Total shareholder return: Making it work in a volatile financial world - 22 Jan 2010

Last updated: 22 January 2010

Total
shareholder return (TSR) has been the dominant measure used to
determine vesting in long-term performance share plans in the UK and
Australia. Its use has also become increasingly common in the US and
Canada. Many have been quick to hail it as the ultimate and only
measure of a company’s performance. However, it may not be the panacea
for ensuring pay for results over the long term. Mercer’s point of view
is that effective long-term incentive plans should reflect a balance of
objectives and reward both financial and shareholder results. Relying
on a single metric may oversimplify the assessment of performance and
potentially encourage inappropriate risk-taking. The hazards become all
too apparent in markets characterized by extreme volatility, such as
those seen since mid 2008.

With severely depressed share prices across most sectors, and little
insight into the future performance of many economies, companies are
struggling to select and calibrate long-term internal financial
targets. Now more than ever, the focus seems to be shifting toward
viewing TSR as a “true” measure of performance, given its strong
alignment with shareholder outcomes. However, TSR incorporates actual
financial performance and market expectations, which could be
influenced by a variety of factors. Owing to that and other
disadvantages outlined in this perspective,

the use of TSR in a volatile market needs to be carefully considered to
avoid unintended, and even counterintuitive, outcomes. Furthermore, TSR
may not be appropriate for all types of long-term incentive vehicles –
for example, share options, which already have a built-in TSR hurdle
that needs to be achieved before they are “in the money.”

In this Perspective, we consider how to reassess the way in
which TSR is used in long-term incentive plans. The current economic
environment has made target-setting based on absolute measures
challenging, and we believe that, going forward, the spotlight will be
on relative, not on absolute, TSR. Therefore, we focus here on relative
TSR, or how a company performs relative to its peers, and how (or
whether) its shortcomings can be addressed to ensure that it remains an
effective measure of results and long-term shareholder value creation.

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