Despite the bad press, they’re still a major factor in executive compensation. But performance measures are under the microscope
Stock options have long been one of the cornerstones of a competitive executive compensation package. But new accounting rules and growing scrutiny from institutional investors are prompting organizations to revisit — and perhaps rethink — how stock options are designed and implemented.
Stock options continue to be among the most prevalent types of long-term incentives in Canada. In fact, according to a recent Watson Wyatt study, 98.6 per cent of the 214 companies that form the S&P/TSX Composite Index reported having stock option plans in 2003.
While few dispute the need for fair, competitive and performance-linked executive compensation, Canadian institutional investors are calling on organizations to review how they use stock options. Some of the guiding principles being advocated by institutional investors include:
•having a large portion of an executive’s compensation package based on performance, with pay and performance linked through meaningful and measurable performance targets;
•ensuring executives are significant shareholders in the companies they lead — with an emphasis on owning shares versus holding options;
•ensuring complete disclosure of executive compensation arrangements;
•ensuring board compensation committees seek independent executive compensation advice; and
•limiting the number of stock options granted, and ensuring those that are granted are focused on the achievement of long-term business objectives and subject to appropriate vesting criteria.
In the United States, major institutional investors are also quite vocal about the need for change. Specifically, they hold the view that traditional time-vested stock options are not “performance-based,” and that grant levels and vesting criteria should be linked to performance criteria other than share price. U.S. institutional investors have also expressed a lack of confidence in companies’ use of “earnings per share” as a performance measure because of the potential for manipulation of results.
Like their Canadian counterparts, U.S. institutional investors have been calling for fuller disclosure of executive compensation arrangements, in proxies and other filings, including the actuarial value of executive retirement benefits and the value of all executive perquisites.
So how are companies responding to this growing pressure for more performance-based long-term incentive plans? In general, we are starting to see a movement away from 100-per-cent reliance on traditional time-vested stock options and towards “full-value” plans such as restricted share units and performance share units. Under a full-value plan, the executive receives the total value of each share on vesting, not just the appreciation. Institutional investors tend to favour this approach as it focuses on maintaining the existing shareholder value, as well as increasing it.
If one looks at the types of long-term incentive plans in place, it is clear that stock options continue by far to be the most popular vehicle (see chart). Yet when one looks at the prevalence of other types of plans, one does see a trend towards a greater use of other types of vehicles. For example, in a comparison of 2003 over 2002, 33 per cent of the 214 companies that formed the S&P/TSX Composite Index reported the use of performance shares in 2003, up from only four per cent in 2002. Similarly, 10 per cent of the companies reported using restricted shares in 2003, up from three per cent in 2002.
The challenge is that while making long-term incentive plans more performance-based makes sense in principle, in practice it can represent a complex undertaking. The move towards using full-value shares has a range of implications, including:
•accounting changes;
•valuation issues;
•affordability issues;
•higher taxes on gains than with options; and
•less leverage potential for executives than with options.
The realizable value of restricted share units and performance shares is typically lower than with traditional stock options if the stock price increases significantly because they are less highly levered. This raises the question as to whether the lower upside potential on such plans can inhibit or reduce the performance orientation of the executive team.
The move towards more performance-based long-term incentive plans is further complicated by the challenge of determining what performance measures should be used. Should these measures be relative measures or absolute measures? Should they be externally focused against a peer group or internally focused? If a peer group comparison is selected, how does one define an appropriate peer group and will it be stable over the performance period? How does one define threshold, target and maximum performance? And what role will board discretion play with a plan that utilizes rigidly defined metrics?
Time-vested restricted share units
If one explores alternatives to traditional stock option plans, it becomes clear that there is no ideal solution. Consider time-vested restricted share units, which are notional units that are converted to shares (or cash) upon vesting. The positives of such plans include the fact that they have less of an impact on share dilution levels than options because fewer units are required to provide the same compensation value, and they help an organization achieve share ownership guidelines.
However, the reality is that such plans are no more performance-oriented than traditional stock option plans. There is also less likelihood that a restricted share unit plan will provide a zero pay-out in comparison to a traditional stock option plan.
Performance share units
Now consider performance share units. The unit value is tied to the stock price. Typically, the number of units that come due depend on whether the company meets or exceeds its performance targets. For example, no units may vest if the threshold performance requirement is not met, whereas 150 per cent of the target units may vest if the performance is at maximum.
Again, while there are performance elements in such a plan, there is also a need for judgment regarding how performance expectations are defined and how results are measured. To that end, the selection of a peer group requires careful judgment. Further, the efficacy of the measure can be eroded if any organizations in the peer group experience a significant change such as that caused by mergers or acquisitions. As well, in the event of an economic downturn, the plan may yield pay-outs for relative performance even if actual total return to shareholders is on the decline.
Achieving performance with traditional stock options
When contemplating the future design of long-term incentives, it is important to recognize that one can achieve pay for performance even with traditional stock option plans.
The Watson Wyatt study of the 2003 proxy circular reports for the 214 companies that formed the S&P/TSX Composite Index found that while total return to shareholders rose 26 per cent, the pay of chief executive officers increased by a much smaller amount, with base pay up by four per cent, total cash compensation (base pay plus annual incentive awards) up by nine per cent and total direct compensation (base pay plus annual incentive awards plus long-term incentive awards) up by 10 per cent. Further, the study found that the 176 companies that paid CEO bonuses in 2003 significantly outperformed the 39 companies that paid no bonus to CEOs.
Ultimately, the key to ensuring that an organization’s long-term incentive plan is delivering value — to the executives, the organization and shareholders — is to start by ensuring that the plan design is guided by a defensible compensation philosophy. Institutional investors are making it clear that a philosophy of paying executives at the 75th percentile of the market can’t be accepted if the organization is delivering median or average performance. It is also critical that the long-term incentive design aligns with the company’s business strategy — not just competitive practice.
Issues to consider, questions to ask
When establishing performance measures, it is important to:
•consider what makes sense for the type of long-term incentive plan being used;
•keep it as simple as possible;
•balance the need for performance with the need for employee retention and affordability; and
•understand the range of potential pay-outs under different performance scenarios by modelling the possibilities before finalizing a plan design.
When establishing performance measures, some key questions to ask include:
•Is there readily accessible data for the measure today?
•Is there readily accessible historical data?
•Is the measure easy to communicate and understand?
•Can executives substantially impact the achievement of the measure?
•Can the measure be unduly subject to manipulation?
•Is the measure valid across economic cycles?
Finally, from an overall plan effectiveness perspective, some key questions to ask include:
•Where is the stock option dilution level relative to the market and institutional shareholder comfort levels?
•Have executive compensation policies been disclosed to shareholders in the manner required by the regulators?
•What impact could stock equity plan account expenses have on profit and loss statements and the balance sheet?
•With full executive pension disclosure around the corner, what does the company’s total executive compensation arrangement look like?
Ultimately, while statistics regarding plan prevalence and executive compensation levels provide useful insights on general market trends and practices, it is critical that organizations look beyond such data when assessing the value and effectiveness of executive compensation plans. What organizations need to examine is the extent to which executive compensation plans support the achievement of short-term and long-term business objectives. Organizations and boards need to consider how the link between executive rewards and corporate performance is achieved.
Ray Murrill is the executive compensation practice leader for Canada in Watson Wyatt’s Toronto office. He can be reached at (416) 943-6052 or at [email protected].
Stock options continue to be among the most prevalent types of long-term incentives in Canada. In fact, according to a recent Watson Wyatt study, 98.6 per cent of the 214 companies that form the S&P/TSX Composite Index reported having stock option plans in 2003.
While few dispute the need for fair, competitive and performance-linked executive compensation, Canadian institutional investors are calling on organizations to review how they use stock options. Some of the guiding principles being advocated by institutional investors include:
•having a large portion of an executive’s compensation package based on performance, with pay and performance linked through meaningful and measurable performance targets;
•ensuring executives are significant shareholders in the companies they lead — with an emphasis on owning shares versus holding options;
•ensuring complete disclosure of executive compensation arrangements;
•ensuring board compensation committees seek independent executive compensation advice; and
•limiting the number of stock options granted, and ensuring those that are granted are focused on the achievement of long-term business objectives and subject to appropriate vesting criteria.
In the United States, major institutional investors are also quite vocal about the need for change. Specifically, they hold the view that traditional time-vested stock options are not “performance-based,” and that grant levels and vesting criteria should be linked to performance criteria other than share price. U.S. institutional investors have also expressed a lack of confidence in companies’ use of “earnings per share” as a performance measure because of the potential for manipulation of results.
Like their Canadian counterparts, U.S. institutional investors have been calling for fuller disclosure of executive compensation arrangements, in proxies and other filings, including the actuarial value of executive retirement benefits and the value of all executive perquisites.
So how are companies responding to this growing pressure for more performance-based long-term incentive plans? In general, we are starting to see a movement away from 100-per-cent reliance on traditional time-vested stock options and towards “full-value” plans such as restricted share units and performance share units. Under a full-value plan, the executive receives the total value of each share on vesting, not just the appreciation. Institutional investors tend to favour this approach as it focuses on maintaining the existing shareholder value, as well as increasing it.
If one looks at the types of long-term incentive plans in place, it is clear that stock options continue by far to be the most popular vehicle (see chart). Yet when one looks at the prevalence of other types of plans, one does see a trend towards a greater use of other types of vehicles. For example, in a comparison of 2003 over 2002, 33 per cent of the 214 companies that formed the S&P/TSX Composite Index reported the use of performance shares in 2003, up from only four per cent in 2002. Similarly, 10 per cent of the companies reported using restricted shares in 2003, up from three per cent in 2002.
The challenge is that while making long-term incentive plans more performance-based makes sense in principle, in practice it can represent a complex undertaking. The move towards using full-value shares has a range of implications, including:
•accounting changes;
•valuation issues;
•affordability issues;
•higher taxes on gains than with options; and
•less leverage potential for executives than with options.
The realizable value of restricted share units and performance shares is typically lower than with traditional stock options if the stock price increases significantly because they are less highly levered. This raises the question as to whether the lower upside potential on such plans can inhibit or reduce the performance orientation of the executive team.
The move towards more performance-based long-term incentive plans is further complicated by the challenge of determining what performance measures should be used. Should these measures be relative measures or absolute measures? Should they be externally focused against a peer group or internally focused? If a peer group comparison is selected, how does one define an appropriate peer group and will it be stable over the performance period? How does one define threshold, target and maximum performance? And what role will board discretion play with a plan that utilizes rigidly defined metrics?
Time-vested restricted share units
If one explores alternatives to traditional stock option plans, it becomes clear that there is no ideal solution. Consider time-vested restricted share units, which are notional units that are converted to shares (or cash) upon vesting. The positives of such plans include the fact that they have less of an impact on share dilution levels than options because fewer units are required to provide the same compensation value, and they help an organization achieve share ownership guidelines.
However, the reality is that such plans are no more performance-oriented than traditional stock option plans. There is also less likelihood that a restricted share unit plan will provide a zero pay-out in comparison to a traditional stock option plan.
Performance share units
Now consider performance share units. The unit value is tied to the stock price. Typically, the number of units that come due depend on whether the company meets or exceeds its performance targets. For example, no units may vest if the threshold performance requirement is not met, whereas 150 per cent of the target units may vest if the performance is at maximum.
Again, while there are performance elements in such a plan, there is also a need for judgment regarding how performance expectations are defined and how results are measured. To that end, the selection of a peer group requires careful judgment. Further, the efficacy of the measure can be eroded if any organizations in the peer group experience a significant change such as that caused by mergers or acquisitions. As well, in the event of an economic downturn, the plan may yield pay-outs for relative performance even if actual total return to shareholders is on the decline.
Achieving performance with traditional stock options
When contemplating the future design of long-term incentives, it is important to recognize that one can achieve pay for performance even with traditional stock option plans.
The Watson Wyatt study of the 2003 proxy circular reports for the 214 companies that formed the S&P/TSX Composite Index found that while total return to shareholders rose 26 per cent, the pay of chief executive officers increased by a much smaller amount, with base pay up by four per cent, total cash compensation (base pay plus annual incentive awards) up by nine per cent and total direct compensation (base pay plus annual incentive awards plus long-term incentive awards) up by 10 per cent. Further, the study found that the 176 companies that paid CEO bonuses in 2003 significantly outperformed the 39 companies that paid no bonus to CEOs.
Ultimately, the key to ensuring that an organization’s long-term incentive plan is delivering value — to the executives, the organization and shareholders — is to start by ensuring that the plan design is guided by a defensible compensation philosophy. Institutional investors are making it clear that a philosophy of paying executives at the 75th percentile of the market can’t be accepted if the organization is delivering median or average performance. It is also critical that the long-term incentive design aligns with the company’s business strategy — not just competitive practice.
Issues to consider, questions to ask
When establishing performance measures, it is important to:
•consider what makes sense for the type of long-term incentive plan being used;
•keep it as simple as possible;
•balance the need for performance with the need for employee retention and affordability; and
•understand the range of potential pay-outs under different performance scenarios by modelling the possibilities before finalizing a plan design.
When establishing performance measures, some key questions to ask include:
•Is there readily accessible data for the measure today?
•Is there readily accessible historical data?
•Is the measure easy to communicate and understand?
•Can executives substantially impact the achievement of the measure?
•Can the measure be unduly subject to manipulation?
•Is the measure valid across economic cycles?
Finally, from an overall plan effectiveness perspective, some key questions to ask include:
•Where is the stock option dilution level relative to the market and institutional shareholder comfort levels?
•Have executive compensation policies been disclosed to shareholders in the manner required by the regulators?
•What impact could stock equity plan account expenses have on profit and loss statements and the balance sheet?
•With full executive pension disclosure around the corner, what does the company’s total executive compensation arrangement look like?
Ultimately, while statistics regarding plan prevalence and executive compensation levels provide useful insights on general market trends and practices, it is critical that organizations look beyond such data when assessing the value and effectiveness of executive compensation plans. What organizations need to examine is the extent to which executive compensation plans support the achievement of short-term and long-term business objectives. Organizations and boards need to consider how the link between executive rewards and corporate performance is achieved.
Ray Murrill is the executive compensation practice leader for Canada in Watson Wyatt’s Toronto office. He can be reached at (416) 943-6052 or at [email protected].
