LTIPs comprise at least a share options programme. When share options are awarded, they give executives the right to buy a certain number of stocks at spot market prices within a certain time period. Performance hurdles are normally accounting hurdles (e.g., earnings-per-share growth rate) or market-based performance hurdles (such as total stock returns of a relative group of comparable firms). When those performance hurdles are met, the options or rights under the LTIP become exercisable and turn into a fully paid ordinary shares that are either purchased from the market or newly issued by the company. The vesting period (share-based instruments becoming exercisable) for a LTIP ranges from two to five years.
2.8.1
LTIPs peer section
LTIP payments include performance shares, options or rights are not vested (exercised) until some performance hurdles, such as earnings per share growth rate or Total Stock Return (TSR) of a relevant group of comparable firms are met. There are two schools of thought related to evaluating
‘comparable firms’ used to compare the TSR in LTIPs. Cadman and Carter (2013) and Morgenson (2006) suggest that firms select the peer group in an opportunistic way. Conversely, Holmstrom and Kaplan (2003) argue that peer selection is efficient, because ‘benchmarking’ is from a similar industry, size and return covariance. Besides the opportunistic view, there are some controversies related to LTIPs. Porac, Wade, and Pollock (1999) point out that LTIPs are used ex post in the US in designing executive compensation packages rather than ex ante asin the UK. In addition, the boards carefully select peer groups to their advantage and even include poor-performing companies from other industries when the firm performs poorly.
2.8.2
LTIPs in the US
Murphy (1999) points out that the empirical relationship between the pay of top-level executives and firm performance is small and there is a decoupling between incentive plans and firm
performance. On the other hand, Lambert, Larcker, and Weigelt (1993) oppose Murphy’s view and argue that firm size should be relative to the structure of the executive compensation packages rather than the size of the compensation. Lambert et al. (1993) show that LTIPs have incentive effects and play a significant role in the structure of the executive compensation contracts (Gerhart & Milkovich, 1990).
Brockie Leonard and Mishra (1996) examined the incentive effect of LTIPs by comparing a sample of 175 firms that adopted LTIPs with 175 control firms for the period from 1971 to 1980. The authors find that LTIPs did not provide incentives for firms to outperform the control firms (Brockie Leonard & Mishra, 1996). Westphal and Zajac (1994) studied the 669 largest US industrial and service companies from 1972 to 1990 and find that CEO power and firm poor performance are the main causes of the failure in using LTIPs. Although most firms adopted LTIPs, some do not actually use LTIPs because of the political actions by the influential CEOs and poor prior performance (Westphal & Zajac, 1994).
2.8.3
LTIPs in the UK
The use of LTIPs to motivate managers in the UK started in 1995 (Buck et al., 2001). In 1995, the Greenbury Report recommended that the UK companies should adopt performance related long- term incentive plans for senior executives, preferring them to traditional share options (Buck et al., 2001). The report pointed out that share options had a number of shortcomings: they sometimes led to windfall gains simply as a result of general movements in share prices and did not encourage directors to build up significant shareholdings in their employing companies (Buck et al., 2001). Pass et al. (2000) conducted a survey of 150 UK companies from 1994 to 1998 and show that a substantial number of companies adopted LTIPS (Pass, Robinson, & Ward, 2000). In 2009, LTIPs comprised
around 38% of the total earnings of executives in the FTSE 100 and 33% in the FTSE mid-250 (Pepper, Gore, & Crossman, 2013).
Buck, Bruce, Main, and Udueni (2003) studied UK non-financial firms that used LTIPs during 1997-98 and suggest that LTIPs are positively associated with total executive pay, but negatively associated with pay-performance sensitivity. Similarly, Pepper et al. (2013) studied FTSE 350 companies and suggest that LTIPs are not an effective nor efficient way of motivating CEOs, considering risk, time discounting, uncertainty and fairness.
2.8.4
Valuing LTIPs
Conyon and Murphy (2000) and Stathopoulos et al. (2004) value LTIP performance share grants at the face value of the shares on the grant date and deduct a certain percentage because the award of the shares is contingent on the executive’s attainment of performance criteria. Guy (1999), Conyon, Peck, and Sadler (2001), Conyon and Murphy (2000) and Stathopoulos et al. (2004) value LTIP share options using the modified BS model to incorporate the impact of dividend payments. However, there are criticisms of the BS model. First, share options in LTIPs are not tradable within a short time and the vesting period often lasts three to six years (McKnight & Tomkins, 1999). Huddart (1994), Murphy (1999) and Cuny and Jorion (1995) argue that the best exercise policy is different from the BS assumption because of CEOs’ risk aversion. LTIP share options are not tradable and are usually forfeited if the director leaves the company. In addition, risk-averse CEOs, who are prohibited from hedging (i.e., short-selling) their firm’s shares and have their human capital tied up in the company, are less able than the ordinary investors to diversify away the risk of the options. In addition, Conyon and Murphy (2000) point out that the value of options to both the company and its executives depends on the performance criteria that determine whether the share options will be vested. Empirically adjusting the BS model to accommodate the above limitations is not easy (Guay, 1999). For one reason, there is no clear method of valuing share options from the CEO’s perspective, as opposed to the firm's perspective. Second, it is difficult to estimate the remaining time-to-maturity of options until the options are vested (Guay, 1999).
2.8.5
Event study of LTIPs
Gaver et al. (1992) examined the share market reaction for a sample of 209 LTIPs that occurred between 1971 and 1980. The authors calculated the abnormal daily returns from day -170 to day -21, and find no significant market reaction to the adoption of LTIPs (Gaver, Gaver and Battistel, 1992). Conversely, Mishra and Nielsen (2000) and Westphal and Zajac (1998) present significant positive excess returns around the announcement of LTIP adoption for the adopting companies and report a
positive association between excess returns around the announcement of LTIP adoption and changes in some accounting based performance measures.
2.8.6
Summary of LTIPs
The findings on LTIPs are mixed. There has been debate on the use of LTIPs to align CEO interests with shareholder interests. Smith and Stulz (1985), Yermack (1997) and Arora and Alam (2005) suggest that LTIPs increase the relationship between CEOs’ wealth and firm performance, thus providing more incentives for the CEOs to maximize the shareholders’ wealth. However, Bertrand and Mullainathan (2001) and Bebchuk and Fried (2004) suggest that LTIPs have less to do with interest alignment and more to do with enriching CEOs.