Why Long-Term Incentive Plans (LTIP) Donít Work Well

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Chloe Xu
Director, Australia

Why Long-Term Incentive Plans (LTIP) Donít Work Well

A Long-Term Incentive Plan (LTIP) is designed to improve employees' long-term performance by providing rewards that are usually not tied to the companyís share price. LTIPs have been a key component of pay packages for executives for a long time. However, recent academic studies based on in-depth surveys with over 700 senior executives across 40 countries have found that executives don't appreciate and value them, and are not motivated by this component of their pay plans. Reasons why pay-for-performance incentives don't work well are listed below:
  • EXECUTIVES ARE MORE RISK-AVERSE THAN THEORY SUGGESTS. They are inclined to choose less risky options when they are being asked about their preference on pay packages and perceive an LTIP as 'extraordinarily complex' and even 'arbitrary'.
  • EXECUTIVES CARE MORE ABOUT PRESENT VALUE. In other word, an LTIP that may be worth a lot in three to four years is valued very little today. A study showed that executives discount future value at a remarkable rate of approx. 30% a year, which is nearly five times as discount economic theory suggests.
  • EXECUTIVES ARE SENSITIVE TO RELATIVE PAY. Because of the nature of being a social 'animal', people are more focused on and motivated by how they are paid in relation to their peers.
  • INTRINSIC MOTIVATION IS MISSING FROM THE CONVENTIONAL PLANS. It is evident that extra-large pay packages do not necessarily guarantee stronger incentives. Executives reported they would like to reduce their pay packages in exchange for a job that does better on creating the feeling of achievement, status, being empowered, team spirit, etc.
Based on the above findings, companies are suggested to eliminate LTIP and increase other payment mechanisms, paying larger salaries and using annual cash bonuses to promote desired behaviours and outcomes. In addition, to align managersí and shareholdersí interests, they can require executives to invest their bonuses in company stock until a certain share of their net worth, or some multiple of their annual salary.

Given that in most countries the notion of pay for performance is so profoundly rooted that substantial (fixed) salary increases would draw criticism, companies looking to implement the suggested changes will probably face headwinds. However, the LTIPs that have been used for the past quarter century may soon fall out of favour.

Source: Pepper, A. (2016). The Case Against Long-Term Incentive Plans. Harvard Business Review, 94 (10), pp.22-23.

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