Performance Equity in Uncertain Times

Performance Equity in Uncertain Times

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Performance Equity in Uncertain Times

Nobel-prize winning economist Milton Friedman wrote: "The best measure of quality thinking is your ability to accurately predict the consequences of your ideas and subsequent actions."

That was great advice, but it may not currently be possible with performance-based equity. Including performance measures in equity compensation, awards have a tumultuous history. When equity first become popular 35 years ago, negative accounting consequences stifled the use of performance measures. When those rules changed more than a decade ago, stock options were well established as the first choice of equity and restricted stock units (RSUs) were just making their play for relevance. Adding performance measures was a complication that many companies did not want to address. In 2008, we experienced market collapse that impacted nearly every industry and investors which began on the earnest push for building specific performance conditions into equity.

With performance units investors, individuals, rule-makers, and regulators seemed to get what they wanted. Investors got assurances that payouts were linked to their own success. Individuals received awards that had upside potential, like stock options. Rule-makers thought they had found a key to slowing the growth of executive compensation and regulators had a framework of established processes that they could apply without too much hassle. But, companies and compensation committees had a real challenge.

Companies knew that like stock options, performance units had the benefit of tax deductibility under the 162(m), the tax rule that helped create the original explosion in the use of equity compensation. This potential benefit helped offset the difficulty many companies had in determining the correct metrics and setting reasonable goals. Over the past ten years, consultants and companies have become better at this and performance units have taken hold as a key component of executive compensation. Their use has grown consistently…until 2017.

Equilar recently reported that the use of performance equity usage in the “Equilar 500” dropped slightly from 2016 to 2017, from 84.6% to 81.6% of companies using these tools. In both years performance awards made up 63% of the total equity granted to CEOs. While the drop was not precipitous, is perhaps a foreshadowing of the future?

At the beginning of 2018 the tax benefit of using equity, generously provided by 162(m), went away. No longer will companies receive tax deductions for pay above $1Million when the pay is linked to stock options or performance awards. This removes a major driver for the use most types of equity compensation at the executive level. We will see if this plays into compensation committee decision-making during the 2019 proxy season (plan ahead, buy some popcorn now.)

At the same time, we have been riding one of the longest bull market waves ever. Waves come crashing down when they meet the shore, and many are concerned about the tsunami that may occur when the market corrects. This puts even more pressure on the use of performance awards. It is hard to follow Friedman’s advice when you cannot predict the consequences of your ideas and subsequent actions. All of this may drive executive pay into cash and shorter-term pay cycles.

On a related note, delaying pay means providing potentially higher pay. This means the use of shorter-term, cash-related executive compensation may affect the slowing of the growth of pay at the top of the house. Perhaps the unintended consequence of tax reform will be to lower the amount of income that can be taxed. It’s still early, but time is flying by quickly.  What do you have planned for 2019 Executive Pay?

(One more thing… take a minute to get familiar with the recent IRS Guidance on 162(m))

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