In this issue, answers to:

What considerations should be taken for deciding the appropriate magnitude of incentive awards?

How can companies evaluate the long-term incentive mix of grants for 2009?

What action items can be considered for 2009?

As the global financial crisis and economic downturn unfold, directors and senior management teams are trying to come to grips with the implications for their business and human capital strategy. Despite the concerted actions of governments in Europe, the US and Asia, world stock markets continue to decline, thereby loosening equity retention hooks, diminishing alignment to future improvements in performance and leaving executives vulnerable to poaching by competitors. Currency fluctuations are wreaking havoc on global compensation strategies, and the potential for a deeper-than-anticipated recession is making it difficult to evaluate performance results and plan for the future.

Meanwhile, governments are imposing restrictions on executive remuneration at financial institutions that benefit from rescue efforts, and these constraints may be a harbinger of future regulation of executive remuneration programs, particularly in the US and Europe. Shareholders are seizing the moment as well. They are calling for constraints on a range of executive pay and severance arrangements, continuing their demands for pay for results and decrying pay for failure.

This environment has significant implications for executive rewards and talent strategies for the next several years, as well as pay actions for the short term. Several issues are surfacing at once, including:

• How should companies structure long-term incentive (LTI) and equity grants in 2009 to balance delivery of competitive compensation value with the potential for dramatically increased share consumption?

• How do we ensure that programs are aligned with 2009 business objectives?

• How can organizations ensure that their rewards programs motivate and retain executives for the long term?

• What implications does the regulatory environment have on the future design of executive remuneration programs?

We believe that practices in 2009 will be fundamentally different than in previous years. The confluence of economic, regulatory and shareholder oversight factors may lead to reconsideration of compensation strategy. For many companies, we believe, this will result in at least a near-term reduction in LTI value and a rebalancing of the LTI component. As we look to the future, we anticipate that companies will assess the overall mix, performance alignment and risk characteristics of their executive pay programs to respond to the environment.

This Perspective is one in a series of articles that addresses these topics. In this article, which focuses on considerations for LTI awards in 2009, we first discuss considerations for assessing the appropriate magnitude of incentive awards. For many organizations that deliver LTIs to a targeted value, 2009 presents a conundrum of balancing delivery of competitive pay with the potential for a dramatic increase in the number of shares required for equity grants. Second, we offer considerations for evaluating the balance of LTIs for the 2009 grant as a near-term action. While these actions may reflect a short-term fix for current issues, we anticipate that companies will be taking a hard look at their LTI programs as part of the total reward strategy to develop more systematic responses as the situation unfolds. We conclude with a list of action items to consider for 2009. Future articles in this series will examine a number of these items in more detail, including considerations for a systematic executive pay program review, implications of reduced retention value of current programs, and the potential impact of increased regulatory and institutional shareholder scrutiny of executive compensation.

Equity award magnitude for 2009

In the near term, companies are wrestling with their equity guidelines for 2009. Most companies calibrate their LTI awards for participants in value rather than using fixed share guidelines. With equity markets down 40 percent or more, for many companies the number of shares required to deliver the same value of awards will increase dramatically. Similarly, those with fixed share guidelines face the prospect of delivering much less value than in previous years with market declines. For example, if a company wishes to deliver $100,000 of value in full-value shares and their stock price has declined from $50 per share to $25 per share, the number of shares required to deliver that value is 4,000 shares (=$100,000/$25) versus 2,000 when prices were higher (=$100,000/$50). This reflects a 100 percent increase in the number of shares.

In other words, if that company had a share run rate of 1.5 percent in 2008 when prices were higher, the corresponding share run rate in 2009 could be 3 percent as a result of the decline, which may not be tolerable for shareholders in a declining market. Furthermore, the increased share usage might put an untenable stress on the shares available for grant in a company’s equity plan and, if the equity market decline is temporary, it could potentially result in unintended consequences of a windfall. The impact for a particular company will depend on its circumstances, but this illustration underscores the potential implications of not striking a balance between value and dilution.

2009 is a game changer

We believe that many companies will be hard-pressed to maintain the same value of LTI grants for upcoming awards due to plan share deficiencies or the appearance of overreaching, or both. The economic turmoil in today’s markets is unprecedented, so unprecedented actions are likely to be taken.

While companies are still planning their actions for 2009 grants, early indications are that many companies will be reducing grant levels this year, potentially by significant levels (10 percent – 30 percent). While strategies are still evolving and we are seeing a wide range of responses to these market conditions, early approaches include the following:

• Reducing value by a fixed percentage – Some companies are considering an across-the-board haircut to target LTI grant values. For example, a 10 percent to 30 percent reduction in grant guidelines from 2008 is being considered to recognize the market decline and mitigate share usage.

• Using an average share price and volatility to calibrate grants – Instead of using a current “spot” price of stock for calibrating the number of shares granted, companies may use historical 3-, 6- or 12-month average prices to smooth the impact of recent price declines. Similarly, companies could adjust share price volatility calculations to mitigate the impact of recent sharp price declines on option values. (Note that these suggestions apply to the calibration of award levels and should not be used to set the fair-market exercise price or determine accounting costs.) 

• Using a “collar” approach to at least partially adjust grant levels to meet a target value – Companies are allowing an adjustment to the number of shares to adjust to value, but are providing a cap on the maximum adjustment to share grants versus the prior year (for example, 25 percent to 50 percent increase).

• Calibrating grants in light of company performance – Performance for 2008 can be used as a barometer for grant sizes. For example, LTI grants may be adjusted proportionately to be directionally in line with annual incentive payouts relative to targets. This approach takes a performance-granting perspective of awards.

No one-size-fits-all solution

Current surveys generally reflect practices from early 2008 while proxies reflect LTI grants from 2007. This means that market data will play a modest role, if any, in decision making for 2009. We recommend that companies evaluate a range of factors to determine the best course of action for 2009 to suit their unique situations.

• Impact of the economic environment on your company and industry – Consider the shareholder perspective. Share prices in some industries, such as consumer packaged goods, have held up well in this environment, while others, such as financial services organizations, have been hit hard. Grant value reductions are likely to be greater in those sectors with greater share price declines.

• Total share usage and plan capacity – Model the total share usage as a percentage of common shares outstanding under a range of grant scenarios to assess the share-based run rate and implications for share plan capacity. Run rates over the past few years have declined substantially. While 2008 levels may be unrealistically low to replicate for 2009, a dramatic increase (for example, two to three times in the prior year) may be too much. Further, the amount of shares available may not support grant levels without adjustments, and it may take a while for performance to recover enough to obtain a significant new authorization.

• Economic run rate – Consider the proportion of a company’s total market capitalization delivered in equity awards relative to the prior year, and relative to peer organizations. This value is the market value of share grants and the Black-Scholes value of options, divided by market capitalization. This provides perspective on the value transfer and executive “stake in the enterprise,” and is scrutinized by shareholders.

• Retention value of outstanding awards – Analyze the value of unvested LTI awards under a variety of stock price scenarios over the next two to four years to understand the role 2009 grants need to play in retaining critical talent. Unvested gain of two to four times base salary for executives is a guideline to consider to counter potentially attractive hire-on offers from competitors.

• Differentiation for critical talent and high performers – Assess the impact of maintaining values for critical talent and high performers, but reduce grants significantly for others to drive the allocation of awards based on impact and the need to retain. This may require making changes to LTI eligibility or participation rates at certain levels, or for specific job families within the organization.

• Financial expense – Many companies that are aggressively cutting costs and equity expenses may come under review as well. Modeling the impact on accounting expenses will help frame the tolerance for LTI grant levels and how to balance dilution versus value.

• Shareholder and advisory guidelines – Institutional shareholders and proxy advisers such as RiskMetrics Group (formerly ISS) have guidelines on share and economic run rate levels. The impact of grants on those levels should also be examined.

• Compare relative impact on peers – If peer share prices have declined more than your company’s, you may need to use proportionately more shares than your peers for this year, and vice versa. This may point the way to what your peers’ share usage may look like in 2009 to assess the competitive imperative for adjusting grant levels.

The outcomes of these reviews should be considered holistically to inform appropriate actions – at least for the next few months.

Long-term incentive program grants for 2009

After deciding on an appropriate magnitude of awards to deliver, companies should assess possible changes, if any, to the LTI mix for upcoming grants. For many companies, staying the course with the current equity strategy will be appropriate. For others, modest action may be required, while still others will require drastic interventions. We recommend consideration of the

following:

• Maintain a governing objective of retaining a pay-for-performance philosophy in the program.

• Confirm the appropriate mix of shares and options, which may impact overall share usage or accounting costs differently than in the past due to the impact of higher volatility on option valuations. If stock option grants are made in multiple tranches during the year to mitigate price point risk (for example, two to four times per year), predetermine the level and value at the start of the year).

• Use service-based restricted stock for some participants (particularly below the executive level), which supports retention and also may be used to mitigate an overall reduction in LTI value since it is often more highly valued by participants.

• Use performance shares, and reassess performance measures and targets so they are calibrated appropriately to reward for business success in the present environment. This also more closely aligns cost with performance and employee value.

• Goal setting for LTI performance plans may be particularly challenging for some companies if their business environment is very volatile, which puts stress on forecasting multiyear goals.

 

• Potential action steps include assessing the range of performance to determine whether resetting or potentially widening the range for corresponding payouts to account for additional volatility is appropriate; determining the appropriate balance between absolute and relative performance measures; examining the performance period length; and considering the appropriate role of discretion.

 

• At the end of this article, we include reference to other Mercer Perspectives that provide counsel on performance measurement and goal setting.

• Use cash-denominated LTI awards, if needed, when equity is scarce. These awards can support competitive delivery of pay, but companies should note that they trigger variable accounting.

While some companies might consider shifting the LTI mix back toward options to take advantage of low exercise prices, we caution companies to avoid over-reliance on highly leveraged equity vehicles that might encourage excessive risk taking. For example, remixing the grant toward stock options to take advantage of what may be a low stock price should not by itself be viewed as an appropriate rationale for adjusting the mix, particularly amid concerns of stock option backdating. Further, the “negative leverage” drawback of options could be compounded if markets experience further declines. Also consider that any actions taken for 2009 grants will need appropriate disclosure in the CD&A. We recommend reviewing a draft disclosure of the rationale before making final decisions.

Agenda for 2009

Companies will be busy evaluating executive remuneration strategies for 2009. The current environment has potential implications for a wide range of program attributes. Below we offer a list of areas for consideration for developing the 2009 agenda:

1. Alignment of program to business strategy – Ensure that the compensation program reflects adjustments that may be made to business strategy.
2. Balance of incentives for short-term, midterm and long-term performance – Market volatility invites a discussion of whether the plan appropriately rewards a balance of performance time horizons.
3. Long-term incentive vehicles – Examine the appropriate role of options, performance awards, restricted stock and cash-based plans.
4. Performance measurement and target setting – Forecasting may be more uncertain in this environment. Companies should examine: (1) measure selection; (2) goal setting and the range of performance corresponding to payouts; and (3) the use of relative versus absolute measures.
5. Business risk implications – Recent regulation has invited scrutiny of whether compensation plans within financial services organizations led to inappropriate risk taking. A senior official at the SEC has suggested that all companies should examine the impact of compensation programs on risk; 2009 is a good time to test.
6. Global compensation strategy – Equity market declines in countries around the globe, as well as currency fluctuations, invite review of global compensation strategies to ensure appropriate alignment.
7. Executive retention and wealth accumulation (“hold value”) – Declining markets have left options underwater and equity programs with much lower value. Assessing the impact on key talent and developing an appropriate strategy are critical. (See the sidebar “Addressing underwater options” for related information.)
8. Stock ownership guidelines and holding requirements – Declining markets also have impacted executive and director ownership guideline compliance. A related issue is that in some cases shareholders have expressed concern about timing of award payouts – where management received significant awards prior to share price declines when shareholder suffered losses. Equity holding requirements and ownership guidelines should be examined for appropriate alignment.
9. Equity strategy for director compensation – As with executives, calibrating director compensation equity also is impacted by declining share prices. Companies should consider what, if any, actions might be appropriate.
10. Shareholder engagement strategy – Companies may find that they need to seek shareholder approval of additional equity reserves sooner than expected, or undertake actions that may be at odds with shareholder policies that were adopted prior to the current market decline (for example, exceed burn rate commitments). Assessing how best to have a dialog with shareholders will be an important consideration.
11. Other program “hot buttons” for external shareholders – A number of program areas have been focal points for shareholders over the past several years. In a down market, the level of scrutiny on these areas increases. Special attention should be paid to executive severance, change in control, pension benefits and other executive perquisites.

     

Conclusion

Companies are assessing how to respond to the volatile financial environment just in time, and the calculus is constantly shifting. With market tumult comes

opportunity. Companies in this game-changing environment have a unique opportunity to determine how best to configure their executive rewards and talent management strategies to align with key business objectives. Much like the paradigm shift that occurred with equity programs earlier in this decade with the fall of Enron, the adoption of the Sarbanes-Oxley Act and the expensing of stock options, the year 2009 will see a dramatic rethinking of approaches to executive remuneration. With appropriate and thoughtful planning, this process will lead to more effective ways for companies to attract, retain and motivate their executive teams; link pay to performance; and appropriately align programs with shareholder interests.

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