According to a 2017 report from Equilar, an executive compensation data firm, “relative total shareholder return” continues to be the most common performance measure used in long-term incentive plans for CEOs among S&P 500 companies. (See this PubCo post.) But this article in contends that, with a metric of rTSR, the “pay for performance linkage” is “weak”; rather than rewarding long-term performance, use of rTSR is tantamount to giving “management a lottery ticket.”

Stock performance for shareholders is often measured by TSR, which “combines price appreciation and dividends calculated as a return percentage on the beginning share price.” So it stands to reason that, in establishing performance metrics for executive compensation that align with shareholder interests, many companies used TSR as a measure, at least initially. However, concerns were raised that this metric often did not adequately reflect individual or company performance, but rather frequently reflected market or industry trends as a whole, which were typically outside the control of the executive. To address that issue, comp consultants developed rTSR, which “indicates the degree to which the TSR of a company has or has not outperformed an index or a group of companies. In practice, what typically happens is the TSR of a company over a three-year period is ranked against either a group of peers or the companies in an index. The company’s relative TSR is then described as a percentile rank, say 65th percentile if the company is ranked 65th from the bottom of, say, a 100 companies.” Typically, a number of shares vest or are forfeited depending on the company’s ranking.

To evaluate the effectiveness of rTSR as a performance metric, the author of the article (the CEO of advisory firm Fortuna Advisors LLC) conducted two studies of Russell 1000 companies that were public for the full period of each study. For the first study, the firm examined the relationship between the average of a series of ten three-year rTSR performance tests and cumulative rTSR for 701 Russell 1000 companies over the period from December 2004 through the end of 2016. The study calculated average percentile ranks and average payouts over the ten cycles, which were then compared to the hypothetical vesting percentage based on cumulative performance. According to the article, “[a]cross the whole group of 701 companies, management teams would have either been overpaid or underpaid, on average, by 45% of their target…award. Those are pretty big deviations.”

But it wasn’t just the comparison to cumulative periods that reflected distortions: “even within a single cycle the payouts can vary considerably depending on the start and end dates.” In the second study, the firm looked at 850 Russell 1000 companies for the three-year period from the start of 2013 through the end of 2016, calculating the rTSR percentile ranking for each company during 53 three-year cycles ending as of each week in 2016. The study showed that for “one out of every fifteen companies, the reward varied all the way from 0% to 200% depending on which week of the year the performance test was measured. And the average difference from the minimum to the maximum vesting was 86%.” That comparison was performed against the entire index. But “if the test was done by just comparing TSR against the company’s sector[, the] results get worse. At one in thirteen companies, the reward varied from 0% to 200% depending on which week the performance test was measured. The average difference from minimum to maximum vesting was 88%, which is slightly higher than when measured against the whole index.”

Although the concept of rTSR sounds logical in principle, the author asserts,

“in practice it doesn’t work very well. Over an extended period, the average vesting in the three-year relative TSR cycles doesn’t relate well to the cumulative TSR over the full period. Some managements get paid a lot less than their cumulative TSR should justify and some a lot more. Even within a given year, the relative TSR results vary considerably based on which week we determine the performance test. This seems to invalidate the notion that the relative TSR is a useful tool for aligning pay and performance. And it doesn’t get any better if we measure relative TSR against each company’s sector rather than the whole index. Indeed. it gets worse.”

Instead of using rTSR as a performance metric, the author advocates a different approach based on operating performance measures such as “revenue growth and either improvement in return on capital, improvement in operating profit margin, or improvement in residual cash earnings (a cash flow based measure of economic profit).” These measures can be designed to provide award vesting that “relates well to TSR among peer companies and, at the same time, gives management a definitive path on how to drive long-term TSR success through tangible operational goals. Such a fact-based approach to linking TSR to the operations of a business provides a consistent link between results and reward which will be less fickle and volatile. Such an approach is far superior to relative TSR, which seems sound in theory but doesn’t work well in the real world.”

Companies may well have been taking note of these issues. That may explain why, after years of increasing prevalence among companies in the S&P 500, use of rTSR has flattened out as a performance metric for CEO pay. At the same time, use of return on capital and earnings per share as performance metrics each “saw a bump,” according to the Equilar report cited above.


The author of this article is not alone in criticizing the use of TSR as a performance metric and advocating other measures instead. For example, a study conducted in 2015 showed no real correlation between use of TSR and improvements in company performance. (See this PubCo post.) Similarly, a report by Organizational Capital Partners and the Investor Responsibility Research Center Institute, which studied companies in the S&P 1500, asserted that the “best measure of economic value creation is economic profit, i.e. net operating profit minus a capital charge for invested capital. Moreover, the report maintained, tying compensation to share price appreciation through TSR is deeply misguided because factors that affect share price, such as “fund flows, central bank policies, macroeconomics, geo-political risks and regulatory changes are all beyond the control of executive management.” Other compensation consultants have observed that, although TSR might be a useful tool for some purposes, “it is not particularly helpful in short-term compensation decisions. Many firms, for instance, use three-year-TSR performance, but it’s common for three-year TSR to often be a lagging or leading indicator of future performance. That can lead to low pay before strong performance and elevated pay before business heads south.” (See this PubCo post.) Other compensation consultants, relying on behavioral economics, have contended that CEOs should be paid with more short-term incentives that have been designed in a way to improve long-term performance. (See this PubCo post.) Others have taken the opposite approach altogether, contending that no type of performance-based pay for CEOs makes sense because the types of work performed by CEOs require deep analysis or creative problem-solving, tasks that are typically not susceptible to performance incentives. Instead, some have proposed paying top executives with a fixed salary only. (See this PubCo post. and this PubCo post.)