Executive Comp May Party Like 1939

May 28, 2004 (PLANSPONSOR.com) - To truly gain a sense of the direction in which executive compensation is heading in this turbulent time, corporations can examine another tumultuous time in the nation's history to draw uncanny parallels.

At the dawn of the 21 st century the nation’s economic climate has an uncanny resemblance to the period between 1935 and 1954, a time that was marked by a recovering economy, inflation near zero that then increased, increasing tax rates and an S&P 500 index that remained level with a volatility of up to 30%. During this time as well, executives saw a compensation market for their talent that demanded premiums of 15% to 20%, driving the price for executive compensation skyward, according to the Back to the Future: Executive Compensation presentation delivered by Robert Romanchek a consultant with Hewitt Associates and Ezra Singer, a former Executive Vice President, Human Resources with Verizon.

At the period in the past as well, much like the current environment, companies faced a large amount of pressure from the media about their “excessive” executive compensation packages. However, in today’s world executive pay is not nearly as inflated as recent stories may indicate Singer said. “The reality is there has been no value given,” Singer explained, pointing to the fact that companies are forced to affix a present value to compensation vehicles meant as a long-term incentive. Thus, even though a company’s balance sheet may show an executive’s compensation package as being worth a certain amount, in real terms executives have no access to that funding, such as the case with stock options.

Speaking at WorldatWork’s 49 th Annual Conference held this week in , , Romanchek and Singer noted in the present time, we see:

  • tax rates that currently are stable but have an upward bias,
  • stock markets that are “bumpy and sideways” at the moment, and
  • technological improvements that quickly turn into lower-priced commodities.

These factors will, in turn, influence executive compensation trends much as they did in the past, a period that saw the rise of executive compensation vehicles such as deferred compensation, split-dollar life insurance, restricted stock options and deferred pension plans.

Rising Tax Environment

Romanchek and Singer said as tax rates increase, corporations will focus their creativity on concepts that provide deferral of tax. For example, executive pay watchers may see an expansion in the use of nonqualified plans, that could, in turn, place a renewed emphasis on funding and securitization.

Don’t count out the life insurance industry either, though it recently saw legislation placing limitations on their use of split-dollar life insurance plans, Romanchek and Singer said (see R.I.P. Split ). Going forward, the two presenters said the industry will introduce new products allowing companies to defer taxes on executive compensation products and continue to push for new legislation. That legislation, however, will set up tax-advantaged vehicles to benefit all employees, not just executives, Romanchek and Singer said.

Yet, if capital gains and dividend tax rates remain low, the duo sees the potential for a rise in full-value share grants. The downside would be the potential for shareholder advisory groups to turn negative on these if they are pure time vested.

Romanchek and Singer also do not see an immediate decline in the use of the Black-Scholes method to value employee stock option grants. This has become an issue that has gained more and more prominence following the release of the Financial Accounting Standards Board's (FASB) Exposure Draft in March requiring companies to record stock option grants as an expense of financial statements (see FASB Hands Down Option Expensing Proposal ).

Rather Romanchek said Black-Scholes will still be popular in the first year or two of mandatory expensing, simply because there is "no reason why you can't use Black-Scholes for not only the first year, but others after that," Romanchek said. The reason is because FASB merely stated a preference for a Binomial pricing model, but did not rule out continued use of Black-Scholes, the most commonly utilized stock option valuation vehicle. Companies will also be in no hurry because once they elect a Binomial model, they cannot go back to the less complex Black-Scholes method.

However, the two differed on one possible future compensation trend that Romanchek said could be spurred by Microsoft's move to allow for a broker-assisted stock option repurchase program. In Romanchek's opinion, Microsoft will successfully argue that its program created a "fair value" of these options for accounting purposes. This in turn will be the "precursor for allowing compensatory options to be freely tradable after vesting, much like a noncompensatory market tradable option now," Romanchek said.

Singer does not necessarily agree, instead believing companies will be hesitant to adopt such a program allowing for the free transfer of stock options among family members.