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Analyst Alert

Understanding Executive Compensation Policy - Long-term Incentive Plans
By Paul Hodgson, Senior Research Associate
September 26, 2005

This is the third in the series of Analyst Commentaries from compensation analysts at The Corporate Library (TCL) that is examining each section of Executive Comp Analyst (ECA) in detail. The purpose of these commentaries has been not only to explain what users can expect to find in this new compensation tool, but also what The Corporate Library would expect to see from a company that has adopted best practice compensation policies. While this series hopes to provide numerous examples of best practice, users are directed to Senior Research Associate Paul Hodgson's latest book: Building Value Through Compensation (order online) for a comprehensive picture of best practice.

Perhaps more important than any other element of executive compensation, the policy decisions surrounding long-term incentive plans (LTIPs) can demonstrate most clearly a compensation committee's aims in tying executive compensation to long-term value growth at their company. Unfortunately, as a new analysis conducted for The Corporate Library's forthcoming CEO Pay Survey shows, it is the area where most companies demonstrate the weakest relationship between pay and performance. The best practice comments found in this commentary are intended to show users how to either identify or implement those plans and policies that will improve this situation.

The following description lists and describes the data to be found in the Long-term Incentive Plan section of ECA.

Payment Form and Awards Granted in Year
The difference between the awards a plan can grant and those it does regularly grant is shown in these two fields. Payment Form gives the list of potential awards that can be made from a company's LTIP, while Awards Granted in Year lists those awards actually made in the latest fiscal year. A well-mixed LTIP should typically make one or two types of performance-related award every year, utilizing the full range of awards over the life of the plan as most appropriate to the circumstances. Yet it is still true that most companies continue to make single grants of non-performance-related stock options every year, despite the choices available to them.

Awards Vested in Year and Long-term Achievements
The first of these two fields shows which forms of LTIP vested during the last fiscal year - whether stock options were exercised and/or whether other forms of long-term incentive vested on the achievement of performance targets. The achievements field should contain a convincing list of long-term achievements that should justify any payouts or profits received from LTIP grants. But, again as the forthcoming CEO Pay Survey shows, companies are very lax at demonstrating achievements that might be expected to justify what is often the largest proportion of executive compensation.

Maximum Payable - Stock Options, RestrictedStock - StockUnits, Cash, Other
This series of maximum fields is intended to disclose the maximum level of the various LTIP awards either to an individual or group of individuals, annually or over the life of the plan. This is a requirement of Section 162(m) of the Internal Revenue Code, but again companies are lax in compliance.

Target LTIP Payable
As with the annual bonus plan target fields, it is expected that compensation committees indicate the level of target payment expected from a LTIP, usually expressed as a multiple or percentage of salary. This is another field that is sparsely populated owing to poor disclosure.

Option Vesting Rate, Vesting Period, Vesting Frequency and Expiration Period
A summary of the behavior of stock options can be gleaned from this series of fields. There are two fields given in each case. The first field will indicate the most typical practice, while the second will show any other rates, vesting periods, etc applied to stock option grants. The rate at which options vest will generally be given as a percentage, for example 25 percent, showing that the options will vest in four tranches. The vesting period is the length of time it takes for the option to vest in full, most typically three or four years. The frequency at which a stock option vests is most often "annual", though some options vest monthly or every six months, or, in the case of cliff-vesting, the option will vest all at once. Most stock option grants expire after 10 years if they have not been exercised, though some companies are applying shorter expiration periods of five or seven years. A shorter period indicates that some discipline is being applied to options. It is a very poorly performing company that cannot register some stock price increase in a ten-year period; though for an executive to be rewarded for this would not appear to be particularly appropriate. A shorter expiration period would require that progress be made more quickly, and is to be recommended.

Option Deferred Vesting Period
Most stock options begin to vest after only one year; a fact that undermines their claim to be a long-term incentive. Such a deferral would not be registered in this field. Companies properly committed to the long-term would typically delay vesting for three years or more, preventing executives from cashing in on options too early. While a few companies do delay vesting in this way, it is still a rare practice, though one to be encouraged.

Option Performance Measures
The practice of applying performance measures to stock options is another rare practice, but, now that the 'expensing' barrier has been removed from such awards, it is expected that such performance measures will become more common. An earlier Analyst Commentary has already shown the rise in the use of premium-priced stock options, for example. In theory, all stock options should be subject to some form of performance condition, though it will be some time before this theory becomes practice.

LTIP Performance Measures - Corporate
These fields list the set of performance conditions applied to other forms of long-term incentive - either performance-restricted shares or long-term cash bonuses. The same advice that applies to the choice of performance measures for annual bonus plans also applies here. Measures should be tied to the company's strategic plan, should demonstrate real value growth and should combine absolute measures with those comparing the performance of the company to a defined peer group. The Generic List field indicates the complete list of available measures as given in the LTIP rules.

Performance Period, Restriction Period, Retention Period
The first of these fields shows the period over which the performance conditions for long-term cash bonuses or performance-restricted shares will be measured. The Restriction Period field gives the years over which restricted stock or stock units will be restricted, while data in the Retention Period field indicates any time period over which equity that has resulted from a LTIP award must be retained and cannot be sold.

Performance periods are most typically three years, though, given the business cycles of many industries, this is clearly too short. Companies, rather than adopting off-the-shelf LTIPs, should apply to their individual plans the practices that are most closely related to their product or business cycle or their strategy. If it typically takes eight to 15 years to see a pharmaceutical product to market, for example, then a performance period closer to this time period should be adopted. Likewise, restriction periods are often far too short for such awards to be properly called long-term incentives, many beginning to vest after only one year. The vesting of restricted stock, especially if not subject to performance-acceleration, should be restricted until retirement or, in some cases, after retirement. Such an end can also be achieved by applying a retention period to these grants. However, retention periods should be applied to other forms of long-term incentive award also, particularly stock options, which are often cashed out immediately, or soon, after exercise.

Total Shares Reserved For Equity Schemes, Dilution, Last Addition of Shares Reserved for Equity Plans, Year of Last Addition of Shares
Dilution is the issue here. The first field in this series gives the absolute number of shares reserved for all equity plans. The Dilution field calculates this as a percentage of outstanding stock. Last Addition of Shares shows the amount most recently added to the pool of reserved shares, and the final field indicates when this took place. Users will have their own rules for, and attitudes to, dilution, but it should be noted here that our calculations are based on total dilution, including shares reserved for all compensation and benefit plans that use equity as a form of reward.

Repricing and Exchange fields
Most stockholders regard the repricing or exchange of options - even if stockholder approval has been given - with deep suspicion, particularly when directors and officers benefit from the price reductions. These eight fields detail any activity in this area, also indicating where LTIPs will allow the repricing or exchange of options without approval, even when a company may not have taken such action recently.

Stock Ownership Guidelines
Stock ownership guidelines are generally seen as complying with best practice, although recent research, based on findings from ECA, has thrown their effectiveness into question. Nevertheless, they can still be considered a useful failsafe, preventing executives from selling equity that has been granted to them by the company, even encouraging them to purchase stock on the open market - by far the most effective way of aligning executive and stockholder interests. The long list of fields used here has been adopted so that the greatest number of discrete holding requirements can be given. Holding requirements will cover the CEO, any independent chairman, and other levels of executives, as well as, in many cases, director stockholding requirements. The notes field will generally describe the number of years employees are given to meet such requirements, as well as any rules surrounding equity awards. Often, companies require executives to hold the majority of any post-tax equity awards until requirements are met. It should be noted here that, to be effective, stockholding requirements also need to be of sufficient force. An ownership guideline for a CEO of four times base salary is not onerous if he or she is awarded some 400 percent of salary in the form of long-term equity grants each year. Even after sales to pay tax, such a guideline could be met in three to five years without any other action by the CEO.

LTIP Comments
This field contains any commentary that TCL compensation analysts make on LTIP plans and procedures. The entries in this field can include details of: reload or restoration option grant practices; evergreen clauses; a brief description of any amendments or new attributes for LTIPs; or any discounted stock awards. Going forward, the field will also contain either:

an overall assessment of the LTIP and its compliance with best practice policies; or
a series of highlights and/or problems with specific aspects of the LTIP.