, the process is more complicated.

Setting reasonably challenging earnings or return performance targets for three or four years into the future is a difficult task due to the increased likelihood of unexpected events and forecasting errors over a longer horizon. This heightened forecast risk means that non-RTSR financial performance is more likely to significantly fall short of expectations compared to STIs, where performance is evaluated annually. This results in LTI’s falling below threshold performance more frequently than STIs.

While the heightened forecast risk also means that long-term performance may significantly outperform expectations as well, the LTI opportunity cap limits the effectiveness of this benefit to offset the risk of performance falling below threshold outcomes.

Although this factor is hard to quantify and compare against the STI, it significantly contributes to the reported disparity in expected values, with STIs typically offering higher expected value due to their shorter evaluation periods and lower associated risks.

Good Leaver Exits and Pro Ration of LTI

The potential for a CEO to lose their job and for unvested LTIs to be forfeited, in whole or in part, contributes to the generally lower expected value of LTIs compared to STIs.

Should an executive depart in poor terms, they will generally lose all on-foot awards, which will include any deferred STI elements and all on-foot LTI’s. However, under good leaver circumstances, executive exits will often result in a forfeiture of LTI awards only. This is due to the common practice of pro rating LTI’s for service.

On an executive’s exit under good leaver circumstances, unvested awards may lapse on a pro rata basis for the proportion of the performance period that has not been served. Under this pro rata treatment, the amount of LTI award that lapses depends on the timing of the CEO’s resignation within the performance period. The below examples illustrate the lapsing of LTIs under the pro rata treatment where a CEO retires at the end of FY2024:

In a three-year performance period, the FY2024 LTI may lapse by 66%, while the FY2023 LTI may lapse by 33%.
In a four-year performance period, the FY2024 LTI award may lapse by 75%, the FY2023 LTI by 50%, and the FY2022 LTI by 25%.

In both scenarios, the CEO will lose what amounts to at least 100% of their annual LTI opportunity due to the pro rata treatment. Should a CEO have a tenure of 5-years, the loss of 100% of annual LTI opportunity is equivalent to a 20% annual reduction in LTI opportunity. In our illustrative example where annual LTI opportunity is 150% of FR, this is equivalent to a further opportunity reduction of 30% of FR.

There is not typically any similar pro rata treatment for STI awards, which are considered paid and earned at the time of grant. This again is a factor in why LTI awards have lower expected values than STI awards.

In the event that a CEO announces his or her resignation with effect from mid-year, they may forfeit both their STI and LTI opportunities for that year. There is no difference between STI and LTI treatments in such a circumstance.

Executive Control

The degree of executive control over performance outcomes is another element that is reported to limit the weight that executives place on the LTI relative to the STI. Flawed RTSR peer groups and changing market conditions can both result in executives viewing LTI outcomes as being outside their control. This is much more so than for STI outcomes.

A lack of control does not impact a risk-neutral view of the expected value of LTI, however this point raises that there are other psychological factors at play that favor an executive focus on STI over LTI.

The Unintended Consequence of Shareholder Imposed Constraints

Shareholder views on executive remuneration in Australia often focus on fairness. Given the high salaries of CEOs, it is an understandable view that significant outperformance should be demonstrated before any bonuses are awarded. This sentiment underscores a broad expectation that executive pay should be closely aligned with tangible achievements and performance.

However, all of the factors discussed in this article at least partly arise from the unintended consequences of shareholder constraints, which are often more stringent for LTIs. Such constraints include:

RTSR linked awards should not vest below median performance.
Absolute positive TSR gateways are encouraged.
Non-TSR LTI performance conditions should be set at challenging ranges at the time of grant, with investors typically skeptical of board discretion to subsequently adjust the conditions.
Equity awards should always be hurdled.

Each of these commonly held views mitigates against excessive or unmerited pay to executives. However, these are also factors that contribute to lowering the expected value of LTIs, with no similar impact on STIs.

STI Deferred Equity

While the structural limitations to the LTI described in this article have tempered the LTIs role in providing executive equity exposure, there has been a mitigant within STI market practices.

In the past several years the typical STI award mix has increasingly featured a significant deferred equity component. While it will take years for a new executive to build an appropriately material equity exposure via deferred equity allocations to STI awards, the ongoing tilt towards equity settled STIs is a positive step to fulfilling a deficiency left by flawed LTI design.

Moving Forward

There have been some recent changes to LTI market practices, in particular with the introduction of CPS 511, the prudential standard on remuneration set by the Australian Prudential Regulation Authority (APRA). This standard has introduced non-financial measure requirements into remuneration structures and has resulted in Australia’s big four banks introducing restricted shares into LTI plans (see our article Integrating Non-Financial Measures into Incentive Plans: Insights from the Australian Market for further insights). Combined, these developments open the door to long-term incentive awards with lower risk.

Even among non APRA-regulated entities, we see opportunity for LTIs to be further reweighted on an expected value basis, relative to the STI, not only by adjusting quantum but also by better aligning the vesting risk between STIs and LTIs. Currently, the risk profiles of these remuneration elements are significantly misaligned.

Alicja Bielawska CFA also contributed to this article.