FINANCIAL PARTICIPATION
Companies overestimate true value of share incentives
Share incentives are worth an average of 60% of salary for chief executives and 29% of salary for executives immediately below board level. These are levels significantly lower than many companies intend because they are using an out-of-date “rule of thumb” to determine the face value of options and performance shares, according to executive reward consultants Watson Wyatt.
An often-quoted “rule of thumb” is that options are worth around 30% of face value (the value of the underlying shares backing the award), and performance shares around 70% of face value. Watson Wyatt believes that these measures are increasingly looking out of date.
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Present Economic Value
Watson Wyatt values share incentives at the date of award, using its Present Economic Value (PEV) method, which takes account of:
the factors which affect the potential value of the award, such as the performance conditions applied
the expected volatility of the share in question.
Based on this method, the average PEV percentage for the option plans offered by the companies in the firm’s latest UK Executive Reward Survey is just 19% of face value. Similarly, performance shares have an average PEV percentage of only 48%, far below the 70% suggest by the usual “rule of thumb”.
According to Watson Wyatt, there is also wide variation between the plans operated by different companies, yet remuneration committees and shareholders tend to focus on the face value of awards under share plans.
Performance conditions getting tougher
Two factors have broken the rule of thumb, according to Sue Bartlett, a senior reward consultant at Watson Wyatt. “First, performance conditions have become tougher following shareholder pressure, with many plans using multiple conditions, or requiring exceptional levels of performance for a full payout. Second, there have been changes in financial conditions, especially a decrease in general levels of share price volatility, which have led to a reduced chance of significant payouts from options, and hence lower values.”
Bartlett reckons this raises two questions:
First, how should companies benchmark their own plans against those of their competitors to help them to decide on their own plan design and how many shares to award? It is clearly not good enough merely to use a “rule of thumb” to value them.
Second, if prospective values are so low, are the motivational effects of long-term incentives being damaged by over-gearing them, leading to a vicious cycle of bigger awards being made to try to re-establish their value? Some would say we are already seeing this in the increasing size of awards at face value and in the increase in annual bonus potential.
“Companies have met the ever-increasing demands of shareholders who expect, not unreasonably, that pay should be linked to performance. This means tougher performance conditions on share incentives,” said Bartlett.
“However, as is often the case, there have been unintended consequences with share incentives becoming less valuable - and being discounted even more heavily in the minds of the executives themselves.”
Watson Wyatt’s research suggest that this has led many companies to find other ways to bring back the motivational element in the package; some have increased the number of shares awarded and some have boosted the annual bonus plan.
In many cases, the annual bonus is seen as more motivating than the share plans not only because its timescale is shorter but also because the performance measures governing what emerges are usually seen as much closer to the executives' own sphere of influence.
A final word
“This trend, if it continues, of larger but less valued share awards will eventually lead to share plans having little or no incentive effect, while still having the potential for a bonanza for the very small number of executives whose share awards vest in full at high prices, possibly happening at the same time as large bonuses. If this happens we will have turned full-circle to a situation where after years of shareholder activism, share plans are just a 'reward' that provide little or no incentive value even though their style and the size of awards has changed completely since the old days of ‘plain vanilla’ share options with no performance conditions.” - Sue Bartlett, a senior reward consultant at Watson Wyatt.
Want to know more?
Watson Wyatt's 2006 Executive Reward Survey is a detailed analysis of the total remuneration of over 1,900 senior executives in 120 of the UK’s largest companies, including 12 of the FTSE 20, large privately owned companies and UK subsidiaries of foreign-owned companies. The report is available only to participants in the survey.
Watson Wyatt Worldwide is the “trusted business partner to the world's leading organisations on people and financial issues”. The firm’s global services include: managing the cost and effectiveness of employee benefit programmes; developing attraction, retention and reward strategies; and advising pension plan sponsors and other institutions on optimal investment strategies. Watson Wyatt has 6,000 associates in 30 countries and is located on the web at www.watsonwyatt.com