Upfront: New Recipes for the Long-Term Incentive Mix

Stock options have long overshadowed all other vehicles in executives' long-term incentive (LTI) mix. According to a white paper by Mercer Human Resource Consulting, they represented 78 percent of that compensation component in 1999. For a long time, companies calculated that the return on these incentives was worth the expense. Dilution of earnings per share was the only downside they had to consider at a time when they were only required to footnote stock options on their income statements. And this form of equity compensation held high "currency value," or perceived value, for the recipients. Executives were happy with the rewards they reaped, courtesy of a booming economy and rising stock values.

But conditions affecting stock option programs have changed in the past five years. The currency value plummeted in the early part of the decade when stock values dropped or remained flat. In fact, options for many top leaders today remain underwater. At numerous companies, earnings per share took a hit when the FASB handed down Statement 123R requiring organizations to charge these expenses directly against earnings, starting in 2005. Shareholders, particularly institutional stock owners, have complained bitterly about share dilution. Consequently, businesses have had to decide whether stock options' increased cost outweighs their benefit.

Some organizations have opted to reduce the number of stock option grants in their compensation program or discontinue them entirely; by 2005, these executive rewards had dropped to 52 percent of the long-term incentive mix, according to Mercer's 2005 CEO Compensation Survey. "We're going to probably continue to see some slippage in the amount of stock option use," says Steve Harris, Atlanta-based senior executive compensation consultant for Mercer, "but it's not going to go entirely out the door."

Restricted stock awards (RSAs), which have been part of the long-term incentive mix in varying degrees for decades, are filling part of the breach for the time being. In 1999 these rewards represented only 8 percent of the LTI pie, but by 2005 their portion had expanded to 27 percent, according to the Mercer survey. RSAs differ from stock options in that companies gift a specified amount of stock to an employee outright on the grant date. The employee takes possession of the shares when the award vests, after specified restrictions have been lifted. The cost of RSAs is attractive to businesses because they are typically awarded in a 1:3 or 1:4 ratio to stock options. Their time-based vesting makes them a useful tool for retaining top talent.

But restricted stock awards aren't a panacea. They're a port in a storm while organizations try out newer alternatives to balance the LTI mix. "There's quite a bit of what I see as experimentation occurring with long-term incentive programs," reports Harris. "Performance-based long-term incentives are growing in prevalence fairly dramatically." In 2005, 57 percent of surveyed companies used performance-based long-term incentives, up from 37 percent in 2003.