Nygard JCB SeptOct15-7

Corporate Equity Award Amnesia:
Acknowledging Past Performance in Equity
Award Grant Sizing
David M. Nygard, Senior Consultant, Arthur J. Gallagher & Co.'s Human Resources
and Compensation Consulting Practice*
The demand for linking cor-
porate pay to performance has
been growing over the past 15
years, at least. Equity awards,
the largest element of executive
pay, is generally delivered in the
form of full value shares. Equity
awards are based on perceived
market value targets and do not
vary with past stock price per-
formance (“Static Award
Methodology”). This article out-
lines a straight-forward way to
consider stock price perfor-
mance in the sizing of annual
equity-based incentive awards
(“Dynamic Award Methodol-
ogy”) thereby improving plan
share reserve levels, burn rates,
disclosure optics and pay for
performance comparisons.
Anyone who has watched
television sitcom shows from
the 1960s and 1970s is most
likely familiar with the “amnesia
episode.” In it, a primary char-
acter receives an “innocent”
bump on the head and “suers”
a radical personality change.
Usually the injury erases, or
dramatically and selectively
alters, the character's recollec-
tion of the past—familiar man-
nerisms and relationships are
altered or thrown out the
window. The character has a
whole new spin on his or her
life, beliefs, and their potential,
if only temporarily.
To a very real extent, many
corporations act like sitcom
characters that have been
freshly bumped on the head
each year when calculating their
equity award grant sizes using
today's stock prices and pre-
determined award value targets.
The organizational triumphs and
transgressions of the past are
washed away and the focus of
corporate memory is shifted, if
just for that moment, to the
present day and the uncharted
future yet to come.
Those charged with the man-
agement of compensation pro-
grams are trained to see equity
awards through an expensing/
disclosure optics lens, and they
set award value targets using
general market data, surveyed
or otherwise. This is the same
process employed for setting
other components of pay, such
as salary and bonus levels.
However, equity awards are not
like other pay elements in the
rewards mix, and when organi-
zations frame them like salaries
or bonus opportunities, the
long-term perspective of stock
price momentum is lost. This is
where organizations enter into
this state of “amnesia.”
In an age of intense media
scrutiny of executive pay,
shareholder advisory tests and
reviews, say-on-pay votes and
the onset of the Securities and
Exchange Commission's pro-
posed “pay versus perfor-
*DAVID NYGARD is a Senior Consultant at Arthur J. Gallagher & Co. with more than 20 years of experience in the field of
executive compensation. During his career, David has evaluated, designed and communicated rewards programs within the U.S.,
Europe and the Middle East. He has extensive experience in developing and valuing equity and cash-based long-term incentive
programs and calculating their periodic impact on corporate financial statements.
Journal of Compensation and BeneŽts E September/October 2015
© 2015 Thomson Reuters
32

mance” rules, this could be the
perfect time to shake free from
selective equity award amnesia.
NEW HIRES VERSUS
STAFF VETERANS
The corporate performance
accountabilities placed on em-
ployees dier greatly between
new hires and long-tenured,
veteran incumbents—even if
they have essentially the same
jobs. New hires have been se-
lected for their potential, to add
capacity to the current manage-
ment team, and improve future
performance. The new hires
may have many years of expe-
rience, but their actual contri-
bution to the company remains
to be proven. Past performance
elsewhere cannot be used to
calibrate salary adjustments,
bonus opportunities or long-
term incentive awards.
For new hires, initial pay op-
portunities and inherited incen-
tive performance targets are set
from the date of hire going for-
ward to reect broader corpo-
rate talent objectives as they
relate to the labor marketplace
and established strategic
objectives. New hires are gen-
erally given a formal or informal
grace period in which they are
allowed to learn the corporate
culture from the inside and Žnd
the ways to best satisfy and
implement the needs and re-
quirements of their position. Af-
ter that initial grace period,
however, they will be judged on
their merits, joining the ranks of
all the other employees and
becoming sta veterans.
Veteran employees are held
directly accountable for the
corporate performance out-
comes related to the duties and
responsibilities of their position.
Their performance and produc-
tivity is carefully measured
against clear goals, targets and
objectives. These seasoned
employees generally do not
automatically receive annual
salary and bonus opportunity
increases. Rather, raises are
contingent on meeting perfor-
mance objectives. This link of
merit to pay, however, does not
typically apply to the annual
grant size of corporate long-
term incentive equity awards
veteran employees receive. At
each equity award, shares are
calibrated using today's stock
prices to deliver pre-set value
targets at the date of grant.
This is done anticipating that
the actual values delivered in
the future will be a function of
stock price and performance
metric outcomes as these long-
term incentive awards vest and
become earned income.
EQUITY AWARDS ARE
NOT LIKE THE OTHER
ELEMENTS OF PAY
Equity awards are designed
to provide rewards that vest
over several years for accom-
plishments over the long-haul
to veteran employees that are
best positioned to impact per-
formance over time and who
stay around to make sure the
job gets done. Most other ele-
ments in the executive pay mix
are focused on satisfying imme-
diate and on-going needs or se-
curity concerns and reinforce
speciŽc, annually established,
goals and objectives. To get an
idea of where long-term equity
awards Žt in the executive pay
mix it is useful to review the
four primary dynamic elements
to executive compensation:
Base salary, including cost of
living, merit and promotional
increases.
Short-term incentives (also
referred to as annual bonuses),
which measure performance
over a period of one year or
less and are almost always paid
in cash.
Long-term incentives (also
referred to as equity awards),
which are typically denominated
in shares of stock and reward
performance for a period of
time greater than one year.
“Other” elements which in-
clude beneŽts and perquisites,
such as basic beneŽts, SERPs,
other retirement programs, per-
sonal use of aircraft, Žnancial
counseling and other beneŽt
and perquisite plans.
As the pie chart below sug-
gests, the value of long-term
(usually equity-based) incen-
Corporate Equity Award Amnesia
33

tives typically dwarfs the value
of other elements of executive
compensation, especially for CEOs.
Source: How AP and Equilar Calculated CEO Pay, The Associated Press/The New York Times May
26, 2015
In the 1980's the equity slice
of the mix was smaller in value
and corporate awards were
typically made in set numbers
of shares for select levels within
the organization. In the 1990's
this pattern shifted to value
targets as the expensing of
stock awards became annual
balance sheet footnote and the
Black-Scholes model entered
our vocabulary. By 2005 and
the roll out of FAS 123R this
shift to the variable shares and
value target approach to equity
awards was nearly complete.
In 2009, an interesting phe-
nomenon occurred: after more
than a decade of constant in-
creases, CEO year-to-year pay
levels declined, mostly due to a
16% decrease in total long-term
incentive (“LTI”) grant values
while overall total shareholder
return (“TSR”) declined by 38%.
This was followed by an up-
tick of 20% in CEO LTI grant
values, while TSR in 2010 im-
proved by 33%.1
This 2009
CEO pay reduction in LTI
awards was attributed to share-
holder displeasure of overall
TSR performance and share
plan award limitations. In those
early days of the Great Reces-
sion, delivering business-as-
usual target award grants re-
quired a doubling, or for some,
tripling or more of annual award
shares to deliver LTI value
targets. This was especially dif-
Žcult for stock option plans that
used a lot of shares to deliver
equity award values. Companies
were hesitant to provide 100%
of the target value in fear of an
annual shareholders' meeting
revolt. It was at this time, too,
that full value share awards
began to eclipse less ecient
stock options in both size and
prevalence.
The manner in which equity
awards dier from other ele-
ments of the executive pay mix
is also clearly communicated in
the way that public companies
Journal of Compensation and BeneŽts
34

describe them. Within the equity
incentive plan document of a
publicly traded company, there
is inevitably a narrative similar
to this: “The purpose of the
Plan is to promote the overall
Žnancial objectives of the Com-
pany and by attracting and re-
taining talented executives and
motivating the employees se-
lected to participate in the Plan
to achieve long-term growth in
share values thereby linking
their interests to those of our
shareholders.” In the Compen-
sation Discussion and Analysis
(CD&A) section of a company's
proxy statement, there is com-
monly a statement disclosing
that equity award value targets
are determined by a statistical
analysis of a peer group of
companies, and that dollar val-
ues are converted to shares us-
ing today's stock prices or a
date immediately prior to the
grant date. But stock prices are
not set independently in a
vacuum. The share price is im-
pacted by all of the employees
and directors who receive reg-
ular equity awards because of
their unique, collective ability as
a group to maximize the per-
ceived value of the company.
This is demonstrated in the
past, demanded in the present
and expected in the future.
This static methodology has
remained in place for years and
is very similar to methods em-
ployed to set salary and bonus
opportunity levels. However,
over the past decade, the equity
award vehicle of choice has
shifted away from appreciation
awards (stock options/stock
appreciation rights [“SARs”])
where incentive values are only
delivered if there is an apprecia-
tion in share price. Today's
most common equity awards
are delivered by a combination
of performance-based shares
(often with TSR-based targets)
and restricted (time-based)
stock or units which deliver sig-
niŽcant award values the day
they are granted.
With the shift to full value
share awards, do award sizes
that are solely based on statis-
tical value targets and today's
stock prices still reect perfor-
mance? One could argue that
corporations are suering from
equity award amnesia each and
every time they determine the
size of their equity award grant
opportunities.
The following illustration was
developed to explore the ramiŽ-
cations of the static award
methodology further.
Three companies with gener-
ally stable stock price histories
experience the following
changes in their stock prices
over the next three years:
Each company has a stable
stock price historically at $100
and one million shares out-
standing, constantly managed
to that number over time,
Company 1—Share price de-
clines 25% each year,
Company 2—Share price in-
creases 25% each year, and
Company 3—Share price de-
clines 25%, and then share
price increases 25%.
Static Award Example
Share
Price
Change in
Share Pirce
Cumulative
Change in
Share Pirce
Target Value
of Equity
Awards
Equity Shares
Awarded
Shares Awarded to
Total Outstanding
Company 1
Year 0 $100.00 0 0.00% $1,000,00 10,000 1.00%
Year 1 $75.00 -25% -25.00% $1,000,000 13,333 1.33%
Year 2 $56.25 -25% -43.75% $1,000,000 17,778 1.78%
Company 2
35

Share
Price
Change in
Share Pirce
Cumulative
Change in
Share Pirce
Target Value
of Equity
Awards
Equity Shares
Awarded
Shares Awarded to
Total Outstanding
Year 0 $100.00 0 0.00% $1,000,000 10,000 1.00%
Year 1 $125.00 25% 25.00% $1,000,000 8,000 0.80%
Year 2 $156.25 25% 56.25% $1,000,000 6,400 0.64%
Company 3
Year 0 $100.00 0 0.00% $1,000,000 10,000 1.00%
Year 1 $75.00 -25% -25.00% $1,000,000 13,333 1.33%
Year 2 $93.75 25% -6.25% $1,000,000 10,667 1.07%
In the table above, equity
shares awarded and the shares
awarded as a percentage of
total outstanding (burn rate)
increases dramatically for Com-
pany 1 (with falling share
prices), while the inverse occurs
for Company 2 (with rapidly
increasing stock prices and
shares to spare). This is not the
relationship one would expect
from a truly performance-based
pay program. In essence, orga-
nizations typically use value
targets (externally driven) and
current stock prices (a static
reference point in time) to drive
the size of equity awards year
after year to reward employees.
This eectively wipes clean
the slate of performance history
at the beginning of every award
cycle to adhere to pre-
determined externally derived
compensation value statistical
benchmarks. The value of re-
ported equity awards are com-
pletely disconnected to TSR
performance by deliberate
design.
In the static award example
above, a 44% reduction and a
56% increase in stock price has
no impact on the reported LTI
compensation opportunities de-
livered each year to these
CEOs. This disconnect between
LTI and past performance can
lead to companies failing the
quantitative tests conducted by
the Institutional Shareholder
Services, Inc. (ISS). SpeciŽcally,
ISS' Relative Degree of Align-
ment (RDA) test compares his-
torical TSR performance to the
annual awarded compensation
values delivered to a company's
CEO.
Most, if not all, annual equity
award incentive plan partici-
pants are long-established vet-
erans with the company carry-
ing the interests of shareholders
over the long haul. They have
impacted stock prices for years,
just as it is expected they will
impact stock prices over future
years.
In 2009, companies' execu-
tive teams were not “made
whole” because the sharehold-
ers were in deep Žnancial pain.
At that time, it made optical
sense to share some of that
pain. If the burden was shared
then, why are many organiza-
tions now bumping their heads,
forgetting the veteran sta to
current stock price performance
relationship for annual equity
awards now? If corporations
are actually trying to link exec-
utive rewards to the experience
of shareholders, shouldn't they
award somewhat larger LTI op-
portunities when prices are
consistently rising and some-
what smaller opportunities when
prices are sliding south?
Wouldn't that improve the link
of executive interests to those
of shareholders in the case of
full value share award targets?
In the proposed SEC Perfor-
mance Versus Pay disclosures,
wouldn't some acknowledge-
ment of past stock price per-
formance in sizing equity
awards enhance the ISS RDA
performance test and the over-
all optics of pay to TSR perfor-
mance?
DYNAMIC AWARDS
Adding historical stock prices
to the process is just one of
36

many possible dynamic ad-
justed approaches to using per-
formance to sizing annual equity
award grants for existing
employees. For simplicity, we
will build upon the static award
illustration and assumptions
from above, by substituting
two-year average stock prices
for today's stock price to deter-
mine the size of annual equity
awards. This simple modiŽca-
tion adds a dynamic recognition
element to modify the size of
equity award grants based upon
two years of stock price per-
formance history.
Dynamic Award Example
Share
Price
Change
in Share
Pirce
Two
Year
Aver-
age
Share
Price
Change in
Average
Share
Price
Cumu-
lative
Change
in Aver-
age
Share
Price
Baseline
Target
Value of
Equity
Awards
Equity
Shares
Awarded
Dynamic
Value of Eq-
uity Awards
at Gramt
Date
Shares
Awarded to
Total Out-
standing
Company 1
Year -2 $100.00
Year -1 $100.00
Year 0 $100.00 0 $100.00 0 0.00% $1,000,000 10,000 $1,000,000 1.00%
Year 1 $75.00 -25% $91.67 -8.33% -8.33% $1,000,000 10,909 $818,182 1.09%
Year 2 $56.25 -25% $77.08 -15.91% -22.92% $1,000,000 12,973 $729,730 1.30%
Company 2
Year -2 $100.00
Year -1 $100.00
Year 0 $100.00 0 $100.00 0 0.00% $1,000,000 10,000 $1,000,000 1.00%
Year 1 $125.00 25% $108.33 8.33% 8.33% $1,000,000 9,231 $1,153,846 0.92%
Year 2 $156.25 25% $127.08 17.31% 27.08% $1,000,000 7,869 $1,229,508 0.79%
Company 3
Year -2 $100.00
Year -1 $100.00
Year 0 $100.00 0 $100.00 0 0.00% $1,000,000 10,000 $1,000,000 1.00%
Year 1 $75.00 -25% $91.67 -8.33% -8.33% $1,000,000 10,909 $818,182 1.09%
Year 2 $93.75 25% $89.58 -2.27% -10.42% $1,000,000 11,163 $1,046,512 1.12%
Notice how the sustained
price performance excellence of
Company 2 is rewarded with
slower reductions in annual
award share targets, which in
turn enhances the incentive op-
portunities delivered at grant.
There is also an increase in
reported expenses, but it is due
to better TSR-related
performance. TSR performance
is now linked to reported LTI
award values. On the ip side,
the stock price slide of Com-
pany 1 results in an increase of
shares awarded but at a pace
that is less than half the in-
crease of the share count that
would have been awarded oth-
erwise, and there is a corre-
sponding reduction in opportu-
nity values delivered each year.
Reported incentive expenses
are also reduced for Company
1 due to declining TSR
performance. Company 3 has
less pronounced changes in
award share counts and the
targeted values delivered/
expenses booked from year to
year track with stock price
performance.
This simple change is sizing
equity awards does a few
things:
Burn rates are moderated—
changes in the number of
shares awarded year-to-year
37

are much less volatile and more
predictable using two-year av-
erage share prices.
Expense is linked to perfor-
mance—The reported equity
plan expense for the largest
component of CEO pay is now
linked to performance at grant,
which also improves the optics
under proposed performance-
versus-pay disclosure
mandates.
Higher share awards are de-
livered for higher TSR—The
management teams that deliver
greater TSR to their sharehold-
ers receive programmatically
enhanced incentive opportuni-
ties—something that is in per-
fect alignment with the interests
of most investors and investor
groups.
ISS RDA test outcomes are
improved—Value adjusted LTI
awards will programmatically
improve ISS RDA test out-
comes, making it much less
likely that a company would fail
the RDA test and face a chal-
lenging say-on-pay vote in the
future.
CONCLUSION
The move towards a dynamic
award methodology began to
emerge about Žve years ago.
While still in small minority,
more and more companies are
considering and some are
implementing a dynamic meth-
odology whereby stock price
performance is taken into ac-
count in the current awards.
This only makes sense as
shareholders expect alignment
of pay and performance. In the
long run, executives managing
successful companies will be
paid more than others.
Consulting and insurance
brokerage services to be pro-
vided by Gallagher Benefit Ser-
vices, Inc. and/or its affiliate
Gallagher Benefit Services
(Canada) Group Inc. Gallagher
Benefit Services, Inc. is a li-
censed insurance agency that
does business in California as
“Gallagher Benefit Services of
California Insurance Services”
and in Massachusetts as “Gal-
lagher Benefit Insurance
Services.” Neither Arthur J. Gal-
lagher & Co., nor its affiliates
provide accounting, legal or tax
advice.
NOTES:
1
2010/2011 Report on Long-
Term Incentives, Policies & Practices—
Towers Watson Data Services.
38

Nygard JCB SeptOct15-7

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Viewers also liked

Viewers also liked (11)

Similar to Nygard JCB SeptOct15-7

Similar to Nygard JCB SeptOct15-7 (20)

Nygard JCB SeptOct15-7