It seems like every few years, there is another twist in the approach to stock options and performance incentives for executives. But the latest shift seems to have deeper and stronger roots.
New accounting standards have put all long-term incentives on equal footing and an era of underwater stocks from 2001-04 has triggered a renewed awareness that external forces - not management decisions - often drive stock prices.
At the heart of the changed attitude regarding stock options and stock incentives is Financial Accounting Standards Board 123R, which went into effect in January.
FASB 123R effectively requires that all forms of equity incentives involving stock be expensed. In the past, stock options did not have to be recorded on a company's financial statement, while other stock incentives tied to performance did, effectively penalizing companies that used them.
``The rules that went into effect at the beginning of 2006 make the accounting for all incentives more favorable because you get fixed accounting [for] awards at your costs,'' said James Reda, managing partner for James F. Reda & Associates LLC of New York. ``The old accounting rules were problematic for performance shares and restricted stock because you had to take that whole expense and account for it in the quarter that it happened. It would cause strange things to happen on the accounting side and companies would get burned.''
``FASB 123R created a level playing field for all long-term, stock-based incentives,'' said Joe Mallin, managing director in the Atlanta office of Pearl Meyers & Partners, the New York-based executive compensation practice of Clark Consulting. ``When companies examine long-term incentives, the accounting issues now fade into the background'' and they can use incentives they think are more geared toward performance.
The change comes at a time when there also appears to be fairly unanimous agreement that rewarding executives with stock options to buy shares at pre-established - and usually lower - prices set on the date of the grant is a good reward tool, but not a very good performance-driving metric.
``Stock options are not a great inducement to drive performance and are not a good retention vehicle when stocks are under water,'' said Jim Aslaksen, global sector leader for the performance materials practice in the Chicago office of Korn/Ferry International of Los Angeles, who recruits executives for the chemical, plastics and packaging industries.
``The change in the price of stock that is directly related to the actual management of the corporation is very small,'' according to Paul Hodgson, senior research associate for board and executive pay at Corporate Library, a research firm in Portland, Maine, founded by corporate governance critics Nell Minow and Robert A.G. Monks.
``Stock price is usually driven by external factors,'' Hogson said, noting that the price of oil can influence the stock prices of oil companies, as well as plastics and chemical companies that are heavily dependent on oil.
Andrew Goldstein, central division practice leader of executive compensation in the Chicago office of Watson Wyatt Worldwide Inc., agreed.
``There is concern about the dilution caused by stock options,'' Goldstein said. ``To many people, stock options are speculative and there is the feeling that day-to-day operational decisions and improvements are less of a factor in stock price'' and that stock price is more influenced by macroeconomics.
Goldstein and others said they have seen ``a fairly dramatic shift'' away from stock options to other forms of long-term incentives, reducing stock options to about 50 percent of the value of the long-term incentive packages from levels as high as 75-80 percent not so long ago.
``Stock options will be about half the mix of long-term incentives, with the rest being performance shares and restricted stock with longer vesting periods,'' Reda said.
Restricted stocks are grants of stock that have a specified vesting period and cannot be sold for a defined period of time. Performance shares are grants of stock that are given to executives only if certain performance goals - such as earnings per share - are met.
``The shift is driven by the desire to use a variety of performance measures ... to better align financial performance with incentive payouts,'' he said. ``A lot of companies are moving toward restricted stock because it forces the chief executive officer [and other members of top management] to make the right moves long-term, even after the payout has been determined.''
More than one-third - or 54 of the 150 executives on the Plastics News executive pay list - received restricted stock in 2005.
But overall, compensation experts said less than 20 percent of compensation plans in the plastics industry use restricted stock.
For companies that use performance shares as a long-term incentive, Reda cautioned that the strategy is not easy to implement properly.
``That is a difficult incentive to use because you have to forecast going forward three or four years - which is hard to do in today's environment because of things like 9-11, Hurricane Katrina and pipeline shutdowns,'' he said.
``Performance shares make sense, but they are really difficult to do,'' said Reda. ``I think that you have to have a reasonably good handle on what drives the performances that you are trying to achieve, and you have to try to achieve a balance between quantity and quality measures.''
Finally, despite the market shift to other long-term incentives, no one is predicting stock options will completely disappear. ``They will be used in tandem'' with other long-term incentives, said Ron Bottano, senior partner in the Chicago executive compensation practice of Korn/Ferry International.
Because of that, he said companies should adopt measures that ``eliminate the negativity that surrounds stock options.''
``They should issue them at a fair market price and they should require the executive to hold stocks for a minimum of one year'' after they exercise the option, Bottano said. ``They should also grant stock options at the same time each year - for example, after they release quarterly earnings and maybe only for a two-week period after that.''
