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Another year brings another proxy season, and yet another opportunity to examine trends in executive compensation—to learn from the mistakes and study the victories. A review of Fortune 100 company activity highlights several trends. Some are familiar holdovers from previous years that appear to be gaining steam, while others are new and emerging. One that we hope has legs is the increasing transparency and proactive communication of compensation philosophies, designs and rationales to all company stakeholders. Greater transparency is critical to gaining the confidence of shareholders, improving executives’ focus on business goals and adding efficiency to the boardroom conversations about executive pay.

The forces that have influenced executive compensation design over the past few years remain constant and show no signs of abating. External pressure is fiercer than ever, from FASB’s expense for stock options to the demands by institutional shareholders and watchdog groups to “fix” current rewards systems and ensure that the designs that led to past excesses are not repeated.

In light of these pressures, companies continue to re-examine their executive pay solutions. Many companies appear to be making a concerted effort to use pay as a tool to motivate outstanding business performance, while others have the notion that they can stay beneath the radar and avoid controversy if they follow the crowd. We have observed four primary executive pay trends among Fortune 100 companies¹. They are:

1. The use of multiple long-term incentive plans and vehicles with less reliance on stock options
2. A strong focus on ensuring that pay is commensurate with business performance
3. Solutions that lead to accounting expense and dilution management
4. Improved stakeholder communication

A discussion of these trends follows.

Use of Multiple Long-term Incentive Plans and Vehicles with Less Reliance on Stock Options
Almost across the board, companies are de-emphasizing the role of stock options in executives’ total long-term incentive opportunity. Stock options rarely are the “sole source” of executives’ long-term incentive opportunity these days. Yet, it is important to note that the majority of companies are not replacing stock options completely. The number of Fortune 100 companies² using stock options as their sole long-term incentive vehicle has decreased dramatically: Only 12 percent of the F100 companies studied in 2004 relied solely on stock options, down from almost one-third (30 percent) in 2002.

In general, companies appear to be using several plans rather than putting all their eggs in one basket. The obvious trade-off is increased plan complexity, which brings the risk of confusing participants. Yet diversification makes sense for many companies because stock options are better at fulfilling some design objectives than others. For instance, stock options do quite well in aligning executive and shareholder interests, since they only have value if the stock price appreciates. This is particularly true in companies with significant growth prospects, where most shareholder return comes in the form of stock price appreciation rather than dividends. Stock options also help retain talent when the price is going up. They are attractive to executives who are risk seekers and motivated by the potential for significant gains. However, stock options can be less effective in fostering retention when the market is declining. Options also have limited power to change specific behaviors or focus executive efforts on fundamental business priorities. (See Figure 1.)

FIGURE 1—STOCK OPTION SCORECARD

As companies get smarter about when to use stock options, they are augmenting the pay opportunity with other plans and vehicles to create a more balanced program, reinforce specific business imperatives and address different design objectives. For example, over the last two years PepsiCo has granted its top executives a combination of stock options and performance-based restricted stock units, whereas previously it had granted all stock options. Similarly, Alcoa began granting a combination of stock options and performance-vested restricted stock units that are tied to achieving return on capital goals versus a peer index. Both companies have used the new plans to reinforce business imperatives that reflect their respective industries and company strategies—something that can’t be done with “plain vanilla” stock options. Of the Fortune 100 companies reviewed, more than half (54 percent) use two plans/vehicles, while 17 percent use only one and 29 percent use three.

The most prevalent, and potentially alarming, shift is an increasing use of service-vested restricted stock as the partner of choice with stock options. In 2004, 68 percent of the Fortune 100 awarded service-vested restricted stock as part of the ongoing annual LTI opportunity, up from fewer than half in 2002. Merrill Lynch decided to give up stock options completely in favor of service-vested restricted stock, a trend that Goldman Sachs and other financial services firms started two years ago. Likewise, Lowe’s began granting service-vested restricted stock to executives, whereas for the prior three years grants had consisted solely of stock options.

In many cases, service-vested (also known as time-vested) restricted stock may not be the most effective replacement for stock options. Ironically, the widespread use of stock options was a response to ubiquitous service-vested restricted stock and the “pay for pulse” phenomenon it created, even as the stock market struggled at the end of the 1980s. There are situations, however, in which service-vested restricted stock may be appropriate, such as in certain transitional situations (turnaround), or when a company is experiencing high turnover. Service vested restricted stock can also provide some program stability in a volatile market or when significant external activities are influencing performance outcomes. However, in most cases adding performance conditions is a better way to align executive and shareholder interests by focusing on company performance, at least for the most senior executives. See Perspectives article Look Before You Leap for information on service vested restricted stock

Ideally, companies should base their decisions about pay designs on their own unique combination of business circumstances, talent needs and philosophical considerations. (The sidebar, “How to View and Apply the Trends,” presents approaches that address business, market and talent needs.)

Whether compensated in cash or stock, specific performance requirements are typically measured at corporate or business unit levels, depending upon the participant’s role in the organization. Not surprisingly, as companies wean themselves from stock options, shareholder return measures are the most prevalent metrics tied to vesting or payout restrictions in these new plans6. Among the Fortune 100 companies that filed proxies by April 15, 2005, 45 percent measure TRS/stock price, typically relative to a peer group; 40 percent measure earnings (EBITDA, net income, EPS); 38 percent measure capital returns (ROC, ROIC, ROE); and 12 percent measure revenues. The vast majority (87 percent) of these plans utilize two or more measures—generally balancing measures such as return and earnings measures or sales and profitability. Relative performance goals are more prominent than absolute goals, probably because they are easier for companies to set on a long-term basis.

International Paper is one of the companies using stricter performance measurement standards before paying out long-term bonuses. Since 2004, the company no longer grants stock options to top executives as part of the ongoing LTI opportunity, replacing them with performance-based restricted stock that vests according to relative shareholder return and return on investment performance over three years. Although this plan had been available in prior years, it has now replaced the entire LTI opportunity, increasing its prominence and executives’ focus on these key business performance metrics.

Performance conditions applied to earning/vesting of certain awards present the opportunity to ensure both shareholder alignment and focus on business priorities. They address one of the key shortfalls of options by more clearly communicating the most important actions for driving business strategy and ultimately creating shareholder wealth. Goals should be set in light of “top down” business needs and in consideration of “bottom up” organizational capabilities. Participants in incentive plans must clearly recognize the relationships among business goals, required expected contributions, and their roles and ability to contribute.

Accounting Expense and Dilution Management
Predictably, many companies are intently focused on FAS 123R and new expenses they will now incur. A number of Fortune 100 companies are also attempting to manage this potential accounting expense and reduce share dilution in their redesign efforts. For instance, some companies are altering stock option terms or grant frequency, exchanging stock options for restricted stock at ratios favorable to the company, or managing dilution with stock appreciation rights (SARs). As mentioned previously, the most common method of reducing potential dilution is to use restricted stock, which reduces the number of shares granted. The accounting charge can only be reduced by granting fewer restricted shares than the present value methodology would imply (e.g., a company-favorable restricted shares to stock options “trade”). Reductions in eligibility and participation are also part of this trend to reduce dilution and expense, although typically these reductions are occurring below the executive level. Time Warner announced it would no longer grant stock options to most employees, explaining that the new accounting rules would make it prohibitively expensive. Some companies are also granting stock options with shorter option terms. For example, the proxy statements for Alcoa, CVS Corporation and Lowe’s indicate that the stock option terms have been shortened to six years, seven years and seven years respectively; the norm, however, remains 10 years.

Although accounting is a pivotal consideration, the economics of the different vehicles (i.e., the cash flow and dilutive impact) have not changed one iota. Companies should pay particular attention to the economic costs of equity compensation. See Perspectives article Unassailable Executive Pay Demands for more information. Metrics such as run-rate and overhang are still valued by many institutional investors, but we believe the focus will gradually shift to value transfer or return on investment measures that expressly account for performance. Further, most sophisticated investment managers don’t make investment decisions based on GAAP earnings, but on discounted cash flows, which can be more negatively affected by service-vested restricted stock than stock options. That’s because restricted stock has value even when business performance is flat or declining. Companies changing their eligibility/participation profiles should do so based on business circumstances, participant line-of-sight and philosophical considerations, not solely to reduce the accounting expense.

Stakeholder Communication
Given the amount of change in executive compensation along with blatant abuses highlighted in the press, it should come as no surprise that company stakeholders are seeking clarity. Directors, shareholders and participants must decipher ever more complex compensation designs. Compensation committee members must evaluate compensation plans if they are to exercise their fiduciary oversight and ensure the company does not make headlines for approving a too-rich package not linked to performance. Shareholders want to know that the pay is appropriate for the value they receive in share price increase and dividends, and that directors diligently enforce this relationship. Participants struggle to make sense of the proliferation of measures, goals, milestones, timeframes and related pay opportunities. There is a risk that participants may not “get it” and, as a result, may discount the value of the programs or just give up trying to understand them.

Therefore, as they develop plan designs, companies need to face tough questions—all of which point up the need for good communications:

• How do we ensure the compensation committee has the information it needs to be comfortable with the plans and consequences?
• How do we prove we are doing the right thing for our shareholders and get credit for doing so?
• How do we get the full value from this plan with participants by focusing their efforts and encouraging the right behaviors?

Early signs indicate that companies are increasing both the transparency of plan designs and the rationale for compensation decisions, and are making greater efforts to communicate the cause-and-effect relationship between performance and pay to all stakeholders, internal and external.

Communication to External Stakeholders
While compensation communication is a hot topic being discussed by the SEC³, positive trends are already visible among companies that are proactively communicating the basis for their plan designs. A study conducted in 2005 by Equilar, Inc. found that among a 100-company sample from the Fortune 1500, almost three-quarters were making some changes to the compensation committee report section of their proxies. Among these companies, 60 percent reported changing about a quarter of the information presented in the report compared to the prior year, while 14 percent were rewriting a significant portion. Overall, companies have added about 15 percent more material to their compensation committee reports from 2003 to 2004.

Companies that hesitated to use compensation committee reports as a communication vehicle could learn from companies that disclose information to their advantage. There are at least four critical items to include in the report:

1. Definition of pay/performance benchmark peer group, rationale for inclusion, and any changes made between years
2. Description of eligible population and rationale for inclusion
3. Explanation of incentive plan mechanics, including measures and weightings
4. Details of financial and operational results and impact on pay

BD (Becton, Dickinson and Company) describes its 14-company peer group in its report, identifying eight companies as its performance peers and the other six as talent competitors. International Paper goes one step further, providing the peers used for benchmarking pay and performance and calculating incentive pay, and discussing the changes made to the peer group from the previous year to this year. While listing the peer group does not in itself assure shareholders of a good return on the compensation dollars spent, the disclosure tells executives and shareholders that pay has been positioned intentionally against competitive opportunities at other companies.

Companies such as International Paper are enhancing the detail in the compensation committee report to describe eligible populations and incentive plans, including which measures are used in each year and the respective weightings. (See Figure 2.)

FIGURE 2

“During 2003, the Company, with the Committee’s approval decided to discontinue the stock option program in 2004 for members of executive management, and in 2005 for all other eligible U.S. employees. In the U.S., the stock option program was eliminated and replaced with performance-based restricted shares for approximately 1,250 eligible employees. The annual targets under the MIP were increased for those not eligible for performance based restricted shares…As a result, all compensation for domestic salaried employees is now performance based. “The Company has granted performance-based restricted shares annually under its Performance Share Plan (contained within the LTICP) (“PSP”) to approximately 120 executives in leadership and strategic positions since 2001. Under the PSP, performance shares generally have been granted at the beginning of each year and paid at the end of a three-year performance period based on the achievement of defined performance objectives (ROI and TSR, as described above). In 2004, the target awards under the PSP were increased to compensate for the loss in value previously awarded under the stock option program. “For each of the awards issued under the PSP through 2004, the Company’s performance was measured against the ROI and TSR Peer Groups, weighted as follows: 75% for return on investment, and 25% for total shareholder return.”4

CardinalHealth discloses its bonus calculation, emphasizing how its pay-for-performance philosophy prohibited awards for executives in spite of EPS growth. (See Figure 3.)

FIGURE 3

Communication to Internal Stakeholders—Compensation Committee Members
Compensation committees must sift through an enormous amount of information to make sense of compensation programs, particularly the inter-relationships and potential impacts under different performance scenarios or business events. Because these bodies meet infrequently, they must make efficient and effective use of their time together to ensure their compensation decisions are business-based. Making total rewards information available in a straightforward, comprehensible format allows directors to do just that.

Companies are employing three tools to help compensation committees understand the objectives of a given design and the rationale behind it.

The first tool is an assessment of the company’s business and market characteristics, talent needs, and performance and rewards strategy. (See Figure 4).

FIGURE 4—HOW SHOULD THE MIX BE SPLIT BETWEEN FIXED AND VARIABLE PAY?

This tool can help compensation committee members understand how the company’s unique circumstances might influence design decisions and contribute their own ideas. Tally sheets are another tool to help the committees understand the full financial impact of disparate rewards decisions. Tally sheets can prompt meaningful conversations about stewardship and fiduciary responsibility—discussions that can head off embarrassing “surprises.”

Tally sheets provide the complete picture of compensation, both for the CEO and the executive group as a whole. A tally sheet might include base salaries and annual incentives for the last three years, plus long-term incentives and gain opportunities for the same three years. It also could illustrate what the likely realized gains might be under various performance scenarios. Added to that would be retirement income at different points in time and potential payouts if executives were terminated or retired.

A final tool to aid understanding is an internal equity pay audit. This analysis shows the relationship of pay for the CEO to other executives and how that relationship may have changed over time. By evaluating this relationship, the committee can determine if it appropriately reflects the difference in relative importance of different executive roles as well as the operating style of the management team. See Compensation Standards website for more information.

Communication to Plan Participants
A company’s ability to communicate its pay approach and compensation programs is critical to its success. Companies invest millions of dollars to motivate and retain key executive talent, but the full value of this investment often goes unrealized because executives are in the dark about it.

With the new designs that are emerging, the risk of inadequate returns on compensation investment is higher than ever. If executives do not understand a program from the start, or if the program’s key components and progress toward goals are not communicated regularly, the plan risks losing its performance impact. The costs to an organization can go beyond misunderstanding, leading to turnover of key employees who fail to see potential in their compensation plans.

A 2003 Sibson study of 1,100 employees examined attitudes toward performance and rewards. One of the areas covered was compensation practices. Interestingly, only 25 percent of employees felt their company actively shared information about how pay ranges and grades were set within the organization. While many companies tend to be secretive about pay, this lack of openness about the pay system (only 41 percent of respondents were satisfied) was a major driver of turnover. In fact, employees’ level of satisfaction with the pay system, the openness of communication and their understanding of the pay system all contributed to higher levels of turnover than actual pay levels. Additionally, satisfaction with pay level was linked to the level of understanding about the pay system.

The most effective companies help participants understand how the compensation program links to and supports the business strategy. Conversations about achieving the strategy are constant, keeping the key themes of the compensation program front and center.

To aid communication, more companies are using web-based tools. The benefits of web-based communications are clear: personalized information is available when it is needed, performance against goals can be frequently updated, and an individual’s total compensation potential can be aggregated and displayed as one number. In addition, these targeted and personalized communications can be distributed across large populations without losing the richness of the message or increasing costs. (See Figure 5 for an example.)

FIGURE 5

What’s the gamble in making more pay process information available? Clearly it can be a win-win: Studies show that when communication is open, executives are more likely to be satisfied with their total pay opportunities, see pay decisions as fair, and be motivated by the link between their behavior and pay.

Summary
It’s clear from the 2005 proxy season that executive compensation design is continuing to evolve, opening up the possibility of strengthened programs and better shareholder alignment. But it is not enough just to follow the trends. That would be the easy way. Companies that seize the opportunity to design executive compensation plans that respond to the trends and reflect their unique business needs have a chance to move ahead, adding compensation to the set of management tools that can drive competitive advantage.

Sidebar: How to View and Apply the Trends
While trends offer insight into alternatives and options, the focus should be on using these practices to meet the company’s business strategy, market characteristics and talent needs.

Just as a company’s business strategy is unique and crafted to create an advantage over competitors, compensation strategy should fit the distinctive nature of the business. For example, one company that relies on dividends to deliver value to shareholders (as in an REIT) decided to use restricted stock in place of options, which only reflect stock price appreciation. On the other hand, a start-up company with cash constraints but large potential upside used stock options to secure the type of entrepreneurial talent that desires a highly leveraged risk-reward relationship. Another company, which had stagnated, wanted to focus executives on top-line growth rather than taking expenses out of the business. It incorporated a cash long-term incentive (LTI) with revenue and earnings growth measures to drive home this message.

Business and talent needs also inform the decision about which vehicles are right for the company and business strategy. For example, if considering full-value shares or an appreciation vehicle, the following characteristics should be considered:

• Business needs and market characteristics: Consider business stages and growth potential. For example, a company with limited growth potential may favor full-value shares. Full-value shares are also appropriate for a company focused on total return to shareholders, dividends and cash flow, or for one experiencing high stock volatility. In contrast, a company in a high-growth phase or with high stock appreciation or low stock volatility might consider appreciation vehicles.
• Talent needs and characteristics: If incentive plan participants are more comfortable with vehicles that offer a lower risk and, in exchange, a lower reward, full value shares are appropriate. A company with a high risk of turnover should consider full-value shares as well. The opposite situations—high risk/reward profile or low turnover—favor appreciation vehicles.
• Performance/rewards philosophy: Use full value shares to insulate participants from downside risk or provide moderate wealth accumulation opportunities. Appreciation vehicles provide greater upside potential—and risk—along with significant wealth accumulation opportunities.

Sidebar: Strong Focus on Business Performance Alignment
While many companies have shifted to service-vested restricted stock to complement stock options, 2004 proxies also indicate that a growing number of companies are considering a stronger focus on changing behaviors by incorporating specific business performance priorities as vesting criteria in their long-term incentive plan metrics. Although fewer than half (43 percent) of the new plans implemented by Fortune 100⁵ companies (including those instituting multiple plans) had performance restrictions, that figure is significantly higher than the 37 percent a year earlier. This business focus is manifesting itself in the use of specific metrics and goals for determining vesting and payout.