There’s more to long-term incentives than stock options

More companies moving towards diverse plans in executive compensation

The design of executive compensation programs provides both challenges and opportunities for any company that embarks upon such an exercise. A properly designed program maximizes the potential for wealth creation for both shareholders and executives, and effectively aligns the interests of both.

Analysis of 2005 compensation data reported in 2006 proxies for companies listed on the S&P/TSX composite index indicates that almost 50 per cent of the compensation value for CEOs is derived from long-term incentives.

In the S&P/TSX 60, the elite corporate index in Canada, the emphasis on long-term incentives is even more pronounced. About 60 per cent of the overall compensation value for CEOs is provided by long-term incentives.

Given the focus on long-term incentives in executive compensation, it is important for boards, executives and HR practitioners to be aware of current trends in long-term incentive program design and the types of long-term incentive vehicles that are available.

According to an analysis of executive compensation programs disclosed by companies on the S&P/TSX composite index, the clear trend is for companies to adopt a portfolio approach to long-term incentive programs. While a few years ago long-term incentives would have been delivered almost exclusively by stock options, companies are increasingly adopting a range of long-term incentive vehicles to supplement stock option programs.

In the S&P/TSX 60, 83 per cent of companies reported in their 2006 proxies that they featured three or more long-term incentive plans in their overall program. This represents an increase of 26 percentage points over the number of companies in the 2005 proxies reporting three or more long-term incentive plans. Although the trend towards increased diversification and sophistication in long-term incentive program design is most pronounced in the S&P/TSX 60, diversification is also clearly seen in the broader S&P/TSX composite index.

A wide variety of long-term incentive plans are available for boards and their advisors for consideration. Many organizations have different names for their own long-term incentive programs, with unique variations in design, so the array of programs to choose from can seem bewildering.

However, most long-term incentive plans can be categorized as either appreciation-based, full-share or performance-based. Below is a brief summary of the features that are common to each category.

Appreciation-based programs

Appreciation-based programs are long-term incentive plans that only generate value for the executives if the stock price increases or appreciates. Stock option plans or stock appreciation rights are examples of appreciation-based plans.

Stock option: Stock options allow an executive to purchase the company’s stock at a specified price over a given amount of time. The specified price (known as the “exercise price”) is most often the fair market value of shares on the date the options are granted. Executives derive value from options by exercising them when the fair market value of the company’s shares exceeds the exercise price. They gain the after-tax value of the difference between the exercise price and the fair market value on the date of exercise.

Stock appreciation right (SAR): A SAR gives the participant the right to receive gains based on the increase in fair market value of the company’s stock over the vesting period in cash, shares or a combination of both. The executive is not required to pay the exercise price as he would with stock options. A SAR can be granted in tandem with stock options, giving the executive the choice of purchasing the stock under the option or receiving the appreciation value under the SAR. If the option is exercised, the SAR is cancelled and vice-versa.

Full-share programs

Full-share programs grant the executive stock or units equal in value to the stock. Typically the grants vest in the executive over time. Examples include restricted stock, restricted stock units and deferred share units.

Even if the stock price declines, these programs still generate value for the executive, albeit at diminished levels. Since the executive typically vests in these programs over time, the programs also serve as retention incentives.

Restricted stock (RS): Restricted stock grants are upfront awards of company stock and can be forfeited if vesting criteria, such as continued employment, are not met. The executive cannot sell the shares until they vest.

Restricted stock units (RSU): RSUs are similar to restricted stock grants, except that actual shares are not granted to the executive. Instead, RSUs are a form of “phantom” shares where notional shares are granted to the executive. Upon satisfaction of vesting conditions, the executive can exchange the RSUs for shares in the company or for their equivalent value in cash.

Deferred share units (DSU): DSUs are similar to RSUs in that they are a form of phantom shares, and they give the executive the right to receive shares or the equivalent cash value of the shares subject to vesting conditions. DSUs differ from RSUs in that they are payable upon the executive’s retirement, termination or death.

Performance-based programs

Performance-based long-term incentive programs can include any of the stock option, SAR, RS, RSU or DSU plans described above except that the vesting conditions based on company or individual performance are central features of the plans. As boards struggle to demonstrate and reinforce the link between executive pay and performance, performance-based long-term incentive programs are being adopted more often.

There is no long-term incentive program that can be labelled the best. Rather, the optimal long-term incentive program is one that balances interests of all stakeholders — boards, shareholders and executives — and reflects the business goals of the company. When designing long-term incentive programs, certain fundamental questions need to be raised.

What executive behaviour is the organization trying to motivate? A stock option program that generates value for executives when share prices go up can encourage executives to drive business agendas focusing primarily on share price appreciation. A full share plan can motivate an executive to maintain share price, as well as increase it.

From tax and accounting perspectives, what is the most efficient means of delivering value to the executive? As the share price increases, stock options tend to produce higher realizable gains for the executive than other long-term incentives.

How do executives perceive the value of the long-term incentive program? Executives who are risk tolerant may attach more value to an appreciation-based program, such as a stock option, than an executive who is less risk tolerant and may prefer a full-share based program like an RSU.

However, the most important questions for companies to answer as they design long-term incentive programs and as they attempt to strengthen the linkage between pay and performance relate to the performance measures themselves. How should performance be defined? What business goals are to be targeted and rewarded? How will performance relative to those business objectives be measured and monitored?

Ideally, performance measurement should be based upon readily available data from both a current state and historical performance. Performance measures should be easily understood and communicable, and the executive should be able to impact upon the achievement of those measures. How each company answers these questions will define the overall long-term incentive plan design that is ultimately adopted.

Larry Moate is a senior consultant at Watson Wyatt’s Human Capital Group in Toronto. He can be reached at (416) 943-6031. Michael Ng is a consultant in Watson Wyatt’s Human Capital Group in Toronto. He can be reached at (416) 943-6086.

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