Be prepared to explain your rationale for changing the incentive mix
The use of stock options for executive, manager, and employee compensation has been steadily eroding for a number of years as more companies shift incentives toward other equity-based compensation vehicles. While a great many companies still rely on stock options to create meaningful long-term incentives (LTIs) for key talent, the use of so-called full-value stock vehicles, like restricted stock and performance shares, has been on the rise.
Performance shares or performance plan awards provide shares of company stock or units to eligible executives, managers, or employees based on the achievement of predetermined performance goals. Restricted stock typically vests over a certain period of time.
According to an analysis of the proxy statements of the Fortune 500 by consultancy Towers Watson, the use of full-value performance-based rewards has increased almost in sync with the decline in the use of stock options:
The percentage of companies granting only full-value awards (time-restricted and performance-based stock and unit awards) in their LTI programs has more than doubled since 2006, rising from 13 percent to 27 percent.
The median mix shifted to 77 percent full-value awards and 23 percent stock options in 2013 measured on the number of shares granted, and to 91 percent full-value awards and 9 percent stock options in terms of the fair value of equity awards granted in the year.
Similarly, Mercer's latest Executive Rewards Survey—based on responses from more than 215 employers across all industries throughout the U.S. and Canada—shows that changes to long-term incentive programs increased in 2014 as a result of proxy advisors’ guidelines. These adjustments include the continued shift away from stock options relative to the increased use of performance shares and restricted stock in delivering long-term incentives to executives: 10 percent of organizations were planning to increase the use of performance shares in 2014, and 5 percent were increasing use of restricted stock.
This shifting mix of stock-based compensation can be traced to a number of developments, particularly the Financial Accounting Standards Board's Standard no.123 (revised 2004), which requires companies to claim an accounting expense for the value of stock options granted.
“The change in the stock compensation rules created a more level playing field by requiring an accounting expense for all forms of stock-based pay,” said David Seitz, director of executive compensation for Towers Watson in Dallas.
Other issues also influenced the move away from stock options, including stock market volatility that often left stock options hopelessly underwater, with exercise prices well above the company’s current stock price (options are only valuable if they can be exercised, or converted into shares, below their current market price). Not surprisingly, that volatility hampered the ability of stock options to provide an adequate incentive.
In addition, increasingly active shareholder groups have not been in favor of using stock options as a long-term incentive—viewing them as disconnected with recipients' performance records—and successfully used their influence to push back on plans heavily weighted toward stock options.
The Portfolio Approach to Long-Term Incentives
“Stock options are not dead,” said Seitz. “Companies have moved toward a portfolio approach with two or three forms of long-term incentives, and stock options still play a role in companies’ LTI portfolios.”
In many cases, the company’s goals for LTIs will guide what vehicles to use:
Time-vested restricted stock might be appropriate if the primary purpose is executive retention, “but it may not be the best vehicle for tying incentives to improvement in company performance,” said Jeffrey J. Bakker, a partner at the law firm Neal, Gerber & Eisenberg in Chicago.
Stock options are more likely to be used for top executives because those individuals have the most direct impact on overall company performance, as related in share prices. “Full-value restricted stock awards and restricted stock unit awards, however, have become prevalent among all employee levels,” said Bakker.
Communication Is Vital
If a company has long relied on stock options in its LTI package, any shift in the incentive mix will require some communication. Companies should be prepared to explain the rationale for the change, including why stock options are often not the best vehicle for rewarding individual performance. For instance:
When awarding performance shares, companies need to explain the performance conditions attached to the awards, and how the company will measure that performance and over what time period.
When awarding restricted stock units, eligible employees need to understand what those awards represent and how they differ from restricted stock shares. (In general, restricted stock units do not involve issuing company stock at the time of the grant; instead, the company can distribute the value of each unit, based on the value of company stock, in cash, stock, or some combination of both.)
Employers may also need to provide more education about these full-value stock awards. For example, full-value awards have different tax consequences than stock options. “Recipients of restricted stock awards may have the choice of accelerating the recognition of income on the value of the award through a Section 83(b) election,” said Bakker. “Recipients will need to be educated on the implications, mechanics and risks associated with such elections.”
Stock Options' Place
Even as companies add other vehicles to the LTI mix, stock options can still play a role. However, Seitz agreed with Bakker that companies that include stock options in their LTI portfolios often limit their use to the highest-level executives whose performance directly affects the company’s stock price.
For example, Seitz explained that a common practice is to offer restricted stock to those who are entry-level. As individuals move up the corporate ladder, their mix of LTIs might shift to 50 percent time-vested restricted stock and 50 percent performance-based shares. Once an executive reaches the uppermost levels of the company, that mix might be equally divided into stock options, performance-restricted shares and time-restricted shares.
Setting the Right Goals
One of the most challenging aspects of any incentive plan is goal setting. “With performance-based awards, a company will find it challenging to find the right mix of metrics and targets to optimally align incentives with the desired performance, especially over longer-term periods,” said Bakker.
He noted that executives may see little value in any program with goals that are considered too difficult to attain or depend too heavily on things beyond the executive’s control. However, if goals are too easy to attain, the award will have little impact on improving performance.
Joanne Sammer is a New Jersey-based business and financial writer.
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