FAS 123(R):
Long-Term Incentive Plan
Implications
Presented by: Susan Marcille
Ernst & Young
Performance & Reward Practice Leader
Implications
• As a result of option expensing, companies are
reviewing their overall compensation strategy,
especially as it relates to long-term incentives. To
do so they are focusing on the following:
– Fresh look at linkage to current business strategy
– Delivering same “value” with less dilution and cost
– Diversification in LTIP’s
– Holding periods and ownership guidelines
– Performance orientation to vesting
– Assessing design features in terms of international
effectiveness
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Implications (cont’d)
• Cost analysis for alternative LTIP approaches is
often important in decision making process
• One important objective in LTIP design is program
efficiency defined as the relationship between cost
and employee perceptions of value delivered
• Cost analysis often includes assessment of
financial statement expense, cash flow and tax
implications
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Implications (cont’d)
• Pay elements are shifting
– Base salaries will likely remain fairly flat
– There will be a higher correlation between
performance and incentive payout
• Long-term incentives will likely experience
the most significant change and be
delivered via blended arrangements (stock
options, restricted stock, cash-based
performance incentives)
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Implications (cont’d)
• Companies are evaluating alternative LTIP
devices such as:
–
–
–
–
–
Stock options
Restricted stock
Restricted stock units
Performance shares/units
Stock appreciation rights
• Share versus stock settled
– Others
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Impact of IRS Sec. 409A
• The term “stock rights” under the regulations
includes stock appreciation rights (SARs) and
nonstatutory stock options
• As under the Notice, both stock options and
SARs must be in “service recipient” stock in
order to be exempt from Section 409A
– Must be granted at no less than FMV
– Cannot have any additional deferral feature
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Stock Options
• Companies are continuing to use stock
options to drive attraction, motivation, and
retention of key talent. However, they are
reducing the weight of stock option grants in
the total compensation package and/or
granting options to fewer employees.
– Trend began even before FAS 123R became effective
• Example: the average options burn rate fell 24%
for both the Russell 3000 and S&P 500 companies
between fiscal years 2001 and 2003 (3.12% and
2.26% in 2003, respectively)
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Stock Options
• Companies that decide to utilize stock options as
part of their LTIP strategy are evaluating
alternative design features including:
– Vesting terms
• time vs. performance vesting
– Performance features are considered “share holder
friendly”
– Option term
• considering shorter terms
– Expected to be one of the most common design changes
– Potentially helps with expense, overhang and volatility
related issues (i.e., under-water options)
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Stock Options
– Holding period for stock acquired
• Implementing “targeted ownership” programs
• The existence of stock ownership guidelines is increasingly
being viewed by investors as evidence of good corporate
governance
• Multiple of compensation, typically base salary only, was
the most common type of executive stock ownership
guideline
– The median CEO multiple of salary is 5x
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Stock Options
– Switching from ISOs (qualified) to Non-Qualified
Stock Options on a select basis
• ISO permanent book/tax difference
• Belief that participants do not hold stock long enough to
take advantage of preferential long-term capital gain rates
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Restricted Stock
• Restricted stock may be used much more
often with these characteristics:
–
–
–
–
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Longer vesting terms
Performance-based vesting more likely
Stronger retention incentive
Beware IRS Sec. 162(m) implications
• Restricted Stock (unlike Stock Options) is not
generally exempt from the $1 mill 162(m)
limitations
Cash Based Incentives
• Cash-based incentives may be introduced
to:
– Tie incentives to internal value measures over a
fixed period of time
– Control the income statement impact of the longterm incentive
• Caps
• Predictable
– Reduce dilution
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Stock Appreciation Rights
• Stock Appreciation Rights
– Share settled maintains relatively favorable tax and
accounting treatment
– Uses fewer plan shares
• Benefit not realized until SARs are exercised
– 409A Implications
• Parity for private company and public company
SARs
• Parity for stock settled and cash settled SARs
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Contact information
Susan H. Marcille
susan.marcille@ey.com, 703.747.0511
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Ernst & Young LLP