Better Options

Raising the Bar
The impulse to tie incentive pay to specific measures of performance is laudable. Up to now, however, companies have largely avoided placing performance benchmarks on long-term incentives, especially at companies that rely largely on stock options. The accounting rules that exempt companies from expensing stock options clearly state that the options must have a fixed value and vesting schedule and a set number of shares-essentially removing any teeth from a true performance-based option plan, which, experts say, works best as an all-or-nothing affair. (A performance-based plan like that at Avery Dennison may offer accelerated vesting of fixed-price options and retain the expensing exemption.)

When and if accounting rules require option expensing without exceptions, expect to see a dramatic surge in all-or-nothing options or stock grants, which vest if goals are hit but disappear when they aren't. Although this type of option or stock must be expensed, a company can reverse the expense if the performance goals are not attained and the options or stock never vest-but only if the goals are non-stock-price based, according to Irv Becker, national practice leader of compensation advisory services at KPMG LLP. In this way, companies can take advantage of the benefits of stock options without encouraging the financial shenanigans to boost stock price. (Avery Dennison is one of the few companies in the S&P 500 that currently use non-stock-price-based performance goals.)

But any performance-based plan can come with unintended consequences, no matter what goal is selected. "Any kind of performance incentives could [prompt] some kind of manipulation," says Paul Hodgson, senior research associate at corporate-governance research group The Corporate Library. And goals are notoriously hard to define, which, says Jones of Sibson, is another reason performance-based plans fell out of favor in the 1970s. "Often," she adds, "performance-based plans are a measure not of an executive's ability to reach a specific goal, but his ability to negotiate favorable, easily attainable goals with his superiors or the board."

The key, say experts, is to set multiple goals, making it more difficult for executives to manipulate the numbers. Also crucial is raising the bar if performance goals are routinely achieved. Avery Dennison's performance goal was previously the top half of its peer group, but the bar was raised last year to the top third. Although the company has hit the new goals every year since the program was put into place, CFO O'Bryant isn't concerned that the bar is still too low.

"If you keep raising the bar, and the company continues to reach it, eventually you run out of room and you end up not [rewarding] people for superior performance," he says. "If we consistently perform above it, we ought to be paying our managers well."

Indeed, companies should avoid having only performance-based plans that reward short-term performance, says Hodgson, and to that end plans should be based on goals that are measured over a period longer than one year. "It's much more difficult to manipulate a measure over a number of years," he notes. "It's easy to get a quick hit to earnings for a quarter to get a better stock price when your options are about to vest." Any performance plan must also have measures that counterbalance one another, adds Jack Dolmat-Connell, senior vice president at Clark/Bardes Consulting. The ideal plans, he says, offer a combination of performance goals, stock-ownership vehicles, and cash; the mix will depend on the company's industry and peer group. Manufacturers, for instance, have never relied heavily on stock options, while high tech used them as a substitute for cash compensation for years.

The bottom line for executive compensation, however, is that investors who railed at overly generous stock-option grants will also rail at overly generous restricted-stock grants, or overly attainable performance units or stock. The acid test of a long-term incentive-compensation plan is this: Is it designed to deliver a set percentage of dollar value to an executive-regardless of what happens to the company-or is it designed to reward good performance? Plans that serve the latter purpose stand a good chance of passing muster with the toughest shareholder activist.

The World after Options

Source: Hewitt Associates's 2003 survey of 178 major U.S. cos.

Holding On
Executives aren't so quick to flip restricted shares.

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