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Many companies are now adopting or
considering adopting long-term incentive
plans (LTIPs) where the value ultimately
realized by participants is contingent on the
achievement of specific performance goals
which often are not related to stock-price.
While these types of LTIPs provide opportunities to focus
management on results that will drive shareholder value,
they come with significant risk of unintended consequences.
Examples of unintended consequences include: choosing
measures that do not lead to long-term value enhancement,
that are not relevant to the company's current imperatives,
or that can foster counter-productive behaviors; and setting
goals and calibrating payouts that ultimately over-reward
mediocre performance, or conversely, setting the bar so high
that motivation is weak and retention damaged.
The two keys to making these types of plans work and
avoiding the unintended consequences are well-chosen
performance measures based on thorough analysis of your own
value imperatives and thoughtfully set performance goals.
Most companies have found selecting the right measures
and establishing appropriate goals easier said than done. This
is especially true over multi-year performance periods where
the potential payout size is large. The rewards for getting it
right are great – a motivated, focused management team can
make a real difference in intermediate and long-term results.
The penalties for getting it wrong are increasing in today's
environment of increased scrutiny on executive pay.
In getting there, lessons learned from those who have
been there can be helpful.
HQ: When should a company have, or not have, a
performance-based long-term incentive plan (LTIP)?
Shekhar: There are many factors to consider before
implementing a plan with separate measures.in other words,
a plan other than fair market value stock options or restricted
stock. The four main factors are:
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Philosophical: These plans can provide rewards less
dependent on the vagaries of the stock market.but they
also decouple executive compensation from stock price. |
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Motivational: These programs can help focus management on key imperatives and can be particularly effective in doing so when share prices across the economy are in decline. |
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Organizational: It allows a focus on business unit, not
just corporate, value creation. This can be an important
element in turning around a business, but it can also
create internal conflicts. |
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Conservational: It allows a company to use fewer shares
in its approved plans. This is particularly important when
share prices are depressed and granting similar value
to prior ears would require significantly more shares, all
other things being equal. |
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Any company that is considering a performance-based
long-term incentive plan needs to be sure that it has the
ability to set meaningful and sound long-term objectives and
goals, the ability to calibrate those objectives and goals in
terms of what good and bad performance is, and finally, the
ability to measure and track the goals.
Putting in plans that will stand the test of time requires
a thoughtful, analytical, and business-based approach, and
clear objectives for what you want to accomplish.
HQ: What are your thoughts on the often heard
complaint that it is just "too hard to set three-year
goals given our changing business environment" as
a reason to pass on traditional mid-year incentive or
long-term incentive plan programs?
Shekhar: This is definitely a real issue. Relative growth
measures can answer it to some degree. In other words,
tracking your total return to shareholders (TRS) versus a peer
group shows how you deliver for shareholders relative to
your competitors. Similarly, if you measure growth in revenue
versus peers, you are then tracking performance that accounts
for the market conditions that all companies face.
Beyond relative measures, the question becomes, "Are
there standards of performance we should achieve over a
multi-year period when the ups and downs of the economical
cycle will more or less play out?" The answer is often "yes"
in relatively mature industries, but it can be a "no" in nascent
or volatile industries. By standard performance, I mean that
we might see an expectation that, over a multi-year period,
the market expects to see 10 percent earnings growth from
companies in various sectors.
HQ: Can you provide examples of the types of
performance-based plans to consider?
Shekhar: Typically, we are talking about the following
kinds of plans:
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Cash performance plan – which sets objectives for a two to
four-year period and pays out at the end in cash (or stock)
based on goal achievement. A new cycle can start every
year, or for high stakes focus and protection, cycles can be
end-to-end. This is similar to an annual cash bonus, except
performance eis measured over more than one year. |
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Performance share plan or performance restricted stock
plan – which sets objectives, the achievement of which
results in the vesting of the awards and a payout in stock,
with the payout thus reflecting any change in the stock
price over the period. These types of plans are accounted
for much more reasonably under the proposed IFRS 2
(option expensing) than the old variable accounting. |
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Measurement vs Management of Long-Term Incentive Plans |
HQ: Besides picking measures, what else should
companies have on a checklist to make sure they
have thought of everything to set up it up right?
Shekhar: Well, as a start, the key items after you determine
your objectives are the performance period and structure (i.e.,
overlapping or end-to-end performance cycles), the measure or
mix of measures, how the measures (if there are more than one)
are integrated, how much leverage will be in the performance
goals and in the payouts, will there be any kind of cap on the
value received by participants, what kinds of external events or
changes you want to exclude in the evaluation process (those
not reflective of true results or, in some cases, those outside of
management control), how you want to evaluate the outcome
(i.e., relative to your company's historical performance or
maybe peer performance, or some industry standard). And, you
must always anticipate the reactions of participants: will they
be excited, motivated, and retained, and how will they (or the
Board) deal with changes in the environment (i.e., anticipate
what can go wrong, and balance financial theory purity with
practical human resources considerations).
HQ: Is it recommended that companies use the same
metrics in the short-term and long-term incentive
plans: For example, should we use EBITDA in both?
Shekhar: Generally we would want to see if a long-term
plan gives us a chance to balance out what might be carried
to extremes in an annual plan. In the case you cite as an
example, the question to focus on is "how might EBITDA over
the long-term be prone to misrepresent our performance?"
Private equity investors generally like EBITDA because
it is good indicator of the operational performance of a
business. But over the long run, a public company needs to be
concerned about what it is delivering below the operational
level. Specifically, are we returning on the capital employed?
We could chew through considerable capital while kicking up
EBITDA. Tax strategy (or lack thereof), interest expense and
other factors are missed by EBITDA. So, for a company using
EBITDA in the short-term plan may want to consider using
some kind of return measure at the net level in the LTIP.
HQ: How prevalent are long-term performance
measures that are not based on financial (hard)
results? For instance, how prevalent are long-term
measures that are based on internal measures such
as succession planning, business development
activity, etc.?
Shekhar: Typically, we see very soft and judgmental
measures such as succession planning and business
development activity as more appropriate for individual
performance measurement. For most companies, individual
performance is a factor of the annual incentive plan, not the
LTIP, which usually is much more team-oriented and driven
by company-wide results (think stock options). Softer, more
individualized measures or activity-based measures are
simply weak foundations for the size of the payouts required
to make a LTIP competitive, effective and motivational.
Generally, we believe that corporate or business unit focus
for long-term incentives is appropriate, and that measures
should be hard, but not necessarily only financial. There are
certainly situations where non-financial measures such as
operational/productivity measures in a mono-line business,
quality, or customer satisfaction merit consideration; all of
these can lead to financial results.
The risk is that, any time perceptions are involved, the
measures become trickier and less reliable. The real issue in
thinking about financial versus non-financial is to think about
what drives shareholder value, and then to focus on whether
those drivers can be reliably measured and linked to pay.
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HQ: What are the advantages and disadvantages of
having plans based on business unit performance vs.
corporate performance?
Shekhar: Most long-term plans are based on
corporate performance, as this is a good place to unify the
management team as a whole. It particularly makes sense
if the annual plan is already taking into account business unit
performance. It also makes it easier to transfer a participant
from one business unit to another during the performance
period. This is not as much of a problem in annual plans,
but is a lot more trouble if you have three-year performance
periods and overlapping cycles starting each year and you
try to pro-rate the awards for three different plans. In
addition, if one business unit has a history of poor
performance and payouts, it's hard to get good people to go to
that business unit. On the other hand, if you have
very autonomous business units that are not very
interdependent, then a business unit incentive can be a
significant performance driver.
HQ: Are there any "rules of thumb" to make this
measure selection process easier?
Shekhar: First, you should probably have at least two
measures so that the risk of getting unintended behaviors
from one measure is offset by the behavior the other measure
encourages.
Second, don't have too many measures, usually three at
the most.
Last, it often helps to think of measures in three categories
- stock price, financial, and operational. Stock price measures
provide the least line-of-sight but the greatest shareholder
alignment. Operational measures are just the opposite
– great line-of-sight but potentially indirect shareholder
alignment. Financial measures are somewhere in between.
Stock price measures include stock price goals and total
return to shareholders. Financial measures include franchise
growth (revenue, sales units, market share), profitability
(income, EPS, margins, cash), and capital returns (EVA,
return on capital, return on investment, return on equity,
return on assets). Operational measures include productivity,
transaction or unit cost, quality, customer satisfaction, and
safety.
HQ: How do you measure performance after an
unplanned event occurs, such as an unexpected
but opportunistic acquisition or divestiture, or an
accounting change, during the performance period?
Shekhar: The best way is to set up in advance within the
definition of the measure that, for performance measurement
purposes, such changes will be excluded. For most long-term
incentives, it is important to provide for neutralizing the
effects of unplanned acquisitions. One good way to do this is
to adjust the goals based on the projections contained in the
approved case for the acquisition presented to the Board –
holding management responsible for what it promised.
HQ: Are you seeing an increased interest in LTIPs
among your clients.
Shekhar: We were observing a slight up-tick in interest
prior to the economic downturn, and that trend has accelerated
significantly since the downturn. In today's environment,
introducing a performance based LTIP that is decoupled from
the share price can make a lot of sense for many organizations.
It is a good way to balance the executive LTI portfolio.
Shekhar Purohit is Hewitt's Asia Pacific Executive
Compensation and Corporate Governance practice leader and
can be reached at shekhar.purohit@hewitt.com |
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Non-traditional expatriates lead the pack
China has a more diverse and rich pool of expatriate talent
spurred largely by the availability of strong foreign talent
already residing in China, the increasing interest among the
Chinese residing abroad to return home, and a general in-flow
of foreign talent.
The study reveals that "traditional expatriate", or Western
expatriates, are mostly hired for the top executive and senior
manager levels, whereas "non-traditional" expatriates, such
as China-hired foreigners and returnees (who traditionally
were not a part of the foreign talent pool in the 1980s when
China opened up its economy to the outside world) form a
majority at the lower levels. (see Figure 1)
This diversity has led to multiple reward packages being
designed for different groups of expatriates. Managing
multiple reward packages of the "non-traditional" expatriate
group has led to several challenges, and organizations are
struggling to streamline this.
However, despite the effort, a variety of market practices
still exist for this group.
Hire globally and pay locally
The study reports that most organizations feel it is essential to
send over senior leaders from the country of origin to extend
the company's vision and safeguard its philosophy.
This is a big change in direction from the trend a few years
ago in which organizations actively started hiring locals in
place of the expensive expatriate talent.
Organizations have returned to recruiting expatriates
but are doing so by "localizing" the compensation packages
offered - reducing the benefits and perquisites component in
traditional expatriate packages, and hiring "non-traditional"
expatriates at lower pay packages.
According to the study, 42 percent of participating
organizations in 2007 reported having a formal localization
plan in place or planned to implement one in the upcoming year.
The talent market for "non-traditional" expatriates is fairly
new and is still evolving.
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Foreign organizations that have been in China for a long
time tend to design compensation and benefits packages
that are more aligned to local packages in terms of size and
program features. Foreign organizations that are fairly new
to China or in a rapid-growth phase still tend to bring over
expatriates from overseas, while those organizations that are
more established, coupled with steady business growth (and
across more progressive industries like hi-tech), tend to seek
more "non-traditional" expatriates.
Higher increase for global experience and local skills
Despite "localization" of compensation packages, the annual
salary increases awarded in China have been high. In
Hewitt's salary Increase survey 2006-07, the overall local
salary increase in China has been the third highest in Asia at
8.3 percent.
The China Expatriate Compensation and Benefits 2007
study further revealed that expatriate salary increases were
highest among "China returnees", who received an average
increase of 7.3 percent (see Figure 2). "China returnees"
often have strong technical skills, especially in research and
development, which, when coupled with their language and
cultural skills, make them highly valuable.
It is interesting to note that in the "China returnee" group,
employees at the senior professional, supervisor and director
levels received the highest salary increase. This is due to the
shortage of leadership and technical skills in China.
Reaping the benefits.or not?
According to the study, fewer organizations are offering
costly expatriate benefits packages as in previous years.
Traditionally, organizations in China used to award three
types of premiums to expatriates: foreign-service premiums,
hardship premiums, and cost-of-living adjustments (COLA).
COLA packages can vary, but they are offered as a fixed
percentage of base pay. COLA is the most common expatriate
premium.
In 2007, of those companies that offered premiums,
traditional expatriates hired with a global package were
offered 15.5 percent of base pay as COLA, 12.6 percent of
base pay as hardship, and 13.6 percent of base pay as a
foreign-service premium.
Expatriates on regional packages were offered 13.4
percent of base pay as COLA, 10.5 percent of base pay as
hardship and 9.0 percent of base pay as a foreign-service
premium.
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However, expatriates are not necessarily offered all three
of these amounts, as companies offered a nearly 24 percent
average aggregate premium to global packages and nearly
23.7 percent to regional packages.
Of the various types of premiums, hardship premiums
are disappearing the fastest, followed by the foreign-service
premium. China's explosive growth of suburban villas and
other high-end real estate is one reason why China can no
longer be considered a hardship posting. Adverse pollution
levels and cultural differences, however, can still justify a
need for this premium in some cases. COLAS have been
consistently maintained by organizations.
Although the prevalence of premiums has experienced little
change in global and regional packages, the value of these
premiums has reported a dip. However, China-hired foreigners
and China returnees experienced a drop in both the prevalence
and value of the total premiums offered. (see Figure 3)
Housing continues to be one of the largest components
in expatriate pay. Consistent with findings from previous
years, the majority of organizations still provide housing
assistance to expatriates. |
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However, the budget varies quite significantly. Expatriates
who enjoy global packages have the highest housing budget,
ranging from US$4,000 to $7,000 (median) per month, while
the housing budget for China-hired foreigners and China
returnees ranges from US$1,000 to $3,000 (median) per
month.
During the past few years, there has been no significant
change in housing assistance practices. However, housing
assistance is most likely to be reduced significantly if
"localization" of packages continues to become more
widespread.
Organizations will, at some point, be inclined to do
away with direct housing reimbursement and offer a fixed
housing allowance, which may well be lower than the housing
reimbursement currently offered.
Tax equalization is the most popular tax assistance
practice for expatriates who are hired by regional or global
headquarters. However, organizations do not provide tax
assistance for China-hired foreigners and China returnees.
Most organizations expect them to bear the individual income
tax themselves. (see Figure 4)
Education assistance is a very popular benefit for
expatriates assigned by global/corporate or regional/ Asia-
Pacific headquarters. This factor alone can sometimes be a
deal breaker, especially if the expatriate has a large family.
Private international education in China does not come
cheap, and can sometimes equal the tuition fees of U.S.
universities. Options for education for foreign children
are limited. Also, in most cases, the prevailing medium of
instruction is Mandarin Chinese. As a result, the majority of
organizations provide private education assistance to help
cover the tuition fees of international schools for expatriate
children across all expatriate categories. The policies are
flexible enough to accommodate different kinds of school fees,
especially tuition and transportation, as long as the costs are
within a reasonable amount. |
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While benefits such as educational assistance continue
to be offered to mostly all assigned expatriates, more than
half of the organizations surveyed said they do not offer this
to all China-hired foreigners. Only top executives within this
group are eligible to receive this. For PRC returnees, most
organizations do not include education assistance as a critical
part of the benefits package because their children are more
likely to adapt to the local education system.
Some of the benefits that are being phased out include
home leave and Rest and Relaxation (R&R) leave assistance.
Fully reimbursed R&R trips to Phuket or Bali no longer form a
part of the benefits package. R&R leave is a thing of the past,
and special home leave is less common, too; most companies
offer only standard annual leave. |
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A world of opportunity has opened up for talent in China.
Although immediate shortages of talent pose a threat,
organizations are making continuous changes in their people
processes to more effectively attract, engage, and retain
talent.
The projected economic growth is going to make
overcoming people issues even more challenging in the future
if the right steps are not immediately taken by organizations.
The changing face of expatriate pay is a testimony to
China's efforts in realigning current talent strategies. |
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Lindsay (Oliver) Klump
is a senior consultant in
Hewitt's compensation
and benefits practice in
Shanghai. To learn more
about Hewitt's upcoming
2008 expatriate, China
Hire and Returnee
Compensation and
Benefits study that was
released in November,
please contact Lindsay.
oliver@hewitt.com or
+86 21 2306 6916. |
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Hewitt Quarterly Asia Pacific
is made possible through the combined skills and experience of Hewitt consultants from across the Asia-Pacific region.
For further information please contact:
Hewitt Associates
2601-05 Shell Tower
Times Square
Causeway Bay
Hong Kong
Tel: (852) 2877-8600
Fax: (852) 2877-2701
editor-hqap@hewitt.com |
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