Executive Compensation and the Role of the Compensation Committee

Long-Term Incentive Plans (LTIPs)

Long-term incentive plans are usually delivered with equity instruments and cover a measurement period greater than 12 months and generally have a three- to five-year measurement period. They can be performance based or retention focused or both.

A good idea?

Global organizations faced with a war for talent are also faced with the dilemma of how to retain talent in difficult times, such as when the company is in need of a turnaround. Equity is a key financial instrument that can give positive support to retention efforts. There are two categories of equity with variations of each instrument:

Appreciation awards - these deliver value to the employee only when the share price increases from the stipulated exercise price of the share which is generally the grant date market price. Appreciation awards can take the following forms:

• Stock options: they provide the right to purchase shares of a company's common stock at a fixed price over a stated period of time. In order for the employee to derive value from the stock option, the market price of the share has to "appreciate" beyond the price at which it was granted (the exercise price).
• Stock appreciation rights (SARs): an award based on a specified number of shares at a stated price at grant. After service and vesting conditions are met, the executive can elect to exercise the SAR and either receive stock or cash for the difference between the current market value of the stock and the stated value of the stock at grant. This incentive plan provides cash compensation payouts over a longer period but no ownership advantages unless the SARs are paid out in stock.
• Phantom stock options: upon vesting, generally paid out as a cash bonus equivalent to the difference between the company’s current stock price and the price at grant. These awards may also be used to fund a non-qualified deferred compensation plan. Since no stock is issued, a company may use these awards to minimize share dilution.

Full-Value awards - these deliver the full fair market value of the shares on the vest day and will have vesting schedules which can be based on time or performance measures or specific events (retirement, sale, or disability). They cannot be underwater like appreciation awards and are typically granted in one of the following forms:

• Restricted stock awards (RSA): shares are considered issued and outstanding at grant. Because the shares are issued at grant, participants have voting and dividend rights on unvested awards.
• Restricted stock units (RSU): employees are awarded units that are equivalent to shares of stock. Upon vesting the units are converted to stock, typically at a 1:1 ratio. Since the underlying shares are not issued until the units are vested, plan participants will not have voting rights on unvested units. The units are also not eligible for dividends (since dividends are paid only on actual stock) but do sometimes receive accrued dividend equivalents.
• Performance stock units (PSU): in this type of plan, the executive is granted performance units that represent shares of common stock. They earn these shares when organization performance objectives are achieved.
• Phantom stock: a cash payout based on the value of a company’s stock and generally having vesting requirements. There is no stock ownership. Privately held firms will use this equity vehicle to provide an incentive to key employees. A private company that uses phantom stock is required to have an independent 409A appraisal, a determination of the fair market value of its common stock.

Some of the key decisions in designing an effective LTIP hinge on:

• Appreciation vs Full-Value - selecting one or the other is based on participant preferences, a plan design to create the desired pay for performance relationship, and the life-cycle stage of the company and its future growth prospects. For example, a stock price with high volatility (a high beta), and limited trading volume, may be driven more by external factors than the underlying business performance - limiting effectiveness as an incentive tool.
• Service-Based vs. Performance-Based Vesting - retention objectives need to be met with service-based awards; consideration should be given to whether performance-based awards are sufficient for retention. Hybrid designs have a one-year performance period followed by a two- to four-year service-based vesting period. Although these designs may create the desired three- to five-year performance period, they may not necessarily result in a sustainable long-term performance orientation.
• Absolute vs. Relative Performance - if there is increased market volatility and poor visibility into near-term economic conditions that affect an organization's stock price independent of performance, relative measurement may present an effective alternative for companies with a solid peer group or index to reference, when used in combination with other long-term incentive components.
• Ownership Requirements vs. Holding Periods - ownership standards are intended to align executive and shareholder interests, whereas holding periods are intended more to align rewards with time horizon risks.

PSU Example:

An executive might be granted 10,000 units. If the organization's earnings per share averaged 10% growth over five years, the executive would receive 25% of the shares. If the earnings per share averaged 15% growth over five years, the executive would receive up to 100% of the shares. The executive is taxed on the realized compensation as ordinary income.