Summary
Long-term incentives are considered one of the incentives that best fulfill the functions of attracting and retaining key executives in the company. This article, based on the bibliographic review of the subject, presents the current general trends regarding the design of this type of incentive, observed in the world market.
Each type of long-term incentive is described individually, accessing a specific reading of those aspects that most interest the reader. The most commonly used types of incentives are the following:
- Stock Options b) Restricted Shares c) Phantom Shares Stock Appreciation Rights Financed Purchase of Shares Performance Shares Discontinued Stock Options Deferred Bonds Pension Plan All-Event Compensation
Contextualization
We know that remuneration is any consideration in money and additional ones in cash valued species that the worker must receive from the employer for the provision of services, in accordance with the employment contract (Art. 41 Labor Code). Compensation is made up of different elements such as base salary, individual incentives, team-based pay, and other elements of compensation.
Incentives constitute an important part of remuneration and, in this sense, we can say that in compensation management four types of incentives are distinguished:
- Fixed salary (which determines the lifestyle) Short-term annual (which in many cases is the element with the greatest impact on behavior) Long-term multi-annual (which is the most loyal element) Extra-salary compensation (indirect compensation that constitutes the differentiating element).
The last two types of incentives mentioned are those that have the most effect, the one related to long-term incentives being analyzed in detail in this article.
The main function of long-term incentives is to retain the best executives and talents and, at the same time, prevent them from privileging the short term to focus exclusively on obtaining better profits and thus higher bonuses, over continued success and sustained performance of the company, thereby achieving the alignment of interests between executives and shareholders.
That is why this type of incentive is aimed mainly at senior management, constituting a relevant element of the total compensation they receive, being evident in various studies carried out by different international consultants, that the variable percentage of compensation at this level It is made up in equal parts of short-term bonds and long-term incentives.
These practices, more common in North American companies than in European corporations, began to spread to the subsidiaries of multinationals in the 1990s. As a consequence of the importation of compensation methods by multinational companies, some Latin American companies have created formulas to align its executives with long-term business results and be competitive in attracting the best talent.
In recent years, the continuous growth observed in the implementation of this type of incentives has made it clear that one of the most used is the system of options on shares or stock options, however, there are different mechanisms that have been increasing their use with in order to take advantage of the possibilities offered by the local market.
Long Term Incentives
Most companies around the world are faced with the same executive compensation issues:
- How to attract those with competencies and capacities appropriate to the needs of the company? How to retain them in the long term? How to motivate and encourage high performance behaviors and value creation, aligning their interests with those of the shareholders, reflected in a payment that is not more than what the shareholders think is justified?
So it is not surprising that companies typically cite these three goals for their long-term incentive plans.
The design of the long-term incentive plan is a process that involves a number of factors such as the company's business strategy, market practices, profit and loss projections, consequences on cash flow, Tax efficiency, the influence that executives can have on the performance measures to be used and, finally, if the plan and the adopted performance measures are understood by the participants in the beginning and can remain throughout the life of the plan. It is often impossible to satisfy all of these requirements, however, it is important to identify and prioritize these requirements over time.
Until a few years ago, long-term incentive plans were adopted by companies, keeping the other organizational conditions invariant, those that operated for several years and were not the focus of attention. Since 2004 this reality has drastically changed in Chile and evidence of this is the numerous and well-known changes of executives in important local companies. It could be hypothesized that these changes were produced, in part, by the dissatisfaction of the executives with the conditions offered by the company, where the economic only plays a secondary and hygienic role, being the elements associated with the satisfaction and professional and personal development the defining ones for job change decisions.
For the same reason, long-term incentive plans:
- They need to be reviewed annually. They take various forms, dynamically adapting to the specific needs of each company. They are probably stock option plans, although in some companies they can be used in combination with other incentive plans focused on the long term. variety of performance indicators and performance conditions, which are what lead the company to its particular circumstances, processes and objectives.
Several factors have influenced these changes, among which are the increase in the proportion of executive pay related to the fulfillment of strategic plans and long-term performance of the company, and the impacts of incentives based on actions on the image, market value and sustainability of the company, as a direct consequence of the accounting scandals that started with the Enron case.
For this reason, an important role in the design of long-term incentive plans is that developed by the Compensation Committees, who in the face of the changes that have occurred in recent years have done a fairly strong job, as it is becoming more and more difficult. evaluate competitiveness, effectiveness and cost of each plan and be able to compare it with the market. It is part of the modernization in the management of corporate governments and company boards.
Long Term Incentive Types
Various long-term incentives are distinguished, the most frequently used being the following:
In Chile, this system was authorized in the Law of Public Offering of Shares (OPA) in 2000 and currently the study of Determination of Bonds of General Managers and Area Managers carried out by Seminarium Head Hunting (2004) in 10 companies indicates that within Of the companies that have long-term incentives, 66% use stock options, the best known and most successful case being that of Banco de Crédito e Inversiones, BCI. Quiñenco and Madeco also use this system.
For this system to be effective, it is necessary to sensitize employees to how value is created and how they can contribute to it individually and as a team, since it is essential to move from ownership to commitment and action focused on creating value.
In the case of managers, in addition to stock options, it is also suggested to use other types of long-term incentives (for example, multi-year bonus plans paid in money) based on measurement elements that reflect the value creation factors, where managers and employees have a direct impact. For this reason, it is convenient that these programs are communicated together with the indicators that will be used to measure the results.
In the past decade, the long-term incentive chosen by technology firms was stock options, both for the executive level and for other workers. However, the past market depression as well as the apparently delicate relationship between corporate operations and the operation of the stock market, has raised interest in what are the best ways to create incentives for executives (managers) in order to achieve the highest levels of job performance and contribute to the overall running of the business.
One of the important advantages of this system is that the employee will always own the shares that will have an economic value, even if the price of the share at the time of sale is lower than the value of the share at the time of grant.
This type of incentive is highly valued by those who receive it, and also by the company given its limited cost.
Alternatively, North American companies such as Microsoft Corp., Dell Computer and Amazon have begun to replace the delivery of stock options with restricted shares or restricted shares. In 2002, 43% of the 250 Fortune 100 companies used this type of incentive.
One of the positive aspects of this type of incentive is that it can be combined with stock options, as well as that it can be used when the availability of options is limited, and the payment can be made in a proportion of cash and another of shares.
Its application is indicated when seeking to find a balance between risk / reward of stock options and long-term incentive plans in money, and when the shares available for options are limited.
This type of incentive combines the benefits of stocks and the operational operation of performance incentives.
Unlike restricted shares, delivery is effective only once compliance with the objectives indicated at the beginning of the accrual period is verified.
As in the case of deferred long-term bonds, this type of incentive is linked to the fulfillment of the strategic plan and / or other types of financial or operational milestones.
The difference with options on regular shares lies mainly in the fact that in these the price at which the share would be acquired at the expiration of the option is fixed at the time the option is granted.
This type of incentive guarantees a stronger retention than regular stock options, however, it has a negative perception by investors.
Among deferred bonuses the following types can be distinguished:
- Linked to the long-term objectives of the company, among which we can mention the fulfillment of the strategic plan, the launch of new products, the creation of new business lines, international expansion and / or consolidation and the benefits of the group. Linked to the permanence of the organization.
Despite the short-term culture installed in times of high inflation, the large Latin American business groups are incorporating this tool.
Of the types of incentives described above, the trend in recent years indicates:
- The emergence of stock-based plans rather than stock options; The use of long-term stock plans related to annual bonus awards; The increased use of multiple plans for the same participants.
Finally, the evidence for Latin America reveals that long-term incentives represent approximately 20% of the variable compensation of Executive Directors, Senior Management and Other Executives, the frequency according to the types of incentives used being the following:
- Stock Options: 26% Phantom Shares: 10% Restricted Shares: 3% Perforfamnce Shares: 3%
Even though the previous figures are well below those observed in the United States, where the frequency of stock options is 100%, it is important to mention that more and more companies are using some of these types of long-term incentives.
On the other hand, even when benefits do not operate as great incentives, in today's market it is increasingly important to offer good and better benefit packages to employees, especially those who contribute a lot to the success of your company. In this sense, it is considered as long-term incentives:
In reference to the importance of offering a good pension plan to executives, of the 15 companies participating in the Watson Wyatt Total Compensation Survey (2004), 20% of the total have special Pension Plans for Directors and Managers, showing their usefulness in attracting and retaining company executives, showing concern for their future, as well as fostering a long-term vision in them.
It is important to mention that this long-term incentive avoids the generation of detrimental situations for the company that arise on the part of employees who seek to be fired in order to receive severance pay.
In conclusion, long-term incentives not only constitute a true tool for retention of executives, but also allow the focus of their action to be the long-term, thereby fostering sustained improvements in the company's results, increasing the personal motivation and encouragement to teamwork, achieving greater coherence between the interests of shareholders and employees.
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¹ Psychologist, Academic Director Master in Organizational Psychology, Universidad Adolfo Ibáñez. Mail: [email protected]
² Commercial Engineer, PROSEL Consultant.
References
Technical Articles
Allen, R. & Kilmann, R. (2001). The role of the reward system for a total quality management based strategy. Journal of Organizational Change Management, Vol 14, N ° 2, 110-125.
Bartol, K. & Srivastava, A. (2002). Encouraging knowledge sharing: the role of organizational reward systems. Journal of Leadership & Organizational Studies. Vol. 9 No. 1, 64-76.
Bland, A. (2004). Motivate and reward: performance appraisal and incentive systems for business success. Human Resources Management Journal, Vol. 14 N ° 1, pp. 99-101.
Elson, C. (2003). What's Wrong With Executive Compensation? Harvard Business Review, Vol. 81, No. 1, 56-66. Fernández, I. (2003). Compensation committees. Knowledge and Management Magazine, N ° 56.
Lowe, K., Milliman, J. De Cieri, H. & Dowling, P. (2002). International compensation practices: a ten-country comparative analysis. Human Resources Management, Vol. 41 N ° 1, 45-66.
Zingheim, P. & Schuster, J. (2001). Winning the talent game: total reward and the better worforce deal! Compensation & Benefits.
Internet references
- : Definitions of Long-Term Incentives.: Tailor-made Salaries: Stock options continue their upward path.: Long-term incentives for executives have increased 30% in four years.
