With the economy and markets in turmoil, many organizations are struggling to find the best response across all elements of their compensation strategy, but particularly for their equity-based pay plans.
In an article covering initial results of its recent study "Weathering the Storm in 2009", Mercer discusses the game-changing nature of what we are now facing, notes some of the early approaches being taken, and suggests a list of factors to consider in finding the solution for your organization.
From the Mercer article...
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.
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.
These are challenging times, particularly for those of us charged with managing LTI and equity-based compensation programs. I suspect we'll continue to learn our way - collectively - through this unique period, but it helps to get the kind of perspective and guidance that Mercer offers here.