As the global financial crisis and economic downturn unfold, directors and senior management teams are trying to come to grips with the implications for their business and human capital strategy. Despite concerted action by governments in Europe, the US and Asia, world stock markets continue to decline, loosening equity retention hooks, diminishing alignment to future improvements in performance and leaving executives vulnerable to poaching by competitors.
Governments are imposing restrictions on executive remuneration at financial institutions that benefit from rescue efforts, and these constraints may be a harbinger of future regulation of executive remuneration programmes.
Shareholders are seizing the moment as well. They are calling for constraints on a range of executive pay and severance arrangements, continuing demands for pay for results and decrying pay for failure. This environment has significant implications for executive rewards and talent strategies for the next several years, as well as pay actions for the short term. Several issues are surfacing at once, including:
• How should companies structure long-term incentive (LTI) and equity grants in 2009 to balance delivery of competitive compensation value with the potential for dramatically increased share consumption?
• How do we ensure that programmes are aligned with 2009 business objectives?
•How can organizations ensure that their rewards programmes motivate and retain executives for the long term?
• What implication does the regulatory environment have on the future design of executive remuneration programmes?
We believe practices in 2009 will be vastly different than in previous years. The confluence of economic, regulatory and shareholder oversight may lead to reconsideration of compensation strategy. For many companies, this will result in at least a near-term reduction in LTI value and a rebalancing of the LTI component. As we look to the future, we anticipate that companies will assess the overall mix, performance alignment and risk characteristics of their executive pay programmes to respond to the environment.
In the near term, companies are wrestling with their equity guidelines for 2009. Most companies calibrate their LTI awards for participants in value rather than using fixed share guidelines. With equity markets down 40% or more, for many companies the number of shares required to deliver the same value of awards will increase dramatically.
Similarly, those with fixed share guidelines face the prospect of delivering much less value than in previous years. For example, if a company wishes to deliver $100,000 (Rs49.2 lakh) of value in full-value shares and their stock price has declined from $50 per share to $25 per share, the number of shares required to deliver that value is 4,000 (=$100,000/$25) versus 2,000 when prices were at $50 a share, a 100% increase in the number of shares.
In?other?words,?if that company had a share run rate of 1.5% in 2008 when prices were higher, the same share run rate in 2009 could be 3% as a result of the decline, which may not be tolerable for shareholders in a declining market. Furthermore, the increased share usage might put an untenable stress on the shares available for grant in a company’s equity plan and, if the equity market decline is temporary, it could result in unintended consequences of a windfall.
2009 is a game changer
We believe many companies will be hard-pressed to maintain the same value of LTI grants for upcoming awards. The current economic turmoil is unprecedented, so 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.
•Reducing value by a fixed percentage: Some companies are considering an across-the-board haircut to target LTI grant values.
• 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.
•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, 25-50% increase).
• Calibrating grants in light of performance: Performance for 2008 can be used as a barometer for grant sizes.
Padmaja Alaganandan is India business leader, and Gyananjan Kaur is consultant, human capital, at Mercer Consulting (India) Pvt. Ltd.
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This is the first in a three-part series. The second part will look at possible courses of action for companies in 2009.