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Workshop

Equity-Based Compensation: Responding to the ‘Perfect Storm’

Employers face difficult decisions in reworking executive compensation plans in response to the pressure of the economic downturn, said Matt Ward, senior vice president at Radford Consulting, a compensation consulting firm.

On the management side, much wealth creation is gone and employers need to manage costs, said Ward, who spoke May 18 at a workshop on relative total shareholder return at the WorldatWork Total Rewards 2010 Conference and Exhibition in Grapevine, Texas.

There also is dilution in the value of stock options issued as compensation, shareholders are not seeing the return on investment for the executive compensation by way of increased shareholder value, and the employee also sees a limited return of return on investment, Ward said. The market volatility means that the time is right for employers to consider “an extreme makeover” in compensation plans.

Ward briefly discussed the older conventional wisdom for when certain types of equity vehicles are most likely to provide desired return, depending on the life-cycle and financial status of the company.

A start-up company that expected to grow rapidly, for example, used stock options as the preferred vehicle. If the share pool was extremely constrained, however, and the company did not want to ask shareholders for approval to issue more shares, a mix of cash and restricted stock units would be a preferred option, Ward said.

All changed with the market volatility of recent years, Ward said. Stock options, in particular, can go underwater-be worth less than when granted-and this means lost motivational and retention value to the executive. Current accounting principles also make this vehicle financially inefficient, he said.

Restricted stock units also have their shortcomings, especially in aligning performance with reward. Ward called this pay for attendance.

Performance-based equity arrangements, on the other hand, are more flexible vehicles for rewarding executives, and can be stable in accounting for them, but it can be tough to set multiyear goals.

But the Holy Grail of equity arrangements consists of an arrangement that provides a clear link to shareholder-value creation, balances retention and performance objectives, and is relatively easy to communicate and administer, among other things. This type of arrangement is called relative total shareholder return (TSR), Ward said, adding that such a plan can still provide a “very fair” offering of compensation to executives even in a financial market downturn.

GROWTH AND PREVALENCE OF RELATIVE TSR

Since 2005, when the new accounting standards FAS 123 and ASC Topic 718 were implemented, there has been a dramatic upturn in relative TSR, said Terry Adamson, also a senior vice president at Radford Consulting. However, companies based in the United States are late in adopting relative TSR programs, compared with companies in Great Britain or Australia, Adamson said. He predicts the American firms will “evolve” to adopt relative TSR programs.

The most important aspect of the relative TSA plan is the requirement to measure performance against an appropriate peer group, or to a stock or equity index, or a mix of those two, Adamson said.

The process starts with setting a target share award, which is compared with a peer group performance multiplier that shows whether the original target was achieved. If the target is reached, than 100 percent of the award is earned. If the target is exceeded, the executive receives an additional amount, but this is usually capped, unlike stock options. If the executive fails to meet the target, than the relative TSR calculates a reduction in the award, Adamson said.

Often there is a floor to the compensation reduction-the remainder of the compensation in these situations usually are restricted stock units, Ward said.

Some issues with TSR implementation include disconnects between the grant date and the performance period, long averaging periods, and the complexity of calculating payout bend points, Adamson said.

On the acturarial end, Adamson said ASC Topic 718 requires a valuation based in a risk neutral framework called the Monte Carlo simulation. Unlike the Black-Scholes method, a Monte Carlo simulation includes a correlation coefficient for each entity, he said.

Representatives of two companies who recently implemented a relative TSR program also discussed how they chose a peer group or indexed, and made plan modifications. Sara Holder, an executive compensation consultant with Intel, said the TSR plan was pushed at a time when the options were underwater and Intel’s stock price was underperforming over a period of time.

Intel’s compensation committee wanted to provide an incentive to executives to outperform, and the results so far show that they have, said Halder, although the TSR was put in place when options for some would have provided more value, such as in 2009, when stock-price growth was strong.

Stacy Litka, executive compensation leader at Owens Corning, said her company began moving towards a relative TSR-based plan shortly after coming out of bankruptcy in 2006, issuing stock to all employees, and developing what she called a complex long-term incentive plan that included performance share units with six performance measures that, combined, determined payout after three years.

In 2009, the company revised its long-term incentive strategy to replace the six performance metrics with relative TSR. Payouts of the performance share units are half in cash and half in stock, said Litka, and the cash can be used to pay the taxes on the award. The retention of a cash component was also due to the company transitioning from strictly cash-based long-term compensation, she said. Litka also said executives in her organization are now above target in the TSR plan.

Ward is looking for an increased use of relative TSRs in U.S.-based companies, and said that relative TSR can be offered successfully to a broader base of employees.

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