Every company wants to maximise its chances of success while holding on to its best employees. What if there was a way to do both?
A long-term incentive plan is a compensation strategy that goes beyond the typical bonus scheme by offering your senior employees incentives they really want, for meeting goals that really matter.
Read on for our full guide to long-term incentive plans and what they could look like at your organisation.
What is a long-term incentive plan (LTIP)?
A long-term incentive plan (LTIP) is a strategic compensation programme designed to reward employees for achieving long-term goals. These goals are typically related to the overall success of the business rather than individual performance. That means that LTIPS help to align employees’ interests with those of the company.
As the name suggests, LTIPs are about the marathon, not the sprint. Employees usually don’t get rewarded until the end of the ‘vesting period’, which is typically around 3–5 years. That means there’s a built-in retention benefit, because employees have to stick around to fully reap their rewards.
How do long-term incentive plans work?
The term ‘long-term incentive plan’ means different things to different organisations. For example, some consider retirement plans like the 401(k) (in the US) to be a type of LTIP. Under these schemes, employers match employee contributions to a pension, but the employee only gets full access to the sum the employer has paid if they stay with the company for a certain amount of time.
However, in this article, we’ll be talking about more typical long-term incentive plans, which tend to involve cash-based or equity-based rewards. Here are some of the key features of a long-term incentive plan that you’ll need to understand before you can implement one.
Understanding vesting periods
Because long-term incentive plans are based on high-level strategic goals, they’re usually played out over a period of 3–5 years. This waiting time is called the vesting period. For example, a vesting period of five years means that the employee won’t have full access to the incentives they’ve been offered until five years have passed.
Once that time comes, employers can choose to give their employees access to the rewards all at once, or gradually. These two methods are known as cliff vesting and graded or ratable vesting. In a graded vesting system, an employee might receive 20% of their reward each year from the third year, meaning they won’t have the full reward until the seventh year.
Performance criteria tied to company performance
The whole point of a long-term incentive plan is to align employees’ priorities with those of the company. That means that the performance criteria that the employee needs to meet should be closely tied to the company’s overarching strategy. For example, incentives might be contingent on the company achieving certain financial goals, like increasing its revenue or net profit margin by a certain percentage.
Equity-based incentives (usually)
A long-term incentive plan is supposed to directly link the employee’s financial rewards with the company’s success. So it makes sense for the reward to be something that gets more valuable as the company performs better — in other words, company stock.
Without diving too deep into the world of complex equity instruments, here are a few equity-based rewards that companies use as part of their LTIPs:
- Stock options: The right to purchase company stock at a predetermined price, after the vesting period. Employees can then sell their shares at a profit on the open market — as long as the company is performing well.
- Stock appreciation plans: A cash reward based on the increase in value of the company’s stock. This is a way to reward employees for the company’s strong financial performance without them having to navigate the stock market.
- Restricted stock units (RSUs) and performance share units (PSUs): Shares that are gifted to employees, but that they don’t actually own until a later date — either after the vesting period is over, or after achieving certain objectives.
What about cash?
Some companies choose to provide cash-based incentives instead of equity, for a few different reasons. For one thing, cash is a more stable and predictable reward for employees, because it doesn’t depend on the company’s financial performance. However, this can actually be a downside, because employees might feel less motivated to help the company achieve its goals if their rewards aren’t directly tied to its success.
Another reason to favour cash over equity is that it can avoid putting employees in sticky tax situations. Depending on the type of equity, employees sometimes end up with tax obligations even if they haven’t sold their shares — meaning that they have to pay the bill out of their own pockets.
Cash incentives are also a practical option for unlisted companies (those whose stocks aren’t traded on a stock exchange) because they don’t have easily tradable stock. It can also be an easier solution for smaller businesses with limited administrative resources, since managing equity can be complicated.
Which employees should benefit from a long-term incentive plan?
Long-term incentive plans tie employee rewards to high-level strategic objectives like financial growth. And, although all employees have a role to play in the company’s success, it’s not really fair to expect junior employees to have a direct influence on these sorts of things.
For this reason, LTIPs are typically reserved for the higher-level management of a company, such as its executives and C-Suite. Since these people have more of an impact on the company’s overall strategic direction, it makes sense to reward them when things go well.
That said, some organisations also offer long-term incentive plans to lower-level employees. Although these might look a bit different, they can be an effective way to retain employees for the long term.
According to a 2021 report from World At Work, only 11% of companies offer LTIPs to all of their employees, while 63% only offer them to executives and above. That means that offering a long-term incentive plan to lower-level employees could help you to stand out as an employer.
Benefits of long-term incentive plans
So, why do companies bother with long-term incentive plans? A lot of reasons! Here are some of the top benefits that an LTIP can bring to an organisation:
- Retention of top talent: LTIPs play a crucial role in retaining key employees over the long term by fostering a sense of ownership and commitment. Because these schemes only pay out after a certain amount of time has passed, employees are motivated to stay at the company longer to maximise their rewards.
- Aligning of interests: Under a long-term incentive plan, the incentives offered are often directly tied to the company’s share price. This gives employees a real incentive to boost the company’s financial performance since it will impact their eventual payout.
- Focus on strategic growth: LTIPs are focused on long-term, strategic goals, not quick wins. Employees are encouraged to focus on the big picture instead of getting bogged down with smaller issues.
- Competitive advantage: A long-term incentive plan can give organisations a key advantage over their competitors. As well as helping them to improve their strategic performance, they also ensure that the best employees stay for the long haul. LTIPs can also be a crucial part of an organisation’s employer brand, especially for senior roles.
Putting together an LTIP: 3 things to consider
Here are a few things to keep in mind if you’re thinking about putting together a long-term incentive plan for your organisation.
1. Alignment with core strategy
First, you need to make sure that your LTIP rewards the right things. That means it needs to be aligned with your company’s overall strategy, and encourage high-level employees to move your organisation towards its goals.
2. Tax implications
Depending on your country and the type of reward you offer, there may be tax implications for your employees when they receive equity- or cash-based incentives. It’s important to understand what these look like and to make sure your employees are clued up too. Some companies choose to offer part of the incentive in cash to cover the tax bill incurred by equity-based rewards.
3. Compliance obligations
Depending on where you’re based, there may also be certain legal or regulatory requirements that you need to be aware of. For example, there’s a specific definition of LTIPs for companies listed on the London Stock Exchange, which is outlined in the Financial Conduct Authority Handbook. Staying up to date with these requirements is essential if you don’t want to end up in legal hot water.
Summing things up
Ultimately, long-term incentive plans look different at every organisation. Many companies offer a combination of different incentives in exchange for a range of different performance measures. Everything depends on your culture, strategy and goals — and it can take a bit of time to get it right.
The fact is, setting up a long-term incentive plan is a lot of work — but the rewards in terms of retention, talent attraction, and business performance mean it can pay for itself several times over.