Employee benefits, pay and incentive design have been in place in companies for decades. But, at the same time, people’s preferences and needs have been changing a lot, particularly as a consequence of the COVID-19 pandemic and the recent calls for more flexibility. So it follows that employers must adapt.
In this blog, we’ll discuss one of the modern types of remunerations — the Long-Term Incentive Plans (LTIPs). These are becoming more and more popular among tech companies and startups, but, that said, they might be of interest for any employer — including you. We believe that properly designed LTIPs can be effectively incorporated into any type of corporate structures.
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By reading this entry, we hope you will better grasp the reasons behind setting up such plans and what are the most common types of benefits. Full disclosure: we’ll mostly focus on awards linked to performance and how they are developed to meet the desired business objectives. Lastly, we’ll also share with you the steps todeveloping a good LTIP.
How employee benefits help manage talent
In May this year, we released the results of the Global Workforce Hopes and Fears Survey 2022. Over 52,000 workers across 44 countries and territories responded to the survey and the majority of them said they felt empowered by their current circumstances —meaning, since their specialised or scarce skills are in high demand, they can easily change the workplace and get a rise in benefits or improve other conditions while switching employers.
In fact, more than one-third of respondents said they planned to ask for a raise in the coming year, and one in five said they are extremely or very likely to switch employers. This shows that companies will have to go beyond “just pay” and find different and more appealing ways to retain and attract key talent —and that’s exactly what they are doing.
That’s why, now more than ever, employers need to design and offer attractive benefits to their current and prospective key employees. Don’t know where to start? Fret not; stick with us because we will explain to you all you need to know.
We start with the basics. Employee benefits are any kind of compensation paid to employees. There’s a wide range of benefits that employers can design and ultimately provide. These are typically classified as short-term employee benefits such as wages, bonuses, paid annual leaves, among others; and long-term ones such as pension, post-employment medical care, long service leave or a long-term incentive plan, to name a few.
Employers design such benefits with kind-hearted intentions, but also with the objective to tackle commercial objectives as, increasingly, they face the need to:
Zooming in on Long-Term Incentive Plans
In Europe, Australia and the United States, there’s an increasing trend towards performance-based plans where the employer rewards employees for fulfilling the specific goals mentioned above. While these plans are more relevant for executives, the management level talents tend to be more and more implicated as well. These benefits are known as Long-Term Incentive Plans (LTIPs).
LTIPs are generally designed in such a way as to be simple to understand, objective, and aligned with the performance of the market, business and individual. The specific characteristics of each individual plan should be driven by business objectives and aligned with the Human Resources (HR) strategy.
The objective is to find the right balance between the plan’s costs and benefits to ensure that the employer attracts and retains key employees, and that they will remain loyal and motivated to perform to create value for the company —all while keeping a manageable level of associated costs.
When designing a suitable LTIP, it’s important to view it in conjunction with other financial and non-financial reward elements. In other words, you want to look at the “big picture” to arrive at a fitting incentive arrangement that’s guided by a number of parameters, including the provision of awards that are aligned with the market and the shareholders’ interests. The “big picture” is then built looking at the total reward package of the employee.
There are additional considerations to take into account while designing the plan. In particular, some employers might want to avoid capital dilution and introduce tax-effective compensation arrangements, or employers might be reluctant to buy shares from the market and are sensitised to the problem of Profit and Loss (P&L) volatility. And sometimes some designs aren’t approved as they require extensive administration for bookkeeping and evaluation.
The most common classes of LTIPs
LTIP designs really depend on the needs and objectives of individual organisations. At a high level, they can be classified into one of four types depending on the way managers participate in the company’s capital:
Appreciation-based awards are annual awards of shares or other forms of LTI are the standard model in most companies. The award is granted after a period of time based on continuity of employment and in some cases corporate or individual performance.
Co-investments that facilitate the building up of shareholding and ensure that there’s a strong alignment between the interests of executives and shareholders by having skin in the game. Such an arrangement is becoming the norm in financial services where regulators expect a portion of annual bonuses to be deferred into company shares.
One-off arrangements are used in circumstances such as a turnaround situation or the management team’s retention. An example of such an award might be 5 percent of the company if certain targets are met.
Value-sharing type replicates the reward model found in the private equity industry. Such an arrangement is structured so that management shares a determined percentage of the value created for shareholders above a hurdle. Typical value-sharing percentages range between 5 and 15 percent.
The most popular classes of LTIPs from the list above are appreciation-based or hybrids of appreciation-based and co-investment. In particular, the following LTIP are observed on the global market:
Stock option plan: the conditional right to purchase a share at the “exercise/strike price”, subject to vesting conditions.
Restricted share units (RSUs): the award of shares (generally at no cost for the employee), usually subject to performance conditions, claw back provisions and selling restrictions.
Phantom share plan: where employees are granted the financial benefit of stock without having any beneficial ownership. Subject to vesting requirements, the plan is cash-settled.
Deferred cash plan: the deferral of a portion of the employee’s bonus to be paid out at a specified later date.
Choosing the right LTIP for your organisation depends on your industry and jurisdiction, hence it’s important to understand the positives and negatives of each one. Click on each arrow to expand or collapse to get the details.
– Appreciation-based awards can have massive monetary upsides for employees in the case of company stock price appreciation, particularly in startups and growing companies. – This type of award is also very flexible. You can decide when and how often your employees receive the awards by customising the vesting period (that is, the waiting period before receiving 100 percent award ownership). – Employees usually don’t need to pay for their stock options when they’re available after vesting. It means they just simply receive the awards without paying upfront.
– Employees, however, need to pay for their stock options at the pre-set price (exercise price) when they decide to purchase their options after vesting. They profit by ‘buy low, sell high’. – There’s a risk with these awards, for instance, they can potentially be worthless when their value drops below the exercise price (that is, underwater stock option).
Time-based awards (e.g. Restricted stock, RSUs)
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Pros
Cons
– Time-based awards have similar positives to appreciation-based awards, but a time-based full-value award such as RSU is guaranteed to have a positive value as no upfront payment is needed. Thus, RSUs are considered less risky than stock options. – They also have a vesting period, which means you can customise the process of making them available to employees.
– Employees can’t control the timing of taxation with RSUs as ordinary income tax is due once they vest. But with stock options, tax is only due when they decide to exercise stock options.
Performance-based awards
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Pros
Cons
– Performance-based awards ensure that employees aren’t just waiting for their vesting. To receive their bonus, the employees need to hit certain targets. It’s easy to see why this is an enticing plan for companies.
– However, if the targets aren’t set correctly and are too hard to achieve, the employees could lose morale as they don’t receive anything.
Cash-based awards
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Pros
Cons
– Cash is the most reliable form of bonus without ownership dilution issues. – It’s a popular award for private companies as they have little liquidity and their share valuation is more complicated.
– However, if possible, it’s best to avoid these as cash flow is important to your company’s growth. – Employees receiving cash may not feel as invested in the company as those receiving stock.
How to develop a good LTIP
Based on our experience, the plan design journey can be summarised in four steps.
Assess
The LTIP will heavily depend on the employer’s strategy, operating model and structure, business plan and financial projections for the next three to five years. Therefore, the rewards strategies we design are tailor made for each employer according to their need in supporting the business strategy and developing shareholder value. The employer’s sector and market practices could also create some biases towards certain designs that should be explored first.
Design
As a second step, we need to design the key principles of the LTIP, including eligibility (to whom and to what extent), funding mechanism, payout mechanism and linkage to organisational and individual performance. As a part of this step, we usually recommend LTIP design options.
The key building blocks of the plan design are presented below.
Once the future plan’s elements have been agreed by the board of directors —usually based on HR/Consultant suggestions—, it’s also important to understand the accounting and tax implications as well as the legal validation of the LTIP’s enforceability.
Proof
Once the key features of the LTIP have been set out, we usually devise a financial model to develop, refine, analyse and test the payouts of the LTIP at varying organisation performance and profit shares. The simulation exercise helps to fine-tune the design or/and consider alternatives.
The desired criteria are to be met at an acceptable level of cost and burden. At this stage, employers might also need assistance on key tools and templates for employee communication and preparing official plan documents.
Implement
Lastly, required accounting rules as well as digital solutions to evaluate relevant associated cash flows and accounting figures are implemented. It’s important to train staff on its use and how to administrate the process around awards. Such tools and processes are generally incorporated and documented.
With this, the LTIP goes alive, but the journey doesn’t end here. It will require regular monitoring and fine-tuning to see if, with time, the design meets the expectations, and if values attributable provide the relevant incentive expected.
The design of an LTIP involves several stages and requires multidisciplinary teams, including reward and compensation specialists, accountants, actuaries, lawyers and tax specialists. We want to be very honest with you: the good design generally comes at increased costs, but the increased benefits truly outweigh them.
Now you may ask yourself, “Who’s the ‘we’ behind LTIP rewards?” Actuaries have been successfully employed for decades to help manage traditional employee benefit plans. The LTIP rewards area was considered as a non-traditional field for them in the past, but it’s now becoming a new normal as they have acquired sufficient knowledge in benefits, statistics, and business projections. This allows them to develop the relevant approach in finding the balance between affordability and attractiveness. Sometimes it requires stress-testing and stochastic modelling to understand the impact on payouts and organisation performance.
Conclusion
Based on our experience, Long-Term Incentive Plans can be very effective instruments to attract and retain key managers. They’re also aligned with the modern approach to benefit offering to be based on the individual preferences of the employee.
To make the LTIP meet the initial objectives, it’s important to keep the plan up to date, introducing new features following the market situation or changes in the company’s strategy. Cross-disciplinary expertise would allow you to establish and maintain LTIP, won’t be too expensive for you and at the same time be really attractive for your employees. So, let’s give it a try!
In Europe, performance-linked plans are increasingly prevalent among executives while levels below board are paid with restricted stock and cash plans without performance conditions. I expect that modern HR strategies and new market trends will increase the popularity of the LTIPs across new sectors and grades.
Alina Vorontsova, Employee benefits Specialist, Actuarial Services, and Senior Manager at PwC Luxembourg
Keep in mind that any employee benefit should be regularly reassessed. This is especially relevant for LTIP as they are dependent on the market conditions. Introducing plan changes means that you care about your employees and they will value it.
