The concept of paying cash to executives at retirement has fallen out-of-favor over the past 20 years, along with its broad-based counterpart - the defined benefit pension plan. But, this is an approach worth revisiting for companies concerned about retaining key talent and with the potential misalignment of financial incentives created by large equity grants.
Equity is a very popular form of executive compensation. Shareholder optics are great as executives do not make money unless the shareholders make money. Executives like equity because it offers the opportunity for a large paycheck if the business results are strong and/or the stock market broadly appreciates. Beyond the optics, however, equity compensation has significant hidden drawbacks for non-executive shareholders.
Large equity grants can create a misalignment of financial incentives between executives and non-executive shareholders. While executives have the opportunity to reap large rewards for making high risk/high reward bets but without the symmetrical risk of loss, non-executive shareholders have a different risk profile; they risk their entire investment on the same investments that executives find so tempting. See Lehman, Bear Sterns, AIG, et al for illustrations of this hazard.
Equity compensation is also an ineffective way to retain executives. When stock prices are falling, executives begin to attach little value to their equity grants and become more vulnerable to competitor entreaties. A competitor can easily make up for underwater options or otherwise provide large equity grants to compensate for a low stock price. An executive's current employer is trapped. They cannot revalue stock options or grant additional shares without appearing to contradict the original rationale of the pay-for-performance equity pay.There is an approach that addresses these two issues. Replace a portion of equity compensation with a cash payment that increases in value based on service rather than performance. This approach provides a retention incentive even in a down stock market and reduces the misalignment of executive and shareholder risk profiles.
While the optics may be poor, the business rationale is strong under the right circumstances. The idea is not to motivate performance but to provide clear value to the executive for staying with the company through up and down markets and business cycles. Other incentive tools - short-term cash bonuses and variations of equity compensation can be used for employee motivation and business alignment.
There are tax, ERISA and security law issues to consider with a cash retention program but they allow for a great deal of flexibility in designing an approach around particular business and executive situations. As an example, a CEO who is 50 years old with a base salary of $750k might be provided with a benefit that is equal to four times this amount ($3.0 million)at termination of employment. The full payment is only made if the executive works until at least 60. Reduced payments might be added if the executive is terminated without cause prior to age 60 with increases for employment after age 60. The payment is made over five years subject to compliance with a non-compete agreement.
This approach would cost about $225,000 a year pre-tax for the 10 years following hire. The $225,000 could either replace an equal amount of equity which would typically leave plenty of compensation for incentive purposes or the $225,000 might be an add-on in exchange for the non-compete.
From the executive's perspective, they see a large payout waiting for them if they work until age 60 regardless of stock price or annual bonus. This incentive to stay with the current employer increases as the executive approaches age 60 and makes them less vulnerable to competing offers in a down stock market or in the event of poor short-term business results.
The retention incentive could be self-funded which allows the company to invest the deferred compensation in its business until the $3.0 million is due or it could purchase a tax-advantaged annuity to provide additional security.
Companies have a great deal invested in hiring and keeping key talent. A cash-based approach should be considered as a piece of an executive compensation program.
