The Advisors' Blog

As I shared last month, many investors still like performance-based awards and it’s unlikely that companies will entirely abandon that structure anytime soon. At the same time, if you’ve worked with companies that grant options, you know that it can come as a surprise and create more than a small amount of resentment that this type of award is not considered “performance-based” – even though it is only valuable if the stock price increases.

Those companies, and others that just like to have more flexibility in plan design, were happy to see (via proxy advisor surveys) that some investors may be open to giving “credit” for equity awards that vest over a 5-year period or have some combination of a vesting plus holding requirement that reinforces executives’ alignment with long-term stock performance. If proxy advisor policies do become more flexible, this FW Cook blog discusses some things to think about if your company considers shifting its equity mix to incorporate stock options. Here are the three main concepts (paraphrased):

1. Options may be more effective than time-based restricted stock when it comes to maintaining leverage in long-term incentive programs, because a greater number of stock options than restricted shares are granted for a given award, and they allow for leveraged, pre-tax wealth accumulation over a longer time period.

2. Not all institutional investors may view long-horizon restricted stock as performance-based. Depending on a company’s ownership profile, certain investors may perceive the company as having a performance-based LTI program if they use a blend of long-horizon restricted stock and stock options. To add more certainty that investors (and proxy advisors) assess an LTI program as performance-based while avoiding the need to set multi-year financial goals, companies could add stock price hurdles (i.e., 15% cumulative stock price growth over three years) to stock options before any vesting or could grant premium-priced stock options.

3. Higher market volatility may make stock options more appealing. Volatility often increases the magnitude of in-the-money exercise opportunities for executives, and it also increases the accounting cost per stock option, which reduces share usage for companies that have dollar-denominated equity programs.

I mentioned the proxy advisor policies. The FW Cook blog highlights how influential those policies have been in shaping compensation practices, along with accounting standards. That’s contributed to the homogenization of executive pay that Meredith recently discussed – where differences in pay structures and effectiveness turn on subtle details. The FW Cook team explains a couple of inflection points that have affected pay practices:

The 2007 and 2008 FW Cook Top 250 Long-Term Incentive Reports described the reallocation of long-term incentives from stock options as the sole LTI vehicle to a portfolio approach of stock options and full-value shares (performance shares or restricted stock). The primary driver of the change was the implementation of Accounting Standards Codification (ASC) Topic 718 (formerly known as FAS 123R), which resulted in a charge to earnings for granting stock options and a greater focus on controlling potential shareholder dilution.

A few years later, the 2011 FW Cook Top 250 Long-Term Incentive Report marked the first time in the history of the report that the prevalence of performance shares was higher than stock options, reflecting the advent of Say on Pay and the increased influence of proxy advisors, such as Institutional Shareholder Services (ISS) and Glass Lewis. Neither ISS nor Glass Lewis credits time-based stock options as performance-based, so companies implemented performance shares at higher rates to receive credit for performance-based LTI programs and bolster the likelihood of a “For” vote recommendation on Say on Pay from the proxy advisors.

Obviously, proxy advisor policies are not the only driver when it comes to structuring executive pay programs, but it does look like companies have tried to do what investors say they want.

– Liz Dunshee