Kumar Subramanian
Regional Practice Leader, Executive Compensation and Enterprise Performance

The recent global financial crises and the ensuing declarations of the G20 leaders has created a clarion call from governments and shareholder activists for corporate boards to exercise sound stewardship of the firm's compensation practices. External pressure is fiercer than ever from watchdog groups and institutional shareholders to "fix" current reward systems and ensure that the designs that led to past excesses are not repeated.

The Financial Stability Board (FSB), responsible for coordination among national financial regulators of the G20, has attributed "perverse" incentive compensation practices to be one of the key contributing factors to the global financial crisis. Thus, the FSB has developed principles and implementation standards that are intended to apply to financial institutions and for large, systemically important firms outside the financial sector as well. Most importantly it has recommended more active governance by Boards of Directors in the design, operation, and evaluation of compensation schemes.¹ 

Boards of directors and corporate compensation committees would therefore be well served by pro-actively institutionalizing compensation practices that align the interests of executives, shareholders and regulators. In particular, they should consider the impact and value of shifting their long-term incentives plans from share options to restricted share grants and introducing performance targets for vesting of incentives.

Regulators' perspective

Regulators already have started to act on the Financial Stability Board's recommendations. The principles proposed by the Financial Stability Board contain specific guidelines on executive compensation, including the proportion of variable compensation that should be payable under deferral arrangements, shares or share-linked instruments and the period of such deferrals. Many local regulators in developed economies are in the process of enacting these principles into law and are encouraging corporations to incorporate these guidelines into their executive compensation framework.

At the same time that governments are enacting new laws on variable pay, business is moving toward new forms of deferred compensation. The US is shifting away from share options and towards share awards. Aon Consulting's analyses of the proxy statements of Fortune 250 corporations (see Exhibit 1) reveal that more than 60% of them have granted Restricted Shares (i.e., share awards that vest on fulfillment of service conditions) or Performance Shares (i.e., share awards that vest on attainment of performance conditions) to their executives.

Corporations in Singapore are also following a similar trend. According to the Singapore Institute of Directors' Board of Directors' Survey (2008/09, 2005), while a majority of listed companies continue to use share options as part of their long-term incentive tools for Executive Directors, the use of performance-based share grants is clearly on the rise (See Exhibit 2).

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Shareholders' perspective

From a shareholder perspective, direct share awards offer two key advantages over options:

Whichever mechanism is chosen, the objective of any long-term incentive program should be to ensure that managers' interests are aligned with the shareholders while minimizing the dilution impact on existing shareholders. Additionally, the reward should be linked to outcomes that are at risk, and should be received over a sufficiently long-term period, during which time significant value has been created to shareholders.

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Employees' perspective

An equity-based plan must provide substantial wealth creation opportunity to retain and attract the best executives, while creating sufficient pay differentiation to weed out the non-contributors.  Different types of equity awards have different implications for a firm's imperatives for talent retention, risk orientation and performance differentiation (see Exhibit 3).

Share options should create a strong link between compensation and performance, as it will only be valuable to the recipients if the share price increases. However, in a bull market, a simple share option will deliver value regardless of the executive's individual contribution. Additionally, for multi-business corporations, share options may not adequately distinguish the contributions of each business to the overall success of the share price.

An incentive plan with options that vest only on attainment of business-specific performance targets can overcome this problem and enable a company to differentiate individual or unit performance. The downside is that such plans may not deliver much value to the employee despite excellent unit or individual performance, if the company's share price is stagnant or declining. On the other hand, restricted share awards are valuable, even when the share price declines, and will provide an even greater reward if the share price goes up. In this way, share grants can be a very strong retention tool for management that continues to deliver solid fundamental results. Performance Share awards can galvanize the management team to sustain the sound performance trajectory.

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Design considerations

Ideally, companies should base their executive pay design considerations on their unique combination of business strategy; talent retention imperatives; economic impact to the executive, company and shareholder; and quite often, even accounting considerations.

Share grants may better align shareholders and employees' interests for a company focused on optimizing profitability of existing assets and rewarding shareholders through cash dividends, rather than significant share price appreciation. On the other hand, a share option plan that links vesting to the firm's performance relative to a benchmark group merits strong consideration, if the path to shareholder value creation requires an executive to undertake bold moves to surpass the market.

Incorporating performance standards is another critical aspect of the design challenge. At the most elementary level, companies only link performance to the size of the award. However, more and more companies are using stricter performance standards to ensure both shareholder alignment and focus on sustainable performance. These include applying performance conditions to the vesting of awards and, in a few cases, indexing the exercise price to a peer or a general market index.

Our analyses of 15 large cap Singapore companies (see Exhibit 4) reveals that that the preferred approach is to link award vesting to attainment of performance targets. Most companies use a portfolio of metrics (typically two to four), and some even use a combination of internal and share-based metrics.

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Our approach

Aon Consulting believes that a sound plan design requires an informed perspective across five key areas - type of award, size of award, performance criteria, approach to linking performance and plan duration. Compensation committees should investigate potential alternatives at their disposal for each of these facets and then assess what is the "right" answer for the companies they oversee.

Scenario planning and financial modeling aids that help simulate the economic value delivered to the employees, shareholder dilution and expense impact are an integral part of the review. Equally critical is an informed prioritization of multiple objectives that the design needs to accommodate or balance. These could include:

• What is the overarching objective of our reward strategy – talent attraction and retention or pay for value creation?
• What value drivers underpin our success going forward – growth or profitability?
• What is the anchor of our pay for performance philosophy – encourage focus on overall corporate performance or differentiate the contributions of businesses?
• Should we adjust the performance to the different levels of risk undertaken to achieve the outcome?

Needless to say, the best managed Boards will invest the right level of problem-solving rigor that these issues warrant and by so doing, will ensure the interests of shareholders, employees and regulators are aligned. 

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Contact

For more information about long-term incentives or Aon Consulting’s work in this area, please contact Kumar Subramanian at kumar_subramanian@aon-asia.com.

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