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Explicit relative performance evaluation in performance-vested equity grants

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Abstract

Using data from FTSE 350 firms, we examine factors influencing explicit relative performance evaluation (RPE) conditions in performance-vested equity grants. We provide exploratory evidence on whether the use or characteristics of RPE are associated with efforts to improve incentives by removing common risk, other economic factors discussed in the RPE literature, or external pressure to implement RPE. We find that many of these economic factors, including common risk reduction, are more closely related to specific relative performance conditions than to the firm-level decision to use RPE in some or all of their equity grants. We also find that greater external monitoring by institutional investors or others is associated with plans with tougher overall RPE conditions. The relative performance conditions are binding in most RPE plans, with nearly two-thirds of the grants vesting only partially or not vesting at all. Further, we find evidence that vesting percentages vary in RPE and non-RPE plans.

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Notes

  1. Matsumura and Shin (2006), for example, study a non-executive RPE incentive plan in which bonus payouts increase the greater the organization’s ranking versus its peer group. Hemmer (2004) adds that the common hypothesis that RPE is more beneficial when common shocks are greater need not hold in analytical models when the models’ functional form is changed.

  2. Unlike the United States, where until recently the accounting treatment of performance-vested options and traditional time-vested options differed (with the value of performance-vested options required to be expensed), the accounting treatment of the two types of options does not differ in the U.K. See Bettis et al. (2008) and Gerakos et al. (2007) for studies examining performance-vested equity grant adoption in the U.S.

  3. Common re-testing provisions allow performance to be reevaluated over cumulative 3-year periods that incorporate the fourth or fifth years following the grant. Some firms increase the performance targets when re-testing is employed.

  4. See, for example, Antle and Smith (1986), Barro and Barro (1990), Gibbons and Murphy (1990), and Janakiraman et al. (1992).

  5. In contrast, Johnson and Tian’s (2000) model indicates that performance-vested options also provide stronger incentives to increase share price, but the authors do not examine the use of relative versus absolute vesting conditions.

  6. We use data from 2002 annual reports because this is the first year U.K. companies were required to disclose this information, and because it allows enough time for comparisons of the firms’ performance versus their chosen RPE comparator groups in the years following the equity grant. Most of the plans incorporate a 3-year vesting schedule, giving us an interval long enough to obtain actual payout data. We do not examine multiple adjacent years because nearly all compensation plan characteristics (including the use of RPE and the specific comparator groups) are approved (and remain relatively consistent) for multiple years, and two of the three rolling years commonly used for testing the performance conditions overlap when determining the vesting percentages in adjacent years. Consequently, observations in adjacent years are unlikely to be independent. Annual reports for a handful of companies could not be located. These companies are excluded from the sample.

  7. The Directors’ Remuneration Report Regulations 2002 (DRRR) formally require each U.K. firm to include a detailed remuneration report in the annual report and accounts for all fiscal years ending on or after December 31, 2002. Since some of the companies in our sample do not have December 31 fiscal year ends, their 2002 reports fell under the 1998 Combined Code, which contained similar compensation disclosure requirements as the DRRR. While compliance with the Combined Code was not mandatory, it was appended to the listing rules for the London Stock Exchange such that any instance of noncompliance was required to be justified to shareholders. Consequently, differences in disclosure requirements should not have a significant effect on our data.

  8. One firm had an undisclosed contingency. We assume that this contingency is on vesting since vesting conditions dominate our sample. It may also be the case that the firms in our sample use RPE for other elements of pay. For a sample of 25 firms, we examined the remuneration committee report for evidence on whether bonus payments are based on RPE. Four firms explicitly stated that bonuses are not based on RPE, while the remaining 21 firms provided no indication that explicit RPE is used in determining bonuses.

  9. We find no significant mean or median differences in our independent variables between firms disclosing their specific comparator groups and those not disclosing this information. We also find no significant differences in firms disclosing or not disclosing their performance conditions.

  10. The most common EPS target is a specified EPS growth rate above the U.K. retail inflation rate. The mean (median) EPS growth rate for initial vesting in our non-RPE sample is 3.5% (3%) above the inflation rate, with a mean (median) growth rate of 4.7% (3%) for full vesting. The EPS target for minimum vesting is negatively correlated with the use of a vesting hurdle (r = −.20, p = 0.01), suggesting that firms using hurdles set easier targets. See Choudhary and Orzag (2003, 2005) for studies examining the determinants of non-RPE vesting targets in U.K. executive compensation plans.

  11. The most commonly used pre-defined indices in U.K. RPE plans are the FTSE 350, size-adjusted FTSE indices (FTSE 100 or FTSE 250), and FTSE industry indices. Correlations between the FTSE 350 returns and the FTSE size-adjusted indices exceed 0.90 and produce nearly identical results to those using the FTSE 350 index. Consequently, we do not report results using the size-adjusted indices to simplify presentation.

  12. An obvious limitation of using these two measures is the implicit assumption that pre-defined indices are the appropriate peer groups. We address this issue later in the paper by examining the determinants of whether a firm chooses a pre-defined index or a self-selected set of firms as its peer group.

  13. Garvey and Milbourn (2003) and Rajgopal et al. (2006) use CEO equity holdings and CEO age to proxy for the executive’s ability to hedge market risk. We include a proxy for the wealth of the entire executive team because nearly all of the equity plans in our sample cover the whole executive team, not just the CEO. For similar reasons, we do not include the CEO’s age as a proxy for hedging ability. Clearly, firm-specific wealth is an imperfect proxy for total wealth and may also reflect an undiversified portfolio (which may lead to greater need for RPE to protect undiversified executives from firm-specific risk) and the need for incentives to improve firm performance (which may already be high given extensive executive stock holdings, reducing the need for RPE). Results using LN_WLTH should be interpreted accordingly.

  14. Although we use industry-adjusted returns to proxy for the need for RPE incentives, Rajgopal et al. (2006) use this measure to proxy for managerial quality, which they argue should be inversely related to the need for RPE.

  15. Although we include PAYATRISK% as an independent variable, suggesting that greater equity-based compensation influences the decision to base vesting on RPE, it may also be the case that the use of RPE leads firms to use more equity compensation because vesting may be more difficult. We cannot rule out this alternative explanation.

  16. For example, the BBA Group’s 2002 Remuneration Committee report notes that:

    The Committee selected EPS as the measure for the [non-RPE] share option scheme as it is accepted as being a good indicator of long-term corporate performance. TSR is not used as a performance condition for the share option scheme, as it is with the [RPE-based] Long-Term Incentive Plan, as the Committee is of the view that options have an inherent share price performance measure, being the condition that before any reward is given the share price must increase.

  17. One potential explanation for the higher equity pay is that the RPE plans in our sample impose more compensation risk on CEOs than the non-RPE plans and therefore require higher expected pay. We provide evidence on this conjecture later in the study by examining actual vesting percentages in RPE and non-RPE plans.

  18. We do not include MULTI in this model because only firms with multiple plans can have RPE conditions on only some of their grants.

  19. These results are robust to including the components of COMMONRISK (i.e., the correlation between firm and peer group returns and the standard deviation in firm returns) in the model, either individually or together with COMMONRISK. Our index-based COMMONRISK measures may be inappropriate for firms that choose their own comparator groups. Consequently, we repeated the analyses using only the subset of firms that use a pre-defined index as their comparator. We find greater COMMONRISK positively associated with the use of Some RPE relative to the other two groups but no significant association between No RPE and All RPE.

  20. We also estimated all of our models using separate CORR_RET and stock return volatility variables, together with the COMMONRISK variables. The signs and significance levels on COMMONRISK are similar to those reported in the tables, and the coefficients on CORR_RET and stock volatility are generally insignificant (even when included without COMMONRISK), suggesting that the reported results are not driven by the correlation between the firm’s returns and those of their peers or by the firm’s stock return volatility alone.

  21. We also estimated the RPE_MIN model after excluding plans with payout hurdles since these two choices have a significant correlation. Our conclusions remain unchanged in this subsample.

  22. An alternative theory is that firms opportunistically choose self-selected peer groups they expect to outperform in order to increase vesting probabilities. To provide some evidence on this theory, we examine differences between firm stock returns in the 3 years ending fiscal 2001 and those of their chosen comparator groups over the same period. We find no significant differences in mean or median comparative returns between firms using pre-defined indices and those choosing their own comparator groups. In addition, we replicate Lewellen et al.’s (1996) analysis of whether the prior market returns of self-selected comparator firms were lower than the returns to alternative pre-defined indices that the firm could have chosen (in our case the FTSE 350 or the firms’ FTSE industry). Lewellen et al. (1996) argue that lower returns in self-selected comparator groups (relative to alternative pre-defined indices) are indicative of the biased choice of peers that the firm expects to outperform. The evidence does not support this conjecture in our sample. Mean and median tests using either FTSE 350 or FTSE industry returns indicate that the prior returns of self-selected comparator groups exceeded those of the alternative pre-defined comparator groups. Together with our other results, this evidence suggests that the use of a self-selected comparator group is not related to opportunism.

  23. To provide some exploratory evidence on their simultaneous use, we estimated the models after including the other plan characteristics as additional independent variables. RPE_MIN has a significantly negative association with HURDLE, and the other results for the other independent variables do not change. When SPREAD is the dependent variable, RPE_MIN is significantly positive and, with the exception of dividends becoming insignificant using market returns, results remain consistent for the other predictors. The primary differences occur when RPE_MIN is the dependent variable. The coefficient on SPREAD is significantly positive, but COMMONRISK is no longer significant. In contrast, LTIP and PAYATRISK%, which were previously insignificant, become significantly negative. Overall, these results suggest that the vesting characteristics are not independent but that (subject to our inability to identify instruments for these choices to estimate simultaneous equations) the majority of results for the independent variables in our study are robust to their joint use.

  24. We do not include the choice between an index or a self-selected comparator group in these classifications because the earlier results, as well as RPE theories, suggest that this choice does not necessarily represent an easier or tougher performance condition.

  25. Implementation dates or financial data were not available for approximately one-third of the sample. In these cases, we used the 2002 data in the analyses. Excluding these observations yields similar but weaker results due to lower statistical power.

  26. The actual equity grant vesting percentage was disclosed for 69.5% of all plans (RPE and non-RPE), and we were able to determine the payout for an additional 14.4% of the plans using publicly available data. If firms had 3-year performance testing periods but allowed re-testing of the performance conditions over more periods if they were not met after three periods, we determine the extent to which the grants vested in the initial 3-year period. Some of the plans (12.0%) were operated by firms that ceased being publicly traded during the 3-year performance period (due to mergers or going private). Finally, vesting percentages for 4.1% of the plans could not be determined because the performance period was longer than 3 years, or information on the comparator group, pre-defined index, or performance measure was not publicly available.

  27. The higher vesting percentages in non-RPE plans may be due to the generally strong economic conditions in the U.K. between 2002 and 2005. The strong conditions may have made it easier to reach the EPS targets in most non-RPE plans but would not influence the ability to reach RPE targets if they also improved the financial performance of the chosen peer group.

  28. Estimating the models using indicators for plan “toughness” in place of the individual plan characteristics yielded similar results, with none of the toughness indicators statistically significant.

  29. In multivariate tests using both RPE and non-RPE plans, we find no statistical differences in vesting percentages in the two groups, with MULTI again negative and significant. We also examined vesting percentages in the subsample of non-RPE plans that use EPS targets. Not surprisingly, vesting percentages are significantly lower when annual EPS targets are higher. However, vesting hurdles, PAYATRISK%, and firm size are not significantly associated with vesting in these plans.

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Acknowledgments

We thank Fabrizio Ferri (our discussant), Stan Baiman, Gavin Cassar, Dave Larcker, seminar participants at the 2008 RAST Conference, University of Pennsylvania and Stanford University, and two anonymous reviewers for their comments. The financial support from the University of Pennsylvania Wharton School, Boston College Carroll School of Management, University of Chicago Booth School of Business, the Deloitte Foundation, and Ernst & Young is gratefully acknowledged.

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Authors and Affiliations

  1. Carroll School of Management, Boston College, Chestnut Hill, MA, 02467, USA

    Mary Ellen Carter

  2. The Wharton School, University of Pennsylvania, Philadelphia, PA, 19104, USA

    Christopher D. Ittner

  3. Booth School of Business, University of Chicago, Chicago, IL, 60637, USA

    Sarah L. C. Zechman

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  1. Mary Ellen Carter
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  2. Christopher D. Ittner
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  3. Sarah L. C. Zechman
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Correspondence to Christopher D. Ittner.

Appendix: Variable definitions

Appendix: Variable definitions

1.1 Performance measures

TSR:

Total shareholder return

EPS:

Earnings per share

Other:

Non-TSR and non-EPS performance metrics

1.2 Dependent variables

FIRM_RPE:

0 if the firm has only non-RPE plans, 1 if the firm has more than one performance plan and not all are RPE plans, and 2 if the firm has only RPE plans

HURDLE:

1 if the RPE component of the plan pays off relative to a hurdle and 0 if the payoff is over a range of performance

RPE_MIN:

The minimum RPE payout percentile (1% being the toughest and 100% paying out at any performance threshold)

SPREAD:

Payout range defined as the maximum percentile–minimum RPE percentile for full vesting

INDEX:

1 if the plan utilizes a pre-defined index as a comparator group, 0 if the firm hand-selects a group

%VESTING:

The actual payout percentage of the long-term compensation plan ranging from 0 to 100%

1.3 Other variables

STD_RET:

Standard deviation of monthly stock returns for the 24 months preceding the fiscal year end in 2001, rescaled as the difference from the sample minimum divided by the difference between the sample maximum and minimum so the resulting value ranges between 0 and 1

CORR_RET (Market):

Absolute value of coefficient from a regression of firm returns on the returns of the FTSE 350 index over the prior 4 years, rescaled as the difference from the sample minimum divided by the difference between the sample maximum and minimum so the resulting value ranges between 0 and 1

CORR_RET (Industry):

Absolute value of coefficient from a regression of firm returns on the returns of the respective FTSE industry index over the prior 4 years, rescaled as the difference from the sample minimum divided by the difference between the sample maximum and minimum so the resulting value ranges between 0 and 1

COMMONRISK:

Interaction of STD_RET and CORR_RET (market or industry as appropriate)

CONCENT:

A construct representing the concentration of the firm to its industry based equally weighted standard values of the industry’s Herfindahl index and the firm’s share of the industry sales

LN_WLTH:

Log of value of directors’ equity holdings, calculated as the number of shares held multiplied by the price, at the end of 2001

BOOKMKT:

Book value of equity/market value of equity at the end of 2001

DIVYLD:

Average dividend yield over the prior 3 years

ADJ_RET (Market):

Cumulative returns over prior 4 years less cumulative 4 year returns on the FTSE 350

ADJ_RET (Industry):

Cumulative returns over prior 4 years less cumulative 4 year returns on the respective FTSE industry index

EXT_MNTR:

A construct representing external monitoring based on the percent of shares held by institutions, percent of board seats held by outside directors, and whether the board chair is an outside director

LN_SALES:

Log of total sales (in thousands)

MULTI:

1 if the firm has more than one equity-based performance plan, 0 otherwise

PAYATRISK%:

The value of long-term equity grants divided by the value of total cash compensation for the CEO

LTIP:

1 if the plan is a long-term incentive plan, 0 otherwise

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Carter, M.E., Ittner, C.D. & Zechman, S.L.C. Explicit relative performance evaluation in performance-vested equity grants. Rev Account Stud 14, 269–306 (2009). https://doi.org/10.1007/s11142-009-9085-8

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