Given recent volatility in the share market, Egan Associates has fielded a number of queries from Boards about the risks and benefits of STI deferral to their executives.
The following hypothetical analysis provides clarity into the effects of share price volatility on the value of deferred STI in comparison to cash payments.
The analysis considers a hypothetical $100,000 STI award to be paid to executives of the companies of the S&P/ASX 300, with part of the grant to be deferred into shares. It considers a number of variations:
- Deferral of i) 25%, ii) 33% and iii) 50% of the $100,000 into equity
- Deferral period of i) one year and ii) two years
First we consider a hypothetical 12-month performance period that ends in 2013, with the shares deferred for one year becoming available to the executive in 2014, and the shares deferred for two years becoming available in 2015. The analysis assumes share grants occur a month after the financial year end of each company, providing time for the Board to determine whether the performance conditions have been met.
The difference between the total STI value if a portion of the STI was deferred and total STI value if 100% of the STI was delivered in cash is depicted in the figures below.
One Year Deferral Period from 2013 to 2014:
For all sectors except energy, a median performing company could expect to at least receive the value in shares at the end of the deferral period that they would have received as cash. Depending on the sector, the return would be respectable given the current low interest rate environment, but not as high as savvy investors might achieve elsewhere.
Apart from executives in the financial sector, those whose companies sat at the 25th percentile could expect to receive less value if they received deferred STI than if they had been provided with 100% cash. Substantial gains over the cash amount were achieved by executives whose companies sat at the 75th percentile. Healthcare and ICT showed the biggest gains.
The difference between the outcomes of cash and equity was multiplied by the percentage of equity deferred. Executives of companies where the share price performed well received much higher returns at 50% deferral than at 25%, while those at companies where the share price performed poorly saw higher losses.
2 Year Deferral Period from 2013 to 2015:
Extending the deferral created a greater return for executives in industries that were doing well, with healthcare performing much better than other industries. It also saw lower returns for metals and mining, as the commodity price falls began to bite. Executives in energy companies saw even poorer returns as even those in the top quartile saw lower returns on deferred equity than if they had received cash.
Giving all companies the same year end
Following this consideration of companies based on their actual reporting date, we will now consider a hypothetical situation where all companies of the S&P/ASX 300 defer their shares in January 2015 for one year. This provides an up to date examination of the effects of current volatility on STI deferral.
The difference in value between deferred equity and cash to the executives is below.
As can be seen, the situation has changed dramatically. There is no industry where even executives in the bottom quartile would see a better return through equity than through cash. With the exceptions of healthcare and ICT, only executives in the top quartile were seeing benefits from deferred equity.
Many Boards might see this as evidence that STI deferral is a difficult reward instrument; however, it is important to remember that with the exception of the energy sector where difficult conditions prevail, the top companies are continuing to provide executives with returns under deferred STI. In addition, Egan Associates considers that the intent of deferral is to align executive interests with shareholder returns. Therefore STI deferral may lead to lower returns than cash when the share price declines.