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The focus in stock compensation has shifted from adjusting grant practices for mandatory expensing to questions about how or even whether stock grants should be used. In some cases, the downturn has provided new lessons for employees with equity compensation. Quoted in The Wall Street Journal (Firms Rethink Compensation Plans, Feb. 17, 2009), one CEO said: "We built a performance-based system and there was a lot of risk in there, which I don't think we'd fully recognized because we'd never seen markets like this. To the management team, it was a very swift kick in the behind."

Beyond Underwater Options: Major Issues

Underwater stock options tend to be the most high-profile issue. Companies are taking various approaches to them, as another FAQ explains. However, underwater options are just one impact of the downturn. Companies are also considering shifts toward more restricted stock and cash, modifications in performance share grants, and the advantages offered by ESPPs, and many are undertaking a review of the valuation approach they use to determine the size of new stock grants.

Amid falling stock prices and performance goals that will probably not be met, retention grants for top officers have become a high priority. Even with the rise in unemployment, companies remain concerned that falling stock prices have diminished the role of stock options and other stock grants in retaining and motivating key employees. Most companies avoid any adjustments in outstanding performance share grants, but as part of their next round of grants they may add standard time-vested restricted stock and/or change the goal.

Many companies base grant sizes on either a target amount of compensation or a target number of shares (see related FAQs on these grant guidelines for stock options and restricted stock). The problem for many companies in the down market involves whether to adjust the target dollar value of their stock grants (converted into a specified number of shares/options/units) or to adjust grants that are usually a fixed target number of shares. Under the target value method, lower stock prices means companies need to grant many more options or shares to reach a target value. This, in turn, uses up shares much faster (i.e. increases the burn rate), raises dilution concerns, and creates too large a gain for executives if the price rises quickly. However, the target size approach, without an adjustment in the size, results in a grant with a much lower value.

What Companies Are Doing: Research And Analysis From Consulting Firms

Experts at consulting and research firms have been busily analyzing corporate stock plan practices since the downturn began in 2008.

Towers Watson

Along with other consulting firms, the research firm Towers Watson (formed after the merger of Towers Perrin and Watson Wyatt) warns against relying on market pay data from before the downturn. In fact, it has found that some companies are not following the valuation approach used last year to set grant size.

One alternative approach is to simply reduce the target value of the equity granted (e.g. reduce the value of grants this year to 75% of last year's values), and this is what Towers Watson expects to see at a large number of companies. It predicts companies will "normalize" the size of grants, perhaps by using the average stock price instead of the grant date price (this is for internal valuation to determine grant sizes, not for accounting purposes).

Towers Watson also notes that a larger grant of stock options with a lower exercise price has a greater perceived value to executives than the reverse situation, so a reduction in the grant's accounting value may not matter.

PricewaterhouseCoopers

PwC's 2009 Global Equity Incentives Survey found that the downturn has prompted numerous changes beyond just actions to remedy underwater stock options. PwC noted that the most frequently mentioned change is the replacement of service-based grants with grants based on performance conditions. The surveyed companies were asked what changes they will make to grant practices in 2010 according to current market conditions.

Outlook for changes	Percent of companies
Changes are ahead, but still exploring alternatives	45%
More performance-based restricted stock/RSUs	27%
More service-based restricted stock/RSUs	15%
Relaunch of ESPP (with or without redesign)	12%
Cash or nonequity benefit instead of options	12%
More performance-based than service-based restricted stock/RSUs	8%

James F. Reda Associates

A study published by James F. Reda Associates in August 2009 reviewed proxy statements from almost 200 of the largest companies (by market capitalization) in the S&P 500, looking for changes in executive compensation practices. The firm reviewed proxy statements in the first half of 2009 for changes in response to the economic downturn and increased shareholder scrutiny. It found that 70% of 191 companies reported alterations. A majority of them made what the study deems a "major change." The greater the drop in stock price, the more likely it is that a company modified its program. The study found that, in general, the equity compensation parts of incentive plans, at least for senior executives, have been altered as follows:

• A shift from long-term to short-term incentive plans.
• Performance measures in long-term incentive plans shifted to capital efficiency (e.g., return on equity), cash flow, and total shareholder return.
• Companies are increasing emphasis on time-vested restricted stock and restricted stock units; the surveyed companies changed their LTI mix as shown below:

Type of plan	No. of reported increases	No. of reported decreases	Net changes
Restricted shares and units	13	9	4
Performance shares and units	13	14	–1
Stock options and SARs	6	16	–10
Total	32	39	–7

Buck Consulting

A March 2009 survey by Buck Consulting finds changes in grants ("Taking The Pulse Of Equity Compensation," summarized briefly at the website Talent Management). It reports that decreasing stock prices mean most companies will not make grants with the same equity values as in the past. Among its results:

• 31% of the surveyed companies expect to somewhat increase the number of options or shares in 2009. Very few intend to fully restore last year's value.
• At companies issuing equity compensation based on a number of shares, 60% anticipate no change in awards. At companies making grants on a dollar-value basis, only 30% expect no changes in awards.
• 45% of the surveyed companies are considering a change in the equity compensation mix.
• 29% will increase their use of shares and decrease their use of options.
• 16% will increase their use of options and decrease their use of shares. Buck Consulting notes that this creates the "possibility of delivering more future value from the increased number of options granted."

Hewitt

Hewitt reviewed Form 4 filings made by S&P 500 companies in December 2008 through February 2009. The firm compared them with last year's grants to individuals in the same roles at the same companies, trying to measure how the downturn is affecting grants (Trends In Long-Term Incentive Design Practices And Award Sizes 2009, March 2009). Among the highlights of its results:

• The median decline in total median present value of stock options was 23%, and for restricted stock 25%, compared with a median stock price decline of 44%.
• The mix of stock options and restricted stock (not performance plans) stayed about the same, at 54% restricted stock and 46% stock options.
• Companies seem to lower the value of their LTI awards significantly after the stock price has declined by about 50%; the greater the fall in stock price, the greater the decline in LTI value. For example, companies with a fall in stock price of more than 50% had a 31% decrease in the economic value of their grants. However, those whose stock price declined by less than 30% saw their grant values fall by only 4%.
• To offset the substantial stock price declines, share use increased significantly for new grants even though they had a lower value than in 2008.

Mercer

Among the suggestions that Mercer has made to companies:

• Analyze the value of unvested awards under various stock price changes over the next two to four years. This is important in evaluating the role new grants need to play to retain talent. Unvested gains should equal two to four times base pay to counteract hire offers from competitors.
• Compare stock price changes relative to peers. If they have dropped more, companies need to use "proportionally more shares than your peers for this year, and vice versa." This analysis can also indicate what the share usage of your company's peers will look like this year and whether it needs to adjust grant levels for competitive reasons.

Stock Grants Instead Of Cash?

In a throwback to the 1990s, some consultants are even suggesting the use of stock options or restricted stock to replace portions of cash pay. This is the approach that Vail Resorts took, according to a report in the local newspaper Summit Daily (Summit County, Colorado), which includes the open letter by its CEO that outlines the cutbacks. The company is implementing a wage-reduction plan to keep jobs and save the company $10 million annually. To balance the lowering of wages, it is issuing restricted stock units (vesting a third of the grant per year) to all full-time year-round employees:

• full-time employees Grade 25: wage reduction of 4% but grant of RSUs worth 1.5% of pre-reduction salary
• full-time employees Grades 26 and 27: wage reduction of 5% but grant of RSUs worth 3% of pre-reduction salary
• full-time employees Grades 28, 29, and 30: wage reduction of 6.5% but grant of RSUs worth 4.5% of pre-reduction salary
• all executives: wage reduction of 10% along with grants of stock appreciation rights worth 7.5% of their pre-reduction salary

Executive Compensation

The consulting firm Pearl Meyer & Partners surveyed corporate changes in plan design for executive compensation, plus potential changes ahead in 2010. Some of the key findings on stock compensation occur in public companies' responses about implemented or contemplated changes to long-term incentive programs for executives. The table below indicates the percentage of companies that have made or are considering each change.

Change	Implemented	Contemplated
Request more shares	20.5%	18.3%
Change perf. measures	15.2%	18.3%
New ownership guidelines	9.7%	15.2%
Change existing ownership guidelines	4.1%	15.2%
Switch from absolute to relative metrics	7.4%	8.8%
Lengthen perf. measurement period	3.1%	8.7%
Increase vesting period	4.2%	6.4%
Decrease vesting period	6.3%	3.3%
Reprice options	3.6%	5.8%
New "hold to retirement" provision	0.4%	7.5%
Switch from relative to absolute metrics	3.4%	3.0%
Shorten perf. measurement period	2.2%	3.9%
New "hold past retirement" provision	1.3%	2.6%

Stock Ownership Guidelines

Given the popularity of the multiple-of-salary approach to ownership guidelines, problems arise when the stock price drops and executives find themselves out of compliance with the guidelines. Proxy disclosures in 2009 revealed that companies are taking a variety of actions, from revising their targets, suspending them, or giving executives additional time, to simply not making any changes at all.