Understanding the Nuances of Relative TSR Awards

Relative TSR awards, i.e., awards in which vesting is fully or partially contingent upon the granting corporation’s total shareholder return as compared to its peers, continue to grow in popularity. In the most recent Equity Incentives Design Survey, cosponsored by the NASPP and Deloitte Consulting, 61% of companies that grant performance awards tie vesting to relative TSR, up from only 30% in 2007.

Relative TSR is the only metric utilized by a majority of respondents to the survey. The next most commonly used performance metric, return on invested capital or net assets, is utilized by only 26% of companies that grant performance awards.

Given the prevalence of relative TSR awards, it’s worth taking a close look at some of the nuances of how these awards work. To help me do that, I interviewed Mr. Relative TSR himself, Terry Adamson of Infinite Equity for the NASPP’s Equity Expert podcast. Here are some of the highlights of our conversation.

Peer Groups

One advantage of relative TSR awards is the simplicity of goal setting. Companies don’t have to predict company financial performance several years out to establish appropriate targets, they just have to determine how they want the company to perform against its peers. But companies do have to decide on a peer group that the company will be measured against.

Although one solution is for companies to compare themselves against in index, Terry prefers that companies put together their own custom peer group. Academics that have studied companies that use broad indices as their comparator group have been critical of this approach, finding that it weakens the link between pay and performance and creates a lot of systematic volatility.

Terry’s own experience has been that when executives select the peers that the company will be compared against, they typically act in good faith and make a concerted effort to select those companies that they compete against in the marketplace. He finds that this helps company leaders feel good about the pay-for-performance alignment they are creating with the awards.

Payouts for Negative Performance

Something that might surprise you about relative TSR awards is that they can pay out even when the company has experienced negative performance. This is because relative TSR awards measure companies against their peers, rather than against absolute metrics. If the entire peer group experiences a decline in absolute TSR, but the company’s decline is less than that of its peers, executives may still be eligible for a payout.

This is something that investors sometimes take a dim view of, so I asked Terry what he thinks of it. He is a little more supportive of payouts for negative performance, but also sees benefits to limiting payouts in this circumstance. He notes that, at least theoretically, if the company beats its peers, executives deserve a payout that is above target.

On the other hand, however, he explains that limiting payouts when TSR performance is negative can reduce the fair value of the award. If companies use the fair value to determine how large awards will be, this will result in larger grants, an outcome that will likely be welcomed by executives (especially if the executives expect TSR performance to be positive). Thus, limiting payouts when TSR performance is negative could be a win for both shareholders and executives.

TSR as a Modifier vs. a Standalone Metric

Some companies use relative TSR as a standalone metric and others use it as simply a modifier to their other metrics. In the modifier approach, vesting might be tied to an operational metric, like revenue or earnings per share, but the payout is adjusted—or modified—up or down based on the company’s relative TSR performance.

Terry comes up half empty on the modifier approach. While he understands the attraction of it and has seen this approach grow in prevalence, he thinks that using TSR as a standalone metric is easier for award holders to understand and creates a stronger pay-for-performance alignment.

Outperformance Plans

There are several approaches that can be used to measure relative TSR performance. The approach I’m most familiar with is a percentile calculation. The target is usually for the company’s TSR to be at the median or 50^th percentile of its peers. If the company exceeds this target, the payout is increased, usually maxing out once the company reaches around the 75th percentile. If the company’s TSR is below the median, the payout is reduced, usually with no payout for performance below, say, the 25^th percentile.

Another approach is to tie payouts to the company’s numerical ranking. If the company is first among its peers, the awards pay out at the maximum; the payout is reduced as the company’s ranking falls.

The last approach is an outperformance model, which is one of Terry’s favorites. He explains that in this approach, payouts are tied to the percentage by which the company’s TSR exceeds or falls short of the median. For example, the plan might specify that for every 1% (or 100 basis points) that the company exceeds the median TSR of its peers, an additional 5% of the award will vest. 

In a scenario where a company and its peers all have TSRs that are clustered closely together, this ensures that the company doesn’t have a significantly outsized (or undersized) payout for performance that is only marginally better (or worse) than its peers.

Learn More (and a Football Metaphor)

Listen to the full podcast, “Half Empty or Half Full? A Closer Look at TSR Awards,” to hear more of my interview with Terry, including his predictions for how much more growth we might see in TSR awards and what he thinks of some of the market-based alternatives, such as awards in which vesting is tied to market cap or stock price targets. You’ll also hear me use a football metaphor, something I have never done before and will likely never do again.