FAS 123(R): Long-Term Incentive Plan Implications Presented by:Susan Marcille Ernst & Young Performance & Reward Practice Leader Presented by:Susan Marcille Ernst & Young Performance & Reward Practice Leader

2 Implications As a result of option expensing, companies are reviewing their overall compensation strategy, especially as it relates to long-term incentives. To do so they are focusing on the following:As a result of option expensing, companies are reviewing their overall compensation strategy, especially as it relates to long-term incentives. To do so they are focusing on the following: –Fresh look at linkage to current business strategy –Delivering same “value” with less dilution and cost –Diversification in LTIP’s –Holding periods and ownership guidelines –Performance orientation to vesting –Assessing design features in terms of international effectiveness

3 Implications (cont’d) Cost analysis for alternative LTIP approaches is often important in decision making processCost analysis for alternative LTIP approaches is often important in decision making process One important objective in LTIP design is program efficiency defined as the relationship between cost and employee perceptions of value deliveredOne important objective in LTIP design is program efficiency defined as the relationship between cost and employee perceptions of value delivered Cost analysis often includes assessment of financial statement expense, cash flow and tax implicationsCost analysis often includes assessment of financial statement expense, cash flow and tax implications

4 Implications (cont’d) Pay elements are shiftingPay elements are shifting –Base salaries will likely remain fairly flat –There will be a higher correlation between performance and incentive payout Long-term incentives will likely experience the most significant change and be delivered via blended arrangements (stock options, restricted stock, cash-based performance incentives)Long-term incentives will likely experience the most significant change and be delivered via blended arrangements (stock options, restricted stock, cash-based performance incentives)

5 Companies are evaluating alternative LTIP devices such as:Companies are evaluating alternative LTIP devices such as: –Stock options –Restricted stock –Restricted stock units –Performance shares/units –Stock appreciation rights Share versus stock settledShare versus stock settled –Others Implications (cont’d)

6 Impact of IRS Sec. 409A The term “stock rights” under the regulations includes stock appreciation rights (SARs) and nonstatutory stock optionsThe term “stock rights” under the regulations includes stock appreciation rights (SARs) and nonstatutory stock options As under the Notice, both stock options and SARs must be in “service recipient” stock in order to be exempt from Section 409AAs under the Notice, both stock options and SARs must be in “service recipient” stock in order to be exempt from Section 409A –Must be granted at no less than FMV –Cannot have any additional deferral feature

7 Stock Options Companies are continuing to use stock options to drive attraction, motivation, and retention of key talent. However, they are reducing the weight of stock option grants in the total compensation package and/or granting options to fewer employees.Companies are continuing to use stock options to drive attraction, motivation, and retention of key talent. However, they are reducing the weight of stock option grants in the total compensation package and/or granting options to fewer employees. –Trend began even before FAS 123R became effective Example: the average options burn rate fell 24% for both the Russell 3000 and S&P 500 companies between fiscal years 2001 and 2003 (3.12% and 2.26% in 2003, respectively)Example: the average options burn rate fell 24% for both the Russell 3000 and S&P 500 companies between fiscal years 2001 and 2003 (3.12% and 2.26% in 2003, respectively)

8 Stock Options Companies that decide to utilize stock options as part of their LTIP strategy are evaluating alternative design features including:Companies that decide to utilize stock options as part of their LTIP strategy are evaluating alternative design features including: –Vesting terms time vs. performance vestingtime vs. performance vesting –Performance features are considered “share holder friendly” –Option term considering shorter termsconsidering shorter terms –Expected to be one of the most common design changes –Potentially helps with expense, overhang and volatility related issues (i.e., under-water options)

9 Stock Options –Holding period for stock acquired Implementing “targeted ownership” programsImplementing “targeted ownership” programs The existence of stock ownership guidelines is increasingly being viewed by investors as evidence of good corporate governanceThe existence of stock ownership guidelines is increasingly being viewed by investors as evidence of good corporate governance Multiple of compensation, typically base salary only, was the most common type of executive stock ownership guidelineMultiple of compensation, typically base salary only, was the most common type of executive stock ownership guideline –The median CEO multiple of salary is 5x

10 Stock Options –Switching from ISOs (qualified) to Non-Qualified Stock Options on a select basis ISO permanent book/tax differenceISO permanent book/tax difference Belief that participants do not hold stock long enough to take advantage of preferential long-term capital gain ratesBelief that participants do not hold stock long enough to take advantage of preferential long-term capital gain rates

11 Restricted Stock Restricted stock may be used much more often with these characteristics:Restricted stock may be used much more often with these characteristics: –Longer vesting terms –Performance-based vesting more likely –Stronger retention incentive –Beware IRS Sec. 162(m) implications Restricted Stock (unlike Stock Options) is not generally exempt from the $1 mill 162(m) limitationsRestricted Stock (unlike Stock Options) is not generally exempt from the $1 mill 162(m) limitations

12 Cash Based Incentives Cash-based incentives may be introduced to:Cash-based incentives may be introduced to: –Tie incentives to internal value measures over a fixed period of time –Control the income statement impact of the long- term incentive CapsCaps PredictablePredictable –Reduce dilution

13 Stock Appreciation Rights Stock Appreciation RightsStock Appreciation Rights –Share settled maintains relatively favorable tax and accounting treatment –Uses fewer plan shares Benefit not realized until SARs are exercisedBenefit not realized until SARs are exercised –409A Implications Parity for private company and public company SARsParity for private company and public company SARs Parity for stock settled and cash settled SARsParity for stock settled and cash settled SARs

14 Contact information Susan H. Marcille Ernst & Young LLP