Issue with Negative Returns
Should management be rewarded when absolute TSR is high but relative TSR is low (i.e., a reward to reflect gains realized by the stockholders even though the issuer’s stock price did not outperform the issuer’s peer group)? Should management be rewarded when absolute TSR is low but relative TSR is high (i.e., a reward to reflect the issuer’s stock price outperforming the issuer’s peer group even though the issuer’s stockholders lost value, in other words, it could have been worse but for the management team’s skill and efforts).
Addressing Negative Returns
There are a variety of ways to address negative returns within a relative TSR program, including:
- Elimination. Eliminate payouts when absolute TSR is negative over the measurement period (consider whether the reverse should apply – trigger a payout when absolute TSR is high but relative TSR is low).
- Cap the Opportunity. Implement a cap to the payout opportunity when absolute TSR is negative over the measurement period (consider whether the reverse should apply – same as above). When absolute TSR is negative, a cap would typically limit the payout at the target level.
- Downward Adjust the Payout. A modifier could be implemented to downward adjust the payout when absolute TSR is negative (consider whether the reverse should apply – trigger an upward adjustment to the payout when absolute TSR is positive).
It is common for compensation committees to initially denominate an executive’s award in dollars (e.g., the executive is awarded a target TSR equal to $300,000 as of the date of grant), and then convert that dollar amount into a number of shares covered by the relative TSR award. A design issue is whether the dollar amount should be converted into shares on the basis of grant date stock price or grant date “fair value” (the latter determined using a Monte Carlo simulation). If the conversion is based upon grant date “fair value,” then keep in mind that implementing any of the above design considerations will decrease the “fair value” of the award, thus having the direct result of increasing the number of shares subject to the award (i.e., using the above example, a lower fair value will require more shares to equal $300,000).