If companies are to attract and keep the best people as the job market continues to improve, they will need to ensure that their compensation plans remain competitive. As many firms reduce or eliminate stock options in light of new FASB rules that require expensing of these incentives, some of the following alternatives are being evaluated or used with greater frequency:
- Restricted stock. Actual shares issued to employees that are subject to a vesting period (usually three to five years). The shares are then worth whatever the stock is worth, making them less risky than options.
- Performance shares. Shares are paid out only if certain performance targets are met. Considered a good alternative to options, performance shares improve alignment between employees and shareholders.
- Stock appreciation rights (SARs). Often viewed as a substitute for options, SARs allow employees to receive any increase in a stock's value between the time a grant is made and when it is exercised.
- Cash bonuses. Some companies are replacing options with performance-based payouts or enhancing existing bonus programs.
- Expansion of deferred compensation plans. Profit sharing directed to deferred compensation plans and larger contributions to retirement plans are other alternatives.
Even companies that plan to continue stock options are altering the terms of these incentives to minimize controversial features. For example, some are reducing the number of years options can be held before they expire. Others are offering so-called premium-priced options, which provide a payout only if the share price rises a certain percentage above the grant price. Another alternative is indexed options, which are based on a stock index. Unlike stock options, indexed options -- when exercised -- are settled in cash.
Strategy Shifts
Companies replacing options with restricted stock programs are awarding stock to rank-and-file employees over time, a strategy which many believe helps attract and retain employees. While restricted stock has been traditionally reserved for the most senior executives, proponents of giving stock which vests over time to staff-level employees say this strategy rewards loyalty and outstanding performance in both good times and bad.
Senior executives, however, are still more likely to have a combination of stock award programs -- some that may be tied to tenure and others linked to key metrics. The latter are often referred to as performance shares
Retaining Executive Talent
In rethinking pay strategies, companies are on a quest to find the golden carrot of compensation -- that is, the perfect mix of incentives from a financial and human resources perspective. Although there is no one-size-fits-all approach, there is a pronounced shift toward more results-based pay systems. This is particularly true at the most senior levels.
To attract and retain executive talent, many companies continue to offer an equity component. The best candidates often expect it and, when used effectively, it melds the interests of shareholders and key employees. To satisfy both parties, firms are making sure they clearly articulate reward structures and tie them to specific, measurable goals. For instance, top executives increasingly find their compensation linked to measures such as the ability to increase operating cash flow by a certain percentage or to outperform a peer group in areas such as total shareholder return.
As companies re-examine their practices, they may want to consider how different incentives can help them achieve some or all of these compensation goals:
- Attract and retain top performers
- Motivate workers to achieve performance goals that support long-term value creation
- Unite the interests of employees and shareholders
- Align compensation with a company's specific business situation or culture (e.g., certain tools favor a mature company or one undergoing a turnaround)
- Facilitate stock ownership, particularly at the executive level
A Mixed Approach
Because there is no longer a prevailing approach to incentive pay, more employers are adopting a mix of equity- and cash-based tools. Some are even tailoring their offerings to regional expectations and supply-and-demand considerations in certain markets. The competition for talent can be a decisive factor. In an improving job market, companies may lean toward plans that are performance-based and vest over time, effectively "locking in" top performers.
Options and comparable forms of compensation that require candidates to assume considerable risk will likely be less popular in the current environment. Those who have not realized gains from similar plans in the past could be reluctant to gamble again. In selecting the right mix of incentives, the most progressive firms keep in mind that their ability to attract and retain quality candidates also depends on non-monetary factors. Workers frequently cite meaningful work, a desirable corporate culture and the ability to achieve work/life balance as keys to job satisfaction.
Companies exploring pay alternatives can find value in soliciting employees' views. An open dialogue established through such efforts as employee focus groups and surveys is beneficial in laying the groundwork for compensation changes.
Change always opens the door to new opportunities. This is certainly true of the requirement to expense options. It has been a catalyst in forcing many businesses to seriously re-evaluate pay strategies for the first time in more than a decade. As they do, they are striving for a better balance between reward and reason by using tools that create the right incentives while addressing individual company needs.