FAS 123(R): Long-Term Incentive Plan Implications Presented by:Susan Marcille Ernst & Young Performance & Reward Practice Leader Presented by:Susan Marcille.

FAS 123(R):Long-Term Incentive Plan Implications

FAS 123(R):Long-Term Incentive Plan ImplicationsPresented by:Presented by: Susan MarcilleSusan Marcille

Ernst & YoungErnst & YoungPerformance & Reward Practice LeaderPerformance & Reward Practice Leader

Presented by:Presented by: Susan MarcilleSusan MarcilleErnst & YoungErnst & YoungPerformance & Reward Practice LeaderPerformance & Reward Practice Leader

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ImplicationsImplications

• As a result of option expensing, companies are As a result of option expensing, companies are reviewing their overall compensation strategy, reviewing their overall compensation strategy, especially as it relates to long-term incentives. To especially as it relates to long-term incentives. To do so they are focusing on the following:do so they are focusing on the following:– Fresh look at linkage to current business strategyFresh look at linkage to current business strategy

– Delivering same “value” with less dilution and costDelivering same “value” with less dilution and cost

– Diversification in LTIP’sDiversification in LTIP’s

– Holding periods and ownership guidelinesHolding periods and ownership guidelines

– Performance orientation to vestingPerformance orientation to vesting

– Assessing design features in terms of international Assessing design features in terms of international effectivenesseffectiveness

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Implications (cont’d)Implications (cont’d)

• Cost analysis for alternative LTIP approaches is Cost analysis for alternative LTIP approaches is often important in decision making processoften important in decision making process

• One important objective in LTIP design is program One important objective in LTIP design is program efficiency defined as the relationship between efficiency defined as the relationship between cost and employee perceptions of value deliveredcost and employee perceptions of value delivered

• Cost analysis often includes assessment of Cost analysis often includes assessment of financial statement expense, cash flow and tax financial statement expense, cash flow and tax implicationsimplications

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• Pay elements are shiftingPay elements are shifting– Base salaries will likely remain fairly flatBase salaries will likely remain fairly flat– There will be a higher correlation between There will be a higher correlation between

performance and incentive payoutperformance and incentive payout

• Long-term incentives will likely experience Long-term incentives will likely experience the most significant change and be the most significant change and be delivered via blended arrangements (stock delivered via blended arrangements (stock options, restricted stock, cash-based options, restricted stock, cash-based performance incentives)performance incentives)

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• Companies are evaluating alternative LTIP Companies are evaluating alternative LTIP devices such as:devices such as:– Stock optionsStock options– Restricted stockRestricted stock– Restricted stock unitsRestricted stock units– Performance shares/unitsPerformance shares/units– Stock appreciation rightsStock appreciation rights

• Share versus stock settledShare versus stock settled– OthersOthers


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Impact of IRS Sec. 409AImpact of IRS Sec. 409A

• The term “stock rights” under the regulations The term “stock rights” under the regulations includes stock appreciation rights (SARs) and includes stock appreciation rights (SARs) and nonstatutory stock optionsnonstatutory stock options

• As under the Notice, both stock options and As under the Notice, both stock options and SARs must be in “service recipient” stock in SARs must be in “service recipient” stock in order to be exempt from Section 409Aorder to be exempt from Section 409A– Must be granted at no less than FMVMust be granted at no less than FMV– Cannot have any additional deferral featureCannot have any additional deferral feature

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Stock Options Stock Options

• Companies are continuing to use stock Companies are continuing to use stock options to drive attraction, motivation, and options to drive attraction, motivation, and retention of key talent. However, they are retention of key talent. However, they are reducing the weight of stock option grants in reducing the weight of stock option grants in the total compensation package and/or the total compensation package and/or granting options to fewer employees.granting options to fewer employees.– Trend began even before FAS 123R became effectiveTrend began even before FAS 123R became effective

• Example: the average options burn rate fell 24% Example: the average options burn rate fell 24% for both the Russell 3000 and S&P 500 companies for both the Russell 3000 and S&P 500 companies between fiscal years 2001 and 2003 (3.12% and between fiscal years 2001 and 2003 (3.12% and 2.26% in 2003, respectively)2.26% in 2003, respectively)

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• Companies that decide to utilize stock options as Companies that decide to utilize stock options as part of their LTIP strategy are evaluating part of their LTIP strategy are evaluating alternative design features including:alternative design features including:– Vesting termsVesting terms

• time vs. performance vestingtime vs. performance vesting– Performance features are considered “share holder Performance features are considered “share holder

friendly”friendly”

– Option termOption term• considering shorter termsconsidering shorter terms

– Expected to be one of the most common design changesExpected to be one of the most common design changes– Potentially helps with expense, overhang and volatility Potentially helps with expense, overhang and volatility

related issues (i.e., under-water options)related issues (i.e., under-water options)

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– Holding period for stock acquiredHolding period for stock acquired• Implementing “targeted ownership” programs Implementing “targeted ownership” programs • The existence of stock ownership guidelines is increasingly The existence of stock ownership guidelines is increasingly

being viewed by investors as evidence of good corporate being viewed by investors as evidence of good corporate governancegovernance

• Multiple of compensation, typically base salary only, was Multiple of compensation, typically base salary only, was the most common type of executive stock ownership the most common type of executive stock ownership guidelineguideline– The median CEO multiple of salary is 5xThe median CEO multiple of salary is 5x

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– Switching from ISOs (qualified) to Non-Qualified Switching from ISOs (qualified) to Non-Qualified Stock Options on a select basisStock Options on a select basis• ISO permanent book/tax difference ISO permanent book/tax difference • Belief that participants do not hold stock long enough to Belief that participants do not hold stock long enough to

take advantage of preferential long-term capital gain ratestake advantage of preferential long-term capital gain rates

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Restricted StockRestricted Stock

• Restricted stock may be used much more Restricted stock may be used much more often with these characteristics: often with these characteristics: – Longer vesting termsLonger vesting terms– Performance-based vesting more likelyPerformance-based vesting more likely– Stronger retention incentiveStronger retention incentive– Beware IRS Sec. 162(m) implicationsBeware IRS Sec. 162(m) implications

• Restricted Stock (unlike Stock Options) is not Restricted Stock (unlike Stock Options) is not generally exempt from the $1 mill 162(m) generally exempt from the $1 mill 162(m) limitationslimitations

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Cash Based IncentivesCash Based Incentives

• Cash-based incentives may be introduced Cash-based incentives may be introduced to:to:– Tie incentives to internal value measures over a Tie incentives to internal value measures over a

fixed period of timefixed period of time– Control the income statement impact of the long-Control the income statement impact of the long-

term incentiveterm incentive• CapsCaps• Predictable Predictable

– Reduce dilutionReduce dilution

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Stock Appreciation RightsStock Appreciation Rights

• Stock Appreciation RightsStock Appreciation Rights– Share settledShare settled maintains relatively favorable tax and maintains relatively favorable tax and

accounting treatmentaccounting treatment– Uses fewer plan sharesUses fewer plan shares

• Benefit not realized until SARs are exercisedBenefit not realized until SARs are exercised– 409A Implications409A Implications

• Parity for private company and public company Parity for private company and public company SARsSARs

• Parity for stock settled and cash settled SARsParity for stock settled and cash settled SARs

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Contact informationContact information

Susan H. MarcilleSusan H. Marcille

[email protected]@ey.com, 703.747.0511, 703.747.0511

Ernst & Young LLP

FAS 123(R): Long-Term Incentive Plan Implications Presented by:Susan Marcille Ernst & Young Performance & Reward Practice Leader Presented by:Susan Marcille.

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