The Importance of LTIPS in Compensation Planning
By: Paul R. Dorf, APD, CRI
Privately-owned companies have many things going for them, plus some significant disadvantages when compared to publicly-traded firms. One major issue is the fact that whereas public companies use stock as a compensation tool, most private organizations will not use their equity to reward their executives or key employees. This has always been a significant disadvantage, which is being changed through the use of Long-Term Incentive Plans (LTIPs). A recent study indicated that while 98% of public companies provide some form of long-term plan, which are typically stock-based, 63% of private companies are now offering LTIPs, most of which are cash-based. This is an 80% increase from 2007, when only 35% offered LTIPs in private companies. The use of LTIPs is extremely important since they can easily account for at least one-third of the typical executive’s total compensation package.
There are five (5) related LTIP questions: (1) What are LTIPs? (2) How do they work? (3) What are the restrictions on them? (4) What are the benefits of LTIPs? (5) How do we go about developing one?
(1) What are LTIPs?
Long-Term Incentive Plans (LTIPs) are specifically designed incentive programs that provide a significant potential award over and above Base Salary and annual incentives/bonuses covering performance periods in excess of 1 year. LTIPs fall into two major categories: (1) multi-year plans tied to three to five years fixed or rolling performance periods; and (2) career-based plans in which the benefits accrue over the individual’s working career, to be paid when they retire.
(2) How do LTIPs work?
The design feature that is most important for private companies is that the awards are paid in cash, although equity can also be used. A major advantage of LTIPs is that companies have tremendous freedom in their design, unlike the myriad of government regulations impacting stock plans. LTIPs can be designed to meet the company’s existing systems and capabilities. The performance periods and measures typically relate to the company’s strategic plan and goals, which are established at the beginning of a performance period.
(3) What are the restrictions on LTIPs?
The only requirement in designing an LTIP is that it must comply with the requirements of IRC §409A, since the LTIP is considered Non-Qualified Deferred Compensation. Noncompliance makes the entire plan non-enforceable for all participants, in which case the funds must be given back and become fully taxable plus incurring a 20% excise tax.
(4) What are the Benefits of LTIPs?
There are a number of significant advantages inherent in LTIPs; these include:
- Retention – Regulations require that LTIPs must contain a “substantial risk of forfeiture”. The most common requirement is continued employment, therefore the LTIP acts a “golden handcuff”, which subjects the participant to loss of any accumulated LTIP awards if the participant voluntarily terminates or is fired for Cause.
- Focus of Desired Results – Clearly, the objective of any incentive plan is the successful achievement of one or more pre-set performance goals; establishing goals up front allows the participants to “focus on the target”.
- Balance of Short- and Long-Term Decision Making – A common criticism is that since participants are non-owners, they are only concerned with short-term, annual results; whereas, LTIPs allow participants to share in the long-term results, and therefore consider the consequences of both their short- and longer-term decisions.
- Sharing in the Organization’s Growth – A very important concern by many executives is that the work and investment they make in the company’s long-term success does not accrue to them. The LTIP allows them to share in the company’s growth, by tying their rewards to that success, as though they were an owner.
(5) How do we go about developing one?
Building an LTIP requires a number of items: these include commitment by the Owner/Shareholders, acceptance of a Compensation Philosophy covering the What, Who, Why, and How of compensation; either a Strategic Plan or at least an understanding of what is expected in the future, a well thought-out design, and the willingness to communicate targets and results.