Upside is Considerable in STI Deferral

“A bird in the hand is worth two in the bush” is an old saying, and it’s one that describes the psychology of many executives when considering the value of their pay package.

Many organisations felt obliged when introducing STI deferral for executives to increase the size of the overall benefit to compensate for the fact that some of the bonus payment would not be accessible straight away and might reduce significantly in value before the executive gained access to it. Of course, payment in shares that are restricted for sale is more risky than receiving cash. However, many executives appear not to consider the possible upside.

Egan Associates examined STI deferral grants made in 2012 that vested in 2013 and 2014 (STI deferral usually occurs for one or two years, generally divided into two tranches with restrictions ending for the first tranche after 12 months and the second tranche after 24 months.)

Taking the stated grant date (or the end of the reporting period if no grant date was named), the closing price on market at grant date and the closing price on the day deferral ended, it was possible to examine how much executives had lost or gained arising from STI deferral into shares or share rights.

Of the top 100 companies by market capitalisation at 30 June 2014, 39 deferred a proportion of the KMP’s STI into equity, had made grants in 2012 and had restriction periods of two years or less.

Over the period of deferral, the share price performance of most companies provided executives with an STI award worth significantly more than it would have been if the award was purely in cash.

The distribution of the increase in value of the shares over the deferral period is displayed in the following figure.

Increase in value of Deferred Shares 2012 to 2014

Executives at less than a quarter of the companies experienced a loss in value in the shares over the period of deferral. Those at over a quarter of the companies enjoyed increases in the range of 40% to 100%.

The performance from 30 June 2012 to 30 June 2014 of the S&P/ASX 100 index (which will not match exactly the time periods for deferral of the individual companies but provide an indication) is displayed in the figure below, with the value of the index rebased to 100 at the start of the period.

S&P/ASX100 Performance

As expected, the S&P/ASX 100 experienced approximately the rise of the median companies in our sample. In a falling market, the median would not be so favourable.

To illustrate, hypothetically taking the same grants and moving them back five years to just before the financial crisis, the resulting distribution looks like this after the shares become accessible:

Growth in Share Values 2007 to 2009

Here, the value of the shares granted to executives at three quarters of the companies fell, for the lowest performers by over half their original value.

Yet, the performance of the markets around the world in the two years after 2007 was so unusual as to spark global intervention. Executives are unlikely to experience this kind of market often. In addition, almost a quarter of the companies examined actually saw a positive return on the deferred shares over the problematic period, so a loss in value was also not a foregone conclusion. Some executives saw significant increases in the value of their shares.

The key point for employers is that STI deferral provides a value differential between good performance and bad. Executives leading organisations with sound fundamentals and an eye towards disruptive forces weathered the storm with minimal damage. Those who did not were hit the hardest. If these executives received cash in 2007, the former group would receive the same return as the latter. There would be no skin in the game and no forced focus on the longer term.

Deferral also encourages retention, and enables clawback, for circumstances where executives:

  • Act dishonestly;
  • Breach their obligations to the group;
  • Receive an award the Board considered unwarranted or unfair;
  • Cause reputational, financial or operational harm; or
  • Behave in a manner that could adversely affect the company’s financial performance or long-term strength.

There are, naturally, alternative methods to achieving these goals. Deferral will not suit every company. But it is an important tool in the armoury of top companies that is easily understood by executives.

When facing resistance from executives over the introduction of deferral or the increase in the deferred proportion, Boards should be certain to:

  • Stress the scenario outlined in the first figure rather than the black swan scenario in the second.
  • Where there is an executive shareholding policy, discuss the use of deferral shares to achieve maximum shareholding requirements.
  • For companies undergoing a transition, note the significant upside possible if planned initiatives run smoothly and also note the fact that grants made at a depressed share price have a high likelihood of seeing a significantly positive return over the period of restriction.
  • If applicable, remind the executives that the shares will earn dividends while they are restricted.
  • Consider the possibility of introducing a threshold below which deferral does not occur.
  • Inform the executives of policies for the release of shares (for example good leaver policies, disability or death policies etc).

While the above observations should apply broadly across the market, there will be global settings which influence share values which are substantially beyond the influence of a leadership group. Boards will always need to reflect on possible outcomes beyond the control of the senior executive group.

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