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'Opting' for pay alternatives: as the debate continues over stock options, there is a pronounced shift toward more rational, results-based pay systems. This is particularly true at the most senior levels.

Major changes are afoot in compensation. In August, the Financial Accounting Standards Board (FASB) began the final draft of a rule that will require companies to recognize the cost of employee stock options on their income statements. FASB originally slated the accounting change to begin in 2005, although requests for a delay until 2006 are being considered. With this shift looming, much of the discussion has focused on how stock options should be valued.

Less attention has been given to how the potential move away from using options as a compensation tool might affect employers' ability to attract, motivate and retain talented employees, particularly at senior levels. But as the accounting change prompts firms to explore alternative forms of pay, they will also want to factor in the impact of an employment market that seems positioned for a turnaround.

CFOs are projecting a net 6 percent gain in the hiring of accounting and finance professionals during the fourth quarter, according to Robert Half Management Resources' (RHMR) quarterly Financial Hiring Index. The projection a year ago was for just a 1 percent rise, which indicates that businesses today appear to be gearing up for growth. Moreover, competition is heating up for the best candidates. In another survey conducted by RHMR last January, 18 percent of CFOs said that finding qualified staff was one of the biggest challenges facing their companies over the next 12 months.

Despite signs of an upturn, in the short term, at least, we're unlikely to see a return to the frenetic hiring pace of the late 1990s, when demand for talent exceeded supply and lucrative pay packages built on stock options were the norm. Nonetheless, top candidates are finding themselves with more choices than they had two years ago.

If companies are to attract and keep the best people as the job market improves, they will need to ensure their compensation plans remain competitive. But with compensation trends in flux, what constitutes an enticing pay package? A decade ago, the answer was easy: options and more options. Today, it's not so clear-cut.

Forces Driving Change

Several factors have forced companies to rethink their approach to incentive compensation. Most significant is the FASB ruling. In the wake of well-publicized accounting scandals, moreover, there has also been a public backlash against the heavy use of options to compensate employees. Some contend the practice has hurt shareholders by diluting share prices, while providing financial windfalls to corporate executives. Employees themselves were disappointed with falling stock prices, which left their options under water when the economic slowdown hit. But proponents of broad-based employee stock option programs cite the recruitment benefits of offering equity incentives to employees at all levels.

For growing companies, particularly those in the high-tech sector, stock options present a way to offer workers an equity stake early in the company's history, allowing them to benefit from the company's growth and potential for stock appreciation. Options can also level the playing field for smaller firms competing for talent with large companies that may be able to offer higher starting salaries. In California's Silicon Valley, stock options were the norm among technology firms during the technology boom.

There is an upside to the debate over options: It has given companies the freedom to rethink how they reward both rank-and-file employees and top executives. Now that options may become subject to the same accounting treatment as other forms of compensation, their value as a pay tool can be viewed more objectively. As many firms consider reducing or eliminating options, 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 their terms 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, based on a stock index. Unlike stock options, indexed options--when exercised--are settled in cash.

Strategy Shifts

A number of companies have acted in advance of the anticipated accounting change by announcing they will voluntarily expense options. Some have gone even further, completely reshaping their approach to compensation.

Those replacing options with restricted stock programs are awarding stock to rank-and-file employees over time, a strategy many believe helps attract and retain employees. While restricted stock has been traditionally reserved for the most senior executives, the theory behind its broader issuance is that staff-level employees do not have as much influence over decisions that could affect stock movements as do those at the executive level.

Therefore, the reasoning goes, these employees shouldn't be penalized when the stock drops. And in a down market, employees whose compensation is largely tied to stock options tend to become dissatisfied. Proponents of stock that vests over time say this strategy rewards employees for their loyalty and for performing at high levels in 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 rational, 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.

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. The competition for talent can be a decisive factor, and 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, since 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, can help lay the groundwork for compensation changes.

Change always opens the door to new opportunities. This is certainly true of the impending 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.

RELATED ARTICLE: Goals to Strive For

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 (for example, certain tools favor a mature company or one undergoing a turnaround)

* Facilitate stock ownership, particularly at the executive level

Paul McDonald is Executive Director of Robert Half[R] Management Resources (, the worldwide provider of senior-level accounting and finance professionals on a project and interim basis.
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Title Annotation:Compensation
Author:McDonald, Paul
Publication:Financial Executive
Geographic Code:1USA
Date:Oct 1, 2004
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