What is a Long Term Incentive Plan and How Does it Work?

A long term incentive plan (LTIP) is a deferred compensation strategy that helps employers retain valued talent by rewarding employees for meeting specific performance goals. The goals, determined by the company as key to the organization’s success, may or may not be tied to the price of company stock shares or the company’s value.

Although long term incentive plans vary in structure, they can be an important aspect of Total Compensation. In talent-focused environments, LTIP plans afford the employer valuable latitude to customize the reward to the individual recipient.

Long Term Incentive Plans: Both Flexible and Structured

Typically, the annual benefit under an LTIP can be calculated for each employee, and either vests or is payable over a predetermined time. Often, this period is established as three to five years.

Because the benefit can be paid in percentages with additional percentages of the total layered into subsequent years, the plan participant may not receive a “full” benefit amount for several years.

Executives who leave a company before the benefit is vested will forfeit the unvested portion of the award. Most commonly, vesting is either structured as cliff vesting which entitles the employee to the full benefit at a specified time or as graduated vesting in which there could be no benefit vesting in the early years of the plan followed by phased in vesting in subsequent years.

An LTIP may also require that the reward be contingent upon the executive signing a release of claims against the company and its owners. Terms of payment may also be conditional upon the executive’s commitment to a restrictive covenant such as a confidentiality agreement, a non-compete or a non-disparagement agreement. In general, an LTIP offers flexibility, making it appealing to employers who seek to leverage reward against retention.

Although the employer bears the cost of administering the long term incentive plan, there is rarely a need for a business valuation. Of additional value to the employer is that the award becomes tax deductible to the employer upon payment. Likewise, the executive should bear in mind that income tax on awards received under a LTIP plan are almost always due in accordance with the tax year in which they are received.

5 Primary Components to an Effective LTIP

As attractive as an LTIP may be, the Harvard Law School Forum on Corporate Governance article, “Executive Long-Term Incentive Plans,” judiciously observes, “Designing an effective long term incentive plan (LTIP) can be very difficult, as boards must be aware of the potentially high costs that come with an overzealous LTI design.” The operative word is “effective” and serves as a reminder that professional guidance is critical in long term incentive plan design.