Get better results from long-term incentive pay: performance-based long-term incentives do not merely reduce the variance in earnings or reduce P & L expense. They can improve business performance over the long run.

• Author: Ericson, Richard
• Position: Compensation

Which would you prefer: Greatly reducing the variability in your earnings or getting better efficacy from the huge grants of long-term incentives you make each year?

You don't have to choose. A typical company can have both.

Stock option costs are starting to show up in company financial statements under the controversial Financial Accounting Statement (FAS) 123(R). The amount of these expenses has been the focus of much concern, but the stock market has largely shrugged off option-expensing as a non-event.

Companies still concerned with the book effects of long-term incentives should focus not only on the amount but on the behavior of these costs. Using "performance share" or "performance unit" grants, for example, can greatly reduce the variability of earnings when compared to a policy of stock option or restricted stock grants under FAS 123(R). In the following example (Figures 1 and 2), a typical company reduces earnings variation by 50 percent.

An average public company makes long-term incentive grants with value totaling around 1 percent of the value of its equity each year. If the company's price-earnings ratio is 15, these grants add up to 15 percent of earnings, or around 10 percent on an aftertax basis. If the grants were stock options or restricted shares, FAS 123(R) normally would call for them to be expensed over their vesting period (33 percent per year, say).

Since grants are made every year, amortization of three years' grants is underway at any given time; the annual run rate of expense stays at 10 percent of earnings. When earnings rise or fall, the subtraction of this large, fixed cost has the effect of increasing the variability of earnings.

Performance shares and units have very different effects. These plans allow participants to earn shares or cash, respectively, based upon the attainment of performance goals. In the simplified example on the next page, income at 80 percent of target means no award is earned. The performance unit or share grant will result in zero expense over its life.

Earnings at 120 percent of target means 200 percent of the targeted payout is earned, with expense rising in tandem (other outcomes normally are interpolated). The reduction or increase in incentive expense, when performance deviates from target, substantially buffers the impact on book earnings.

Earnings variation was reduced by 50 percent, from plus or minus 22.2 percent to plus or minus 11.1 percent. Why did this happen? In a word...