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Disillusioned investors are demanding stronger links between executive pay and long-term performance.
Kris Frieswick, CFO Magazine
May 1, 2003
Avery Dennison Corp. sticks to what works — not just in its business, but also in its executive compensation. The adhesive-products company has pointedly not abandoned its stock-option program, despite the recent exodus from options by many other companies. Instead, Avery Dennison adheres to an options-based pay package that rewards performance and reassures investors — no small feat these days.
Why aren't investors railing against the options program at Avery Dennison? For starters, its stock options are performance-based. Executives can cash in after three years — but only if the company outperforms two-thirds of its industry peers on return on total capital. Otherwise, the options vest in 9.9 years, at a fixed exercise price. Either way, Avery Dennison doesn't have to expense them, thanks to the fixed price and original vesting schedule.
But performance-based options aren't the whole story. The company's long-term executive comp plan also includes a cash-bonus system based on division-specific goals, ranging from economic value added to earnings growth. Avery Dennison hasn't fallen into the trap of relying exclusively on options to compensate executives. "We've been very conservative with our program," says CFO Daniel R. O'Bryant. "We don't have management making tens of millions on options. I don't think we have a problem to solve here." Given Avery Dennison's strong earnings and stable stock price during the past three tumultuous years, no wonder O'Bryant is calm heading into this year's annual-meeting season.
Other CFOs wish they could be so relaxed. More governance-related shareholder proposals (more than 700) have been filed so far this year than in any previous entire one-year period, and 45 percent of those proposals targeted — surprise — executive-compensation matters. A recent Hewitt Associates study found that as a result of this intense shareholder pressure, 18 percent of companies have converted, or are planning to convert, their long-term incentive plans from stock options to more-palatable vehicles, such as restricted stock, performance-based options, or outright stock grants.
Moving away from traditional stock options is generally seen as a good thing by shareholder activists, who view them as a primary cause of corporate malfeasance. And if the Financial Accounting Standards Board succeeds in its renewed effort to require that options be expensed, the chief economic rationale for them will disappear. The question is, what are the alternatives to options — and how effective will they be?
Predictions, as Yogi Berra said, are difficult to make, especially about the future. Stock options were initially hailed as a good way to align executive and shareholder interests, but instead seemed to encourage executives to manage for short-term stock-price gains. Restricted stock is making a comeback, but many compensation experts are dubious about its effectiveness. One thing is clear, though: as new scandals emerge, and as the stock market slump continues, investors are in no mood to tolerate the options status quo. They want their companies to do something different-and better.
CFO magazine talked to CFOs of three companies — Avery Dennison, Progressive Corp., and Sealed Air Corp. — that are trying something other than traditional stock options in their incentive-pay schemes. We also asked compensation experts for their advice on what works. There is still a place for options, they say — so long as they reward executives for superior performance, not just for enjoying the ride in a bull market. And all agree that incentive plans should have the goal that Avery Dennison expressed in a recent proxy statement: "to promote the creation of stockholder value over the long-term."
One executive-incentive vehicle that companies are turning to is restricted stock, which delivers shares that can't be sold until vesting is satisfied. Progressive, a Mayfield Village, Ohio-based insurance company, recently decided to scrap its stock-option plan in favor of restricted stock. "We asked ourselves if there is a fundamental flaw in the way that options are set up," says CFO W. Thomas Forrester. Their answer? "Options have a leverage effect that incents different behaviors," says Forrester — and not all of those behaviors are desirable.
Forrester ticks off some advantages of restricted stock: "Restricted stock doesn't have an expiration date. You get short-term thinking with options. With restricted stock, you have the same dividend and voting interest as shareholders." Also, restricted stock is "much more transparent" than stock options, he adds. And when options are underwater, "there's no retentive effect. With restricted stock, there is, no matter the price." Forrester also likes restricted stock because it allows him to more closely control final compensation payouts than he can with options.
The expensing issue had relatively little influence on Progressive's decision to switch from stock options, says Forrester. More than two years ago, Progressive instituted an antidilution policy: the company purchased sufficient shares to offset the exercise of all options, which assures future investors that their equity positions won't be diluted. The net effect is that Progressive virtually expenses its options. It intends to uphold the same policy with its new restricted-stock program-plus, it will have to expense them as well. The company currently has about 12 million options outstanding, and the last of those will expire in 2011.
Progressive will put the change to a vote of shareholders during this meeting season, although it's not required to do so. They're likely to approve the measure, says Forrester. "We just think options are a bad idea," he says, "because they don't align the interest of employees and shareholders. Restricted stock moves more in lockstep."
Pay for Attendance?
But many compensation experts would dispute the notion that restricted stock is superior to stock options. As far back as the 1970s, they point out, restricted-stock plans were maligned by stockholders as "pay for attendance," since executives would receive a guaranteed payout no matter what happened to the stock price.
"I remember 10 or 15 years ago we were trying to get rid of [restricted stock]," says Blair Jones, head of the leadership performance and rewards practice for compensation firm Sibson Consulting. "The last time that stock options fell out of favor was in the '70s, and we had a flat market just like we do now. People were trying to deliver a lot of dollars to executives, and the stock-options vehicle wasn't doing it anymore. So they switched to restricted stock, which was more about pay delivery than performance."
But at least one company, Sealed Air, doesn't worry about whether giving restricted stock to executives actually moves the stock price up. The Saddle Brook, New Jersey-based packing — materials maker doesn't base any employee compensation on changes in stock price. (Nor has it ever offered stock options, except for a small amount inherited from its acquisition of Cryovac in 1998.) Why? Sealed Air believes, as it stated in its 2002 and 2003 proxies, that "total return to stockholders as reflected in the performance of the Company's stock price is subject to factors...that are unrelated to the Company's performance."
CFO David Kelsey instead bases compensation on four interlocking components: cash salary, benefits, nonperformance-based restricted shares granted to employees throughout the company, and a management by objectives (MBO) program (there is also a profit-sharing program). Restricted-stock recipients pay $1 per share for the certificates to the stock, which cliff — vests after three years. There is no holding requirement, but by and large, says Kelsey, employees generally hold on to stock after it vests. "My sense is that we have a very high retention rate," he says.
The principal purpose of the restricted-stock program, says Kelsey, is "to align management and shareholder interests." Sealed Air views the stock not as a performance incentive but rather as a pure equity-delivery vehicle. The company leaves the job of incentivizing executives to its MBO and profit-sharing plans, which are usually paid in cash, and occasionally in stock. Bonuses are based on improvements in operating income and return on assets, coupled with individual objectives.
Does the lack of options put Sealed Air at a disadvantage in recruiting talent? Kelsey doesn't think so. "The company has traditionally developed a lot of its management talent internally, but the company does recruit outside," he says. "And there are a lot of positive things to be said for a company that espouses the values that Sealed Air does."
Blast from the Past
Questionable incentive power aside, the main reason restricted stock fell out of favor in the 1970s, and again in the 1980s, is that companies came to rely too heavily on it as the sole long-term incentive vehicle for executives — much as they did with stock options. And since restricted stock usually comes with a vesting date, executives could have similar incentives to inflate the company's stock price through dubious means.
As for accounting treatment, although restricted stock can be charged to earnings over the period of restriction (usually three to five years), the entire stock grant is immediately dilutive to earnings per share. And if the stock declines in value after the grant, the tax deduction when restrictions lapse is smaller than the charges to earnings.
In short, restricted stock potentially offers everything shareholders hated about stock options — and more.
At the same time, restricted stock does have its benefits. Because actual stock shares are involved, with a more secure value (at least at nontech companies), about a quarter of the total shares are needed, compared with options, to deliver equal value to executives, says Brent Longnecker, president of Resources Consulting Group, a compensation consultancy. This is because a restricted-stock payout is more certain than an options payout. And if stock appreciates, the earnings hit will be smaller than the eventual tax deduction when the stock restrictions lapse.
Meanwhile, restricted stock can also be tied to company-specific or indexed performance goals, although few companies currently do so. Such performance-based shares vest only when the goals are reached. Similarly, companies can offer performance units-awards expressed as a dollar figure that can pay out either in cash or stock.
Like restricted stock, performance units are a blast from the past. "PepsiCo was the original creator of performance- unit plans in the early '70s, and today they're coming back," comments Longnecker. "That's because stock changes aren't that dramatic anymore. Stock options are great as long as the market is moving up." Longnecker adds that many companies avoid performance shares because they're hard to budget for, since a company can't (and shouldn't be able to) reliably predict whether the shares will vest. This makes them less attractive from an accounting-simplicity standpoint than straight restricted stock.
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
|Among companies considering changes to their long-term incentive plans:||30% will restrict eligibility for stock options at lower levels|
|27% will convert options to restricted stock or performance shares|
|30% will deliver at least 10% fewer options in long-term compensation|
Source: Hewitt Associates's 2003 survey of 178 major U.S. cos.
|Nonqualified Stock Options|
Grants the option to buy stock at a fixed price for a fixed exercise period; gains from grant to exercise taxed at income-tax rates
Outright grant of shares to executives with restrictions to sale, transfer, or pledging; shares forfeited if executive terminates employment; value of shares as restrictions lapse taxed as ordinary income
Grants contingent shares of stock or a fixed cash value at beginning of performance period; executive earns a portion of grant as performance goals are hit
• Aligns executive and shareholder interests
• No charge to earnings
• Company receives tax deduction
• Dilutes EPS
• Executive investment is required
• May incent short-term stock-price manipulation
• Aligns executive and shareholder interests
• No executive investment required
• If stock appreciates after grant, company's tax deduction exceeds fixed charge to earnings
• Immediate dilution of EPS for total shares granted
• Fair-market value charged to earnings over restriction period
• Aligns executives and shareholders if stock is used
• Performance oriented
• No executive investment required
• Company receives tax deduction at payout
• Charge to earnings, marked to market
• Difficulty in setting performance targets
Executives aren't so quick to flip restricted shares.
Most experts believe that if executives treated restricted stock the way they have treated stock options — that is, sell immediately upon vesting — restricted stock would be an all-around poor substitute for options from both an incentive and a retention standpoint. But anecdotal evidence indicates that executives tend to hold on to restricted stock, even after the restrictions lapse, for longer periods than they do with options.
The reasons for this are obvious. One, most companies that use stock options present them to employees as a substitute for cash compensation, often because a company lacks the cash flow to pay top salaries. Two, options are a poor equity-delivery vehicle. The "cashless exercise" of options delivers the promised cash directly into executive pockets, but in order to exercise options and then retain the resulting stock, a massive cash outlay by the executive is required. The economics of the transaction itself encourages executives to cash out rather than hold.
Conversely, executives may hold restricted stock because to do so costs them little or nothing. Additionally, stock ownership is very good PR with shareholders. About 30 percent of S&P 500 companies require executives to own company stock, according to the corporate-governance research group The Corporate Library. And corporations are increasing those requirements. In addition to a stock-ownership requirement, General Electric recently changed its rules to require senior management to hold stock obtained through exercised options for at least one year.
And even though some recent studies indicate that beneficial ownership of stock by executives is not correlated with positive corporate performance, another study, by Jack Dolmat-Connell, senior vice president at Clark/Bardes Consulting, uncovered a relationship in favor of executive stock ownership. Dolmat-Connell defined beneficial ownership more narrowly (as actual shares held, rather than total of shares held plus options granted) and found an inverse correlation between the ratio of options to stock held and corporate performance. In other words, the higher the number of options versus the number of actual shares held by senior executives, the worse the corporate performance another argument tipping the scales in favor of restricted shares.