New approaches to executive pay.

By signing the Omnibus Budget Reconciliation Act of 1993 on August 10, 1993, President Clinton with a stroke of his pen raised taxes and sent experts scurrying to find new ways to reduce the tax burden of America's key executives. But Mr. Clinton is not alone in launching salvos at executive pay. Indeed, the '90s are shaping up as the decade of executive compensation program redesign.

In addition to the 1993 Tax Act, the Securities and Exchange Commission issued major new rules in late 1992 (and amended in 1993) specifying how executive pay is disclosed in public company proxy statements; and the Financial Accounting Standards Board (FASB) released a hotly debated Exposure Draft in June 1993 that proposes dramatic changes to the accounting rules for equity-based compensation programs. Companies also should not lose sight of a possible event that could be the most devastating to executive compensation -- a downturn in the U.S. stock market, for example.

Those charged with motivating and rewarding executives for the remainder of this decade are faced with a difficult task. They must design compensation programs that are effective and efficient, and yet skirt these potential regulatory, tax, accounting, and market land mines.

Design alternatives that may be effective in meeting one objective may adversely affect others. But win-win approaches do exist.

Take An Investment Approach. Executives accustomed to the volatile stock market conditions of the past 11 years may find that an investment approach to their equity programs provides greater returns than those based solely on market timing. Accordingly, an executive who uses the dollar-cost-averaging theory through the systematic exercise of portions of a stock option grant at fixed intervals might find it proves more effective than waiting for that one big hit.

Dollar cost averaging for stock options is the converse of dollar cost averaging for the standard stock investor. In the case of a stock investor, dollar cost averaging typically means investing a fixed amount of money at regular intervals. Accordingly, when a stock price is low, the fixed dollar amount will purchase more shares than when the price is high. Assuming at least some volatility in stock price, this approach yields a lower average cost basis on shares acquired than if a fixed number of shares was purchased at the same intervals.

Conversely, in the case of a stock option exercise where the option price is fixed, a constant dollar amount investment will always purchase the same number of shares. As a result, the executive realizes a greater gain when the price is high. As it's almost impossible, though, to determine when a stock price will be at its highest during an option's term, the periodic exercise approach gives executives a better chance of exercising at least a portion of shares when the price is high. In addition, if shares are retained following exercise, periodic exercise starts the clock running on the one-year capital gains holding period, which, in turn, adds a tax incentive to exercising early.

Consider Convertible Debentures to Reward Executives. The recent tax law changes make this a good time to rethink approaches to stock equity incentive options and other equity incentives. With a 13.05% difference between the 28% capital gains rate and the combined 39.6% ordinary income tax and 1.45% Medicare tax rates, capital gains treatment once again has real value.

Incentive stock options (ISOs) might seem to be the simplest approach to getting the capital gains rate. This approach, however, has some subtle limitations:

* Only options with a less than $100,000 face value may vest and become exercisable in any given year. * An increased Alternative Minimum Tax (AMT) rate (from 20% to 28%) may limit effectiveness for some executives.

* If the FASB's proposed accounting rule changes go into effect, there will be an earnings charge for options granted on or after Jan. 1, 1997 (and pro forma disclosures on or after Jan. 1, 1994).

To receive the benefits of ISOs and avoid these limitations, consider using convertible debentures. Under such a program, executives can purchase debentures with a conversion feature that provides a triple benefit: interest on the investment as a minimum return and the possible conversion of the debenture into stock should the stock price move upward during the debenture's term, while providing certain downside protection.

The principal benefits derived from a convertible debenture are tax-driven. If a debenture has been held for a year or longer, the gain realized upon the debenture's conversion receives capital gains treatment and is not subject to the Medicare tax. In addition, unlike the ISO, the $100,000-per-year vesting limitation and the AMT exposure do not exist for convertible debentures.

Further, to make the convertible debenture function more like a stock option (which does not require an up-front investment on the part of an executive), the debenture can be purchased with a loan (a full recourse loan with a market interest rate). Before the debenture is converted, an executive can deduct the interest on the loan used to purchase the debenture on his or her income tax return to the extent that interest income was derived from the debenture.

The loan purchasing the debenture should be paid off before the debenture becomes convertible to preserve the capital gains treatment. To meet this cash requirement, several approaches can be used to minimize the financial impact on the executive, including a bank loan, periodic withholding from salary or bonuses, or receipt of nonqualified deferred compensation.

Compensation Redesign

Design Alternative      Desired Effect             Adverse Impact

Grant premium-          Reduces impact to          Reduces perceived value
priced stock options    company of proposed        and motivational impact
                        accounting rule changes    to executive

Grant incentive         Gives executive            Increases executive's
stock options           opportunity to delay       exposure to Alternative
                        taxation and get capital   Minimum Tax
                        gains treatment

Add shareholder-        Permits corporate tax      Promotes near-term
approved performance    deductibility for          performance focus, which
criteria to incentive   compensation in excess     could limit longer-term
plans                   of $1 million              potential

Cut back on those       Reduces impact of          Reduces number of
receiving equity-       proposed changes to        executives who are
based awards            accounting rules           focused on long-term
                                                   shareholder value creation

Source: Ernst & Young

Convertible debenture executive compensation programs are complicated, and the services of a qualified executive compensation consultant should be sought when setting up a program. Failure to structure a program properly can result in the loss of favorable tax treatment and possibly trigger unfavorable treatment. Structured properly and creatively, however, a convertible debenture executive compensation program can provide companies with an effective vehicle to motivate and retain key executives.

Remember the Purpose of Compensation Programs. A final tip for designing effective programs, no matter the environment, is always remember the primary focus of most incentive programs: to motivate behavior and reward results. Only by keeping this in mind can compensation programs that support company goals be successfully implemented.

Edwin W. Lewis is a senior member of the Ernst & Young Compensation Consulting Group. He specializes in executive and sales compensation and organization design.