The Changing Face of Executive Pay: Performance Unit Plans

Your company had to restate its earnings (downward) for the past several years. Your senior management received incentive pay based on those earnings. Will you be able to recover that incentive pay? If so, how? If not, how will you explain it to the board and stockholders?

Your company’s deferred compensation plan allows participants to select the type and timing of deferments and payments. They make an inappropriate selection and, due to a recently enacted law, trigger a taxable event for themselves.

Boards are being held legally accountable for the corporate actions and, as a result, are keen to put a stop to option abuse, re-pricing and the unpleasant effect that overhang and dilution have on the reported company value.

Executive compensation is under siege and compensation professionals are being pressed hard to respond.

Taxes: On October 11, 2004, Congress passed the American Jobs Creation Act (JOBS). JOBS added Code 409A to the IRS code. 409A changes the tax rules affecting nonqualified deferred compensation. The changes restrict flexibility, place limits on timing, limit security techniques and limit distribution options. Code 409A will require those with deferred compensation plans to amend most arrangements and terminate some. This code reduces the flexibility of deferred compensation plans. Failure to comply with the code will automatically trigger a taxable event, in come cases for all of the participants in the plan!

Stock options: New reporting rules took effect in June, 2005. They require stock options to be reported as an expense on a company’s financial statements. This, along with the problems of “under water” option values, re-pricing, and high profile abuses have made boards much more conservative in the use of options. America’s largest companies are waving the white flag. The February 28 issue of BusinessWeek reports that nearly two thirds of America’s 200 largest companies have cut back their use of options. Also being discontinued are the use of mega-grants worth more than $10 million and ‘evergreen’ provisions that replace options as they are exercised.

Deferred compensation is an essential part of a pay package designed to attract, retain and motivate the leadership team. Many companies are taking this opportunity to refocus their executive compensation philosophy and include a component that emphasizes internal value.

While not entirely eliminating stock options, these companies are adopting Performance Unit Plans that provide executives with stability to their pay portfolios while ensuring the company receives the agreed-upon ROI.

A Performance Unit Plan is a form of non-qualified, deferred, incentive pay that avoids the problems associated with stock options and is Code 409A friendly. These plans focus on controllable business outcomes and, as such, are effective at attracting, retaining and motivating executives who want a share of the increase in value they create.

With a Performance Unit Plan, performance is guaranteed to build personal wealth. Participants who can’t perform or who are uncomfortable with focused accountability will deselect themselves and go looking for greener (easier) pastures...exactly the results we want in a good retention mechanism.

The objective of a properly designed Performance Unit Plan is to increase asset value by generating profitable growth. It’s linked to internal measures and rewards good performance no matter how the stock market performs.

Performance Units are earned for short-term results and appreciate in value as the value of the company increases. Executives must achieve both short and long-term objectives to maximize their rewards. The appreciation element uses a simple valuation process based on improvement in the ability to create profit. Here’s an overview of the components:
Performance unit: Cash equivalent certificates, earned annually, and based on performance toward annual objectives. These units vest over time.
Increase value: A target increase in the company’s ability to generate profit is established at the beginning of the plan period. Each participant knows, in advance, the wealth they will receive if the company performs at target. Attainment of this target results in the payout of a predefined amount to each participant. (If we reach ‘X’, you receive Y’.)
Appreciation: A well designed Performance Unit plan is not an all-or-nothing plan. During the plan period, performance units have the potential to appreciate as profitable growth moves toward target. The amount of appreciation is a function of the executive team’s ability to successfully anticipate and plan for future business opportunities while maximizing the current return on available resources.

Stay Tuned for a Case History.