Long-term incentive programs (LTIPs) are widely used by organizations to align executive compensation with long-term shareholder value creation. These programs have increasingly come to include performance-based components that tie executive pay to the achievement of specific goals and objectives over an extended period. While LTIPs are effective in motivating and retaining top talent, they can also pose retention challenges if they are too risky or volatile. In this article, we explore the concept of derisking LTIPs and how it can address potential executive retention issues.

Understanding the Challenges

Traditional performance-based LTIPs are designed to reward executives based on the achievement of pre-established performance metrics, such as financial targets, shareholder returns or operational milestones. While these programs incentivize executives to drive long-term value creation, they also introduce a level of risk and uncertainty. Executives may be concerned about factors beyond their control, such as market volatility, economic downturns or industry disruptions, which could affect their ability to meet performance targets and receive full payout.

For instance, from 2016 to 2020, the energy sector witnessed a sharp downturn characterized by plummeting and erratic oil prices. Consequently, companies within this sector faced significant financial strain, marked by diminished share values, reduced revenues and negative earnings, all compounded by substantial debt burdens. As a result, most firms, especially those with heavily leveraged performance-based LTIPs, saw minimal to no payouts. While decreased payouts are foreseeable under such circumstances, the absence of any constraints on executive compensation exacerbates the risk of executive turnover. This risk could have potentially been mitigated through the adoption of derisking strategies for performance-based LTIPs.

The Concept of Derisking

Derisking LTIPs involves modifying the structure or mechanics of the program to reduce the perceived risk and volatility associated with performance-based incentives. This can be achieved through various strategies, including:

1. Balancing Vehicles: Although performance-based Long-Term Incentive (LTI) vehicles offer advantages, overreliance on them can lead to excessive emphasis on a single compensation mechanism. Incorporating time-based LTIPs alongside performance-based vehicles, without performance contingencies, helps maintain a degree of handcuff on executives irrespective of actual performance.
2. Adjusting Performance Metrics: Instead of relying solely on financial metrics, consider incorporating non-financial metrics or strategic goals that are within the executive's sphere of influence and control. This can provide a more balanced and holistic approach to performance evaluation.
3. Using Multiple Metrics: While some positive adjustments have begun to occur, it remains a prevalent practice to place all or most of the emphasis on relative total shareholder return to determine long-term performance. By employing additional metrics such as ROCE, Free cash flow, absolute TSR or other metrics, there is greater balance and less risk of no payout occurring.
4. Setting Realistic Targets: Setting performance targets that strike a balance between being ambitious yet achievable is crucial, considering factors such as the organization's historical performance, prevailing market conditions, and strategic objectives. Unrealistically high targets can demoralize executives and compromise efforts to retain talent.
5. Adding Deferral and Clawback Provisions: Incorporating deferral and clawback provisions that defer a portion of LTIP payouts and allow for recoupment in the event of underperformance or misconduct. This aligns executive interests with long-term shareholder value and promotes accountability.

Benefits of Derisking LTIPs

Derisking LTIPs offers several benefits that can help address potential executive retention issues:

1. Enhanced Stability and Predictability: By reducing the perceived risk and volatility of LTIP payouts, derisking provides executives with greater confidence and stability in their compensation packages, enhancing retention and commitment to the organization.
2. Improved Alignment with Strategic Objectives: Derisking allows organizations to align LTIPs more closely with strategic objectives and long-term value creation, focusing executives' efforts on factors within their control and driving sustainable performance.
3. Mitigated Flight Risk: Executives are less likely to seek opportunities elsewhere if they feel secure in their compensation arrangements and confident in their ability to achieve performance targets. Derisking LTIPs can help mitigate talent flight risk and retain key leadership talent.
4. Increased Shareholder Confidence: Derisking enhances transparency and accountability in executive pay practices, instilling confidence in shareholders and stakeholders that executive compensation is aligned with organizational performance and shareholder interests.

Derisking performance-based LTIPs is a proactive strategy for addressing potential executive retention challenges and ensuring the long-term success of organizations. By modifying LTIP structures to reduce risk and volatility, organizations can enhance stability, alignment and shareholder confidence while retaining top executive talent. As organizations continue to evolve their executive compensation programs, derisking LTIPs represents a valuable tool for promoting retention, engagement and sustainable performance in today's competitive business environment.

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