With an increasing number of listed public companies introducing an element of deferral in relation to annual incentive plans, we have observed variable practice in relation to:
- The period of deferral;
- The equity instruments used for deferral;
- The valuation of those equity instruments for the purpose of allocating value; and
- Adjustment to deferred equity awards at the time when vesting takes place.
Period of Deferral
The dominant period of deferral appears to be twelve months following the determination of the incentive award. The twelve month period of deferral is split between the beginning of the financial year following the performance period or twelve months from the date on which the annual incentive award has been determined.
There are an emerging number of companies that are deferring the award in two tranches of equal value over two years and a small minority with a three year deferral.
A number of organisations philosophically, particularly those with relatively aggressive annual incentive plans, see deferral as a key element of retention.
Instruments of Deferral
It is Egan Associates’ observation that the majority of annual incentive plan deferrals are in the form of a share or performance right, with a number using restricted shares and a small minority using cash, that cash being either unadjusted or adjusted by a factor such as the CPI or the weighted average cost of capital of the company.
Value of Deferred Incentive
Where cash is deferred, the value of the deferred incentive is equivalent to the proportion of the award deferred. Where restricted shares represent the instrument of deferral the number of shares issued is represented by a nominal VWAP, either at the time of the determination of the award and the deferral amount or on the basis of VWAP either side of the date on which the financial year concludes.
In relation to rights, if they are the instrument of deferral they would normally follow the principles adopted for restricted shares. We have, however, noted that some companies are allocating rights adopting a fair value methodology which discounts the prevailing share price for the purpose of allocation by up to 50% at the time of award, adopting a methodology in parallel with that which a minority of companies apply when issuing rights under a long term incentive plan. It is not our view that this is appropriate nor clearly understood by the majority of shareholders.
By way of example, if the deferred incentive amounted to $50,000 then the cash deferral would be $50,000, the restricted shares would have a market value on the basis of VWAP of $50,000 and rights would have a similar value and allocation number. It would be our view that where a substantial discount is applied for the purpose of allocating equity instruments as an element of deferral and the value is up to twice the deferred incentive this is an appropriate practice.
We have observed over recent years that companies which have introduced deferral under their annual incentive plan have often increased the maximum potential award under that plan in recognition of the deferral.
Adjustments to Awards Under Deferral
In relation to the deferral of restricted shares, dividends on those shares are either passed through to the executive during the period of deferral or reinvested. Where rights are the instrument of deferral they are either unadjusted for dividends or additional rights are granted equivalent to the gross value of the dividend paid during the period of restriction. Where cash is deferred the deferred cash is either passed through to the executive or adjusted by some other factor such as the CPI or the weighted average cost of capital of the company.
Our observation is that the annual incentive plan rules indicate that deferred incentives would be forfeited where the executive chooses to leave the company and the deferred component would not be paid. Many organisations have plan rules which provide the Board with discretion whereby deferred incentives are paid in a number of instances which would be similar to rights and entitlements under a long term incentive plan.
Where STI is deferred as an equity instrument and the employee is terminated other than for cause or is made redundant the equity instrument is either released at the time of separation or held but available to the executive when the deferral conditions are met. This latter strategy is often adopted where the employment agreement includes restraint of future employment for a period after separation.