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HR Magazine, November 2002 - Compensation: Weighing Your Options

By Elayne Robertson Demby  11/1/2003
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Expensing stock options should spur HR to rethink their role and value in compensation plans.

It started as a trickle on July 14 when Coca-Cola Co. announced it would voluntarily start expensing stock options granted to employees. That trickle turned into a steady stream within weeks when other corporate giants such as The Washington Post Co., Bank One Corp., General Electric Co. and Wachovia Corp. announced they would begin expensing as well. Then the floodgates opened; even high-tech, option-dependent companies such as Inc. and Computer Associates Inc. jumped on the expensing bandwagon.

The trend caught fire as companies sought to ease Wall Street by providing more transparency and accuracy in financial statements in the wake of corporate accounting scandals. Publicly, companies have stated various reasons for starting to expense stock options. For HR, it’s the result of this expensing that may be most profound if it changes the makeup of compensation plans, as predicted.

In the past 15 years, stock options have become standard fare in many companies’ compensation packages—and not just for senior management. Receiving stock options has become common for thousands of employees, especially those in high-tech startups.

For companies, the appeal is that stock options need not be charged as expenses to earnings statements and, when exercised, firms receive a tax deduction. However, companies that voluntarily expense stock options lose earnings advantage. If stock options “cost” the company, executives will have to take a closer look at their usage and weigh their advantages and disadvantages. Companies may find that stock options in general, or how they’re currently awarded, don’t align with their business objectives. The end result may be a lot of pressure on HR professionals to design, create and implement new types of incentive plans.

“Over the past 10 years there’s been a knee-jerk reaction to designing incentive programs. Now there will be a lot more analysis of stock option programs,” says Blair Jones, a senior vice president at Sibson Consulting in New York. “The fact that this is now ‘costing’ them something will mean that they will have to do more of a cost/benefit analysis to see which design will give them the best return for their dollar.”

Theoretically, she adds, HR should have been doing this all along, but the allure of “free” options meant that most HR professionals did not analyze their purpose within incentive plans. “When something doesn’t cost you anything, you tend to put less thought into how you use it,” she says.

Changes on the Way
Of the companies announcing they will voluntarily start expensing, most seem to be taking a wait-and-see attitude before changing their compensation packages. “It’s too early to tell. There may be some changes, but we just decided to expense last quarter,” says Thomas Kelly, a spokesperson for Bank One in Chicago. More than 20 percent of Bank One employees were granted options in April, he says, and the company plans to grant options again in April 2003, although it may review the plan before then.

In August, General Motors Corp. announced it would begin expensing options in 2003. While GM’s compensation programs are always under review, the company has no plans to change its current practices, says Mark Tanner, GM’s director for financial communications. Approximately 53,000 GM employees hold stock options.

But, which gives all full-time employees options, is thinking about making changes. “We are considering a variety of compensation plans at the moment, but have not made any formal announcement,” says Patty Smith, Amazon’s director of corporate communications. Some form of equity compensation will be part of the package, she says.

Some companies are redesigning their programs in anticipation of stock option expensing, says Henry Federal, a senior consultant and the national practice director for the Compensation and Reward Practice at Findley Davies Inc., a human resources consulting firm in Charlotte, N.C. Federal, who has helped a number of companies through this process, says that these companies’ new plans have a decreased reliance on stock options, use more restricted stock grants as well as cash, and are more performance-based.

Taking Stock
If expensing is being considered or has been adopted, HR should first do a thorough analysis of the stock option program to determine if it meets corporate objectives in the most cost-effective manner, say experts. “If stock options are expensed and reflected as a cost on the balance sheet, then the HR function has more responsibility to align the compensation plan with the goals and objectives of the organization and to be an active participant in creating that alignment,” says Federal.

In reviewing their stock option programs, says Jones, HR executives should ask, “What are we trying to do with this incentive program? Retain employees? Attract employees? Focus employees on meeting financial and non-financial objectives? Trying to build stock ownership across employees? Better align employees’ interests with shareholders’ interests? Recognize top performers?” Depending on how those questions are answered, stock options may or may not be the answer for your company, and how they are awarded and the size of the grants may vary.

Jones says that stock options are not an appropriate tool for motivating employees to meet financial and non-financial goals and, in today’s economic environment, they may not work to retain employees. Furthermore, she says, they may not even help align employees’ interests with shareholders’ interests. “In the 1990s,” she says, “a rising tide raised all ships, meaning that stock options weren’t that effective a tool in aligning employees’ and shareholders’ interests because [employees] didn’t have to do anything to get substantial awards.”

Experts predict that—particularly with broad-based plans in which almost every employee gets options—there will be a lot more soul-searching about whether the plan is really appropriate for the organization.

“A lot of companies got lazy and gave stock options as a percentage of pay without thinking about it,” says Federal.

The stated purpose of most rank-and-file stock option programs, says Jones, was to build stock ownership and to align employees’ interests with the shareholders. However, most employees viewed options as a surrogate for cash compensation and generally sold the shares immediately after exercise.

“The reality was that stock options in the 1990s allowed companies to let the stock market pick up some of their compensation costs,” says Fred E. Whittlesey, an independent compensation consultant in Seattle, who formerly served as director of compensation at

Stock options morphed from being an incentive into an entitlement for the rank and file, says Federal, because employees were given them every year and made money on them every year. “The point of incentives [should be] that they are not attained every year,” he adds.

Lots of Options
For some companies, expensing will have no impact if they do not rely heavily on stock options or if HR’s analysis reveals that the programs meet their needs. However, even if stock options are retained, HR professionals will probably feel the need to tweak programs beyond the plain vanilla type.

For example, according to Michael Powers, a leader of the executive compensation practice at Hewitt Associates in Lincolnshire, Ill., large U.S. multinationals tend to award the same number of shares around the world based on U.S. market practices. Now, many companies may start using competitive market data for specific geographical regions. By following market practices in each region, says Powers, companies may save on compensation costs while still paying competitively for that region.

Federal believes that more performance-based stock option programs—with stock option grants earned rather than merely given out to all employees as a percentage of pay—may be an end result of expensing. “There are a lot of companies,” says Federal, “where every year they tell all employees that they’ll get ‘X’ percent of pay in stock options. Those plans may go away in favor of plans that say, ‘We have to have a revenue growth rate of 20 percent or earnings per share growth rate of 15 percent per year, and if we hit that number over a three-year period you will earn X number of stock options.’ ”

At the executive level, stock options will still be used, but there will be more requirements attached to them. “There is increased pressure from investors to limit executive pay and make it more focused on what makes the most sense for that business,” says Powers. “But stock options will still represent a significant part of executive pay,” he says.

However, the days of executives exercising their options and flipping them for substantial financial gains will probably come to an end. General Electric, for instance, has announced a one-year holding requirement after exercising options.

In addition to that requirement, Federal says a company may mandate executives to own shares valued at five times their pay, and require executives to hold all shares from exercised options until they meet the level mandated in the stock ownership guidelines. This would better align executives’ interests with shareholders’ interests, says Jones, so that only those executives whose companies outperformed their peers would get rewarded.

Expensing also could lead to changes in vesting schedules, the amount of time the options must be held before being exercised, says Whittlesey. Or companies can reduce the number of options or grant them every other year instead of annually.

The number of employees getting options and the size of the grants most likely will diminish both for the rank and file and executives, says Andrew Goldstein, central division practice leader for executive compensation at Watson Wyatt Worldwide in Chicago. Expensing thus will accelerate the trend of rewarding only star performers, he says.

Of course, says Jones, this will put pressure on HR to come up with new ways to measure performance objectively. “It’s been a leading-edge trend for companies to segment their employee population and to focus on those who will make a clear contribution to the company as opposed to treating all employees the same,” she says. 

 One result of expensing most likely will be the increased use of cash for compensation, says Federal. With cash and stock options “costing” the same in terms of expensing on the financials, a lot of organizations may just reward employees in cash, he says, particularly since stock options no longer carry the cachet they once did.

Other types of stock-based compensation that were brushed aside because of stock options’ more favorable accounting treatment also will be used. “Companies will still use equity-based compensation,” says Whittlesey, “but it will be better designed to serve the company and the shareholders.”

HR professionals will use “full value stock programs” such as restricted stock or performance shares, says Goldstein, because they will deliver immediate value to employees. Indeed, even without expensing, companies are not issuing as many stock options. According to a May study by Hewitt Associates of 202 U.S. corporations, 34 percent stated that they planned to decrease the proportion of employee total compensation delivered by stock options or other forms of stock.

HR’s Role
Changes resulting from expensing stock options mean HR professionals will have to put more time and effort into communicating to employees how incentive programs work and what they are worth. Once options are expensed and companies start using other kinds of incentives, attracting and retaining talent requires that employees understand the value of their compensation packages in comparison to those of other employers.

Many experts say that expensing stock options will ultimately be a good thing for the HR function. “When you put all vehicles on an even footing, this opens up possibilities to design programs to create the most value for shareholders,” says Jones. Flexibility in designing compensation programs was one of the reasons that both Coca-Cola and made the decision to expense.

“Expensing opens the door for companies to provide employees with other types of stock-based compensation that they wanted to do before but couldn’t because of the concern over how other forms of stock-based compensation required an earnings charge,” says Whittlesey.

And, says Whittlesey, there is even a silver lining to expensing for companies who currently rely heavily on stock options. “Once companies get past the whining stage,” he says, “they’ll realize that expensing will open up opportunities for them to reprice previously issued options that are underwater”—worth less than their exercise price. Under current accounting rules, although companies are not required to show a charge to earnings when stock options are granted, if those options are later repriced, then that repricing is reflected on the balance sheet. Many companies currently have employees who hold options with the current value below the exercise price. If there is already an accounting cost for stock-based compensation, he says, it will be easier for those companies to reprice options.

For precedent, look to companies, such as the Boeing Co. and Winn-Dixie Stores Inc., that expensed stock options prior to this year. “The Boeing compensation program demonstrates how, when stock options are expensed, a company will step back and really analyze how to design a plan to meet their objectives,” says Jones. Boeing’s stock option awards are a small part of its incentive compensation program. Boeing’s main incentive piece is a performance unit plan. The plan converts units into common shares according to a schedule for achieving and sustaining different levels of stock price growth over a five-year period, says Jones.

Any unconverted options at the end of the period expire. Boeing’s compensation committee has the ability to override the formula and use its discretion to convert any portion of the award to shares if Boeing’s total return to shareholders over the five-year performance period exceeds the average return of the S&P 500. This provision provides downside protection to participants in the plan. Boeing officials could not be reached for comment.

Elayne Robertson Demby is a freelance business writer in Weston, Conn.

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