Restricted stock and hybrid incentives

In the context of the Big Tent Discussion around the competitiveness of UK executive remuneration, some companies have begun to seek closer alignment with US remuneration structure through ‘hybrid’ incentive plans, which incorporate the use of both performance and restricted shares. Around 13% of the FTSE350 operate time-vesting Restricted Stock Plans (‘RSPs’) for their executive directors and a number also operate these alongside a Performance Share Plan (‘PSPs’). Below, we answer common questions in relation to the design of such plans.

Why do companies use RSPs?

RSPs are adopted primarily to address a concern that a performance-based LTIP would not be a robust incentive vehicle for reasons such as (i) performance being sensitive to significant uncontrollable factors, or (ii) setting explicit long-term performance targets constraining flexible decision-making.

Uncontrollable factors may include (i) commodity prices, (ii) FX rates, (iii) actions of a significant customer, (iv) geopolitical events, (v) regulatory changes, and/or (vi) force majeure (e.g. weather).

Flexible decision-making (i.e. the ability to change strategic direction rapidly) may be essential if there is significant disruption in the market and the route to market success is uncertain, or a company is undergoing a material reorganisation (through M&A activity, for example).

Furthermore, companies with significant operations in overseas territories may also choose to adopt RSPs to help better reflect local pay norms in relevant geographies.

Can an RSP be operated alongside a PSP?

Most RSPs are used as the only equity-based long-term incentive, as the rationale for their adoption is typically based on issues with setting long-term targets. However, companies looking to achieve closer alignment to a US package structure have sought to exchange part of the PSP opportunity for an annual award of Restricted Shares. We have begun to observe tentative support for companies proposing this hybrid structure in the UK.

How much can be granted under an RSP?

Investors expect the grant value of an RSP to be no more than 50% of the maximum grant value available under the performance-based LTIP it replaces, to recognise the move to a more certain vesting outcome.

If a hybrid RSP/PSP structure is used, investors generally expect the RSP component to be no more than 25% of the overall long-term incentive opportunity.

Should the RSP grant be linked to performance?

The majority of RSPs are based on fixed value awards (e.g. 50% of salary), with no variation in the grant value. However, some plans vary the grant size according to performance over the period prior to grant, based often on a scorecard of measures capturing performance over 1 year, but often also up to 3 years.

Does vesting need to be linked to an underpin?

RSPs granted to executive directors are more likely to be supported by shareholders if vesting is subject also to an underpin. Market practice varies regarding the nature of such underpins, but the majority of companies with RSPs use a discretionary assessment of ‘corporate health’ by the Remuneration Committee; others use an explicit underpin based often around balance sheet health or minimum acceptable returns (e.g. ROCE>WACC).

How long should the vesting period be?

Investors generally expect the release of RSP awards to be over a minimum of 5 years; most RSPs vest at the end of 3 years but are then subject to a 2-year post vesting holding period (i.e. in line with typical LTIP practice).

What does shareholder consultation look like?

The majority of major institutional investors now accept that RSPs may have a place in an executive director incentive package but require that the rationale for their adoption is clear and defensible. However, thorough shareholder consultation is crucial to garner support for hybrid incentive structures in the UK. In Ellason’s experience, a sensible approach is to conduct an initial consultation with major investors to refine the Committee’s proposals, before taking this to the wider shareholder register.

Ellason recommends starting early, with a shareholder consultation over a period of at least six months, with the Remuneration Committee Chair (and often also the Board Chair) meeting with major investors multiple times in the development of the final proposals. To maximise the level of support for the proposals, we also recommend extending the outreach as far down the register as possible to dilute the impact of adverse voting recommendations from proxy advisors.