Executive Comp: Rethink Incentive Plans for Difficult Times

By Stephen Miller Nov 12, 2008
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The troubled economy is causing fundamental shifts in executive compensation bonus and equity-based incentives plans, according to a November 2008 report by pay consultancy DolmatConnell & Partners.

The report, Executive Compensation in a Troubled Economy, highlights the following trends:

  • A renewed and intense spotlight on executive compensation from the news media, government and public.All are looking to board compensation committees to ensure that they are practicing strong governance and implementing programs that balance executive and shareholder interests.
  • Annual incentive plan payouts for 2008 are often zero because thresholds were not achieved, or below target because financial targets were missed.

• Stock options issued as incentive compensation are significantly underwater (i.e., they have an exercise price greater than the market price of the underlying stock), and restricted stock shares are worth far less than before, reducing their retention value significantly.

  • Annual long-term incentive (LTI) grants need to be rethought because traditional valuation methodologies are yielding unacceptable levels of share dilution, companies do not want to ask shareholders for more shares at this time, and current LTI portfolio mixes might no longer be appropriate.
  • Performance-based LTI plans are not paying outbecause targets cannot be achieved or are unlikely to be met in the near future.
  • ​Annual incentive plan financial targets for 2009 are difficult to predictbecause of the lack of visibility regarding the economy and overall market. Thresholds and stretch targets also have become difficult to set.

Good Governance Practices

These issues can hurt executive retention and motivation. As a result, board compensation committees need to consider if and how they will address these issues, DolmatConnell recommends. To practice good governance, compensation committees can:

  • Employ and regularly review scenario-based tally sheets that consider multiple performance situations and timeframes.
  • Ensure that a balanced downside risk accompanies upside potential for incentive grants.
  • Govern as if the company’s executive compensation plans will end up in the news, because they might.
  • Work with a truly independent executive compensation consultant.
  • Schedule quarterly half-day meetings to give adequate time to committee discussions and decisions. Plan a half-day off-site meeting annually to review trends and best practices in executive compensation. Hold executive sessions at each meeting, with the independent consultant in attendance.

2008 Bonus Plans

2008's performance metrics were set in the fourth quarter of 2007 without anticipating the economic turmoil that was to roil the markets in 2008. At most firms, incentive compensation plans are projected to pay out below target or, in many cases, might result in zero payout, because of the general economic downturn and not because of actions within the company’s control.

Compensation committees should consider whether the organization's current financial situation warrants the payment of bonuses and should weigh retention risks vs. negative investor reaction to bonus payments, according to DolmatConnell.

Underwater Stock Options

With stock prices on average down 45 percent from October 2007 to October 2008, and many firms’ stock prices down as much as 80 percent, underwater stock options are rampant. Companies are considering value-for-value exchanges or special grants while taking into account shareholder scrutiny and firm strategy, DolmatConnell notes.

Annual Long-Term Incentive Grants

Annual LTI grants could be problematic because of the massively depressed stock prices of most firms. Because most companies have share prices dramatically lower in October 2008 than they were a year earlier, using a standard Black-Scholes or binomial model approach to calculate the number of options to grant, or using the current share price to determine how many restricted shares to grant, simply will not work, DolmatConnell advises. Competitive market value transfer is one method to address LTI issues; it uses a standard to measure the same upside potential for equity grants, even if their values are not comparable.

Performance-Based LTI Plans

Many firms have migrated to the use of cash or stock performance-based LTI plans over the past few years. These plans align executives with shareholder interests and, when they are stock-based, they often reduce share dilution significantly by providing the same value as options but with fewer issued shares. However, with the recent stock market declines, many of these plans are unlikely to pay out—or will pay out significantly below target. Firms have little to no visibility going forward with these plans and might consider extending the timeframe for achievement of goals, says DolmatConnell.

2009 Bonus Plans

Firms are struggling with 2009 bonus plan designs, as there is little or no visibility into where the economy/firm financials are going to be over the next six to 12 months. As a result, the problems that exist with performance plans exist with bonus plans too: How do companies set appropriate targets, thresholds and maximums, and what metrics do they use?

Companies might consider using six-month or even quarterly plans instead of annual plans, or they might consider alternative metrics when financial visibility is nearly unknown, according to DolmatConnell.

Stephen Miller is an online editor/manager for SHRM.

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