What is a Long-Term Incentive Plan?

A long-term incentive plan involves a company providing employees with a bonus as a reward for outstanding job performance or giving employees bonuses that are based on length of service. Under a long-term plan, an employee can often begin accumulating performance based rewards in the short-term, but does not take receipt of those earnings until some point in the future. Most long-term service plans involve employees having to wait for at least one year before receiving bonuses, and many plans involve employees having to wait for at least five years before receiving rewards in full.

The use of a long-term incentive plan discourages employees from acting unethically in the pursuit of short-term financial gains. People who work in the financial sector and sales must produce results consistently over the course of several years, and this prevents people from skewing sales results in the early years, as any such actions would be detected long before the incentives were paid. Some companies offer both a short-term and a long-term incentive plan, and the latter is based on the results of the former, although rewards are much more substantial in the long-term plan.

Under the terms of a long-term incentive plan, employees usually receive their bonuses in the form of cash, company stock, or profit shares. Cash bonuses are paid along with the employees’ regular salary at the end date of the plan. Stock incentives either involve the company buying its own stock on behalf of the employee or the company providing the employee with an opportunity to buy stock at a below market rate. Plans that involve stock options rely on the assumption that the company's stock value will rise over time rather than fall. Profit shares involve the employee being rewarded with a fixed percentage of the company’s profits during the period of time that the long-term incentive plan is in effect.

Employees who participate in long-term incentive plans often pay lower taxes on bonuses paid through such plans than on bonuses paid on short-term plans. This is because, in many countries, the long-term capital gains tax rate is lower than the income tax rate that short-term incentives are taxed at. Long-term plans are often reserved for high-level employees and are designed to ensure these key employees remain loyal to the firm. In situations where the company's results deteriorate over the course of time, employees of the firm can end up with minimal rewards at the end of a long-term incentive plan.