Get better results from long-term incentive pay: performance-based long-term incentives do not merely reduce the variance in earnings or reduce P & L expense. They can improve business performance over the long run.

Which would you prefer: Greatly reducing the variability in your earnings or getting better efficacy from the huge grants of long-term incentives you make each year?

You don't have to choose. A typical company can have both.

Stock option costs are starting to show up in company financial statements under the controversial Financial Accounting Statement (FAS) 123(R). The amount of these expenses has been the focus of much concern, but the stock market has largely shrugged off option-expensing as a non-event.

Companies still concerned with the book effects of long-term incentives should focus not only on the amount but on the behavior of these costs. Using "performance share" or "performance unit" grants, for example, can greatly reduce the variability of earnings when compared to a policy of stock option or restricted stock grants under FAS 123(R). In the following example (Figures 1 and 2), a typical company reduces earnings variation by 50 percent.

An average public company makes long-term incentive grants with value totaling around 1 percent of the value of its equity each year. If the company's price-earnings ratio is 15, these grants add up to 15 percent of earnings, or around 10 percent on an aftertax basis. If the grants were stock options or restricted shares, FAS 123(R) normally would call for them to be expensed over their vesting period (33 percent per year, say).

Since grants are made every year, amortization of three years' grants is underway at any given time; the annual run rate of expense stays at 10 percent of earnings. When earnings rise or fall, the subtraction of this large, fixed cost has the effect of increasing the variability of earnings.

Performance shares and units have very different effects. These plans allow participants to earn shares or cash, respectively, based upon the attainment of performance goals. In the simplified example on the next page, income at 80 percent of target means no award is earned. The performance unit or share grant will result in zero expense over its life.

Earnings at 120 percent of target means 200 percent of the targeted payout is earned, with expense rising in tandem (other outcomes normally are interpolated). The reduction or increase in incentive expense, when performance deviates from target, substantially buffers the impact on book earnings.

Earnings variation was reduced by 50 percent, from plus or minus 22.2 percent to plus or minus 11.1 percent. Why did this happen? In a word, leverage. The performance leverage of these grants flows through the books in a productive way.

Awards in the performance-based plan vary by 100 percent in relation to target, when performance varies by 20 percent, so leverage is 5:1. Awards may be 10 percent of earnings at target, but 5:1 leverage means they fall so fast when income is below target that they mitigate the earnings reduction not by 10 percent but by 50 percent. They attenuate earnings gains similarly, so the overall framework smoothes out spikes and troughs in reported earnings.

The overall cost level in this example--and the incremental cost and leverage effects--are the typical consequence of the scale and structure of long-term incentive pay. The fact is that executives, through their interests in typical incentive plans, are substantially leveraged. They bear disproportionate upside and downside effects, taking on risk that otherwise would be borne solely by shareholders.

As it happens, under FAS 123(R), the reality of this dynamic does not show up in the books unless the grants are cash-based, or are share-based but based explicitly on business goals. Stock option grants create substantial award leverage, for example, but their costs are fixed under FAS 123(R).

The more modest variability of gains on a restricted stock grant also is presented under FAS 123(R) as a fixed matter. At present, company granting practices continue to feature stock options and time-vesting restricted shares very heavily. From that typical starting point, making a decisive move toward performance-based long-term incentive pay can greatly shift the fixed/variable profile of book expense.

Performance share gains (and related APB 25 expenses) actually vary based not only upon hitting performance goals but upon share price performance. However, under FAS 123(R), share price movement, post-grant, generally does not affect expense. This means that performance share expenses are set in predictable proportion to the financial results that drive gains on such grants. So, under the new rules, performance share grants can be designed to create a formal hedge against variation in book earnings.

Performance shares have an additional benefit: The share-price element of the expense is fixed at grant, so later increases in share price do not cause expenses to rise. This means expenses at target can be expected to be about 20 percent lower, over the life of a typical three-year grant, than they would be on a cash-based grant with similar present value. That is a larger expense reduction than most companies can expect if they used aggressive assumptions in their option valuations as one point of comparison, and it is one that flows simply from making reasonable design choices and applying the new rules straightforwardly.

Under APB 25, the "fixed" or "grant date" accounting treatment for options was seen as a good thing, but that is because those terms really meant "no expense." Variable accounting for performance-based plans, on the other hand, usually meant recognition of a substantial expense. The trade-off was not so much about the fixed versus variable nature of the cost, but rather the overall amount of expense. Under FAS 123(R), the distinction between fixed and variable costs should be regarded in the more customary business terms--variable costs that are scaled to performance, all else being equal, will reduce the variability in earnings.

Overall, performance-based long-term incentive plans have considerable new accounting advantages under FAS123(R), but that is not the main reason to consider using them. They provide an excellent way to improve the efficacy of incentive pay. The goal-based apparatus of such grants, properly designed, can truly encourage value-creating business decisions.

That is particularly true when compared to stock options and time-vesting restricted shares, whose gains are affected by few and perhaps understood by fewer. Goal-based plans, in contrast, can be devised to place a clear bounty on the long-term results of successful business actions, and do so at the corporate, group, divisional or profit-center level. And, when made in the form of performance shares, they maintain strong concurrent linkages to the share price.

This approach to long-term incentive pay is superior from the viewpoint of earnings stability. Most companies would find it very costly to take actions that greatly reduce earnings variability, but with upgrades in incentive pay design, it can be done at negative cost, since business results can improve as a result of having more effective incentives.

Performance-based long-term incentives do not merely reduce the variance in earnings or reduce P & L expense. They can improve business performance over the long run by creating clear, effective and compelling incentives to take those actions that create the most value over time.

Richard Ericson is a Principal with Towers Perrin in Minneapolis. He can be reached at 952.842.5643 or [e-mail].

RELATED ARTICLE: takeaways

* Stock option costs are starting to show up in company financial statements under FAS 123(R). The amount of these expenses has been the focus of much concern.

* Stock option grants create substantial award leverage, but their costs are fixed under FAS 123(R).

* Using "performance share" or "performance unit" grants can greatly reduce the variability of earnings when compared to a policy of stock option or restricted stock grants.

* Through upgrades in incentive pay design, reducing earnings variability can be done at negative cost, since business results can improve.

Figure 1 Performance Scenarios with Stock Option and/or Restricted Stock
Grants

Net Income                                   $80.00  $100.00  $120.00
Net Income Variance From Target              -20.0%     0.0%    20.0%
Annualized Option/Stock Expense, After tax   $10.00   $10.00   $10.00
Net Income After Option or Stock Expense     $70.00   $90.00  $110.00
Net income Variance From Target              -22.2%     0.0%    22.2%

Figure 2 Performance Scenarios with Performance Shares or Unit Grants

Net Income                                  $80.00  $100.00  $120.00
Net Income Variance From Target             -20.0%     0.0%    20.0%
Annualized Option/Stock Expense, After tax  $--      $10.00   $20.00
Net Income After Option or Stock Expense    $80.00   $90.00  $100.00
Net income Variance From Target             -11.1%     0.0%    11.1%