Current surveys generally reflect practices from early 2008 while proxies reflect long-term incentive, or 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 the following:
• 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 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 may be too much.
• 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, and is scrutinized by shareholders.
• Retention value of outstanding awards: Analyse 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-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.
• Financial expense: Many companies that are aggressively cutting costs and equity expenses may come under review as well. Modelling the impact on accounting expenses will help frame the tolerance for LTI grant levels and balance dilution versus value.
• Shareholder and advisory guidelines: Institutional shareholders and proxy advisers such as RiskMetrics Group 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.
The outcomes of these reviews should be considered holistically to inform appropriate actions, at least for the next few months.
Long-term incentive mix
After deciding on an appropriate magnitude of awards to deliver, companies should assess possible changes, if any, to the LTI mix for upcoming grants. For many companies, staying the course with the current equity strategy will be appropriate. For others, modest action may be required, while still others will require drastic interventions. We recommend consideration of the following:
• Maintain a governing objective of retaining a pay- for-performance philosophy in the programme.
• Confirm the appropriate mix of shares and options, which may impact overall share usage or accounting costs differently than in the past due to the impact of higher volatility on option valuations.
• Use service-based restricted stock for some participants (particularly below the executive level), which supports retention and also may be used to mitigate an overall reduction in LTI value since it is often more highly valued by participants.
• Use performance shares and reassess performance measures and targets so they are calibrated appropriately to reward for business success in the present environment.
• Goal setting for LTI performance plans may be particularly challenging for some companies if their business environment is very volatile, which puts stress on forecasting multi-year goals.
• Potential action steps include assessing the range of performance to determine whether resetting or potentially widening the range for corresponding payouts to account for additional volatility is appropriate; determining the appropriate balance between absolute and relative performance measures; examining the performance period length; and considering the appropriate role of discretion.
• At the end of this article, we include reference to other Mercer perspectives that provide counsel on performance measurement and goal setting.
Use cash-denominated LTI awards, if needed, when equity is scarce. These awards can support competitive delivery of pay, but companies should note that they trigger variable accounting.
Padmaja Alaganandan is India business leader, and Gyan Anjan Kaur is consultant, human capital, at Mercer Consulting (India) Pvt. Ltd.
This is the second in a three-part series. The third part will look at what the focus for companies should be on executive remuneration strategies for 2009.
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