The following post comes to us from James F. Reda, Managing Director, Kimberly A. Glass, Principal, and David M. Schmidt, Senior Consultant, all in the HR & Compensation Consulting Practice at Arthur J. Gallagher & Co. It is based on their recent article, which was published in The Journal of Compensation and Benefits.

The demise of stock options continues, according to recently filed information with the U.S. Securities and Exchange Commission (“SEC”).  The slide in stock options began in 2003 and extends to today. While a large percentage of companies use stock options as a component of their long-term incentive program, the percentage of the LTI award continues to erode. This erosion has many causes such as:

a)      Institutional Shareholder Services’ (“ISS”) power increasing as a result of the Say on Pay (“SOP”) voting rule;

b)      The view of shareholders and their advisors (such as ISS) that stock options were not “performance based”;

c)      ISS encouraging companies to have more than 50% of their LTI award contingent on performance;

d)      Changes in stock award accounting that required stock option awards to be expensed (they did not hit the income statement prior to 2006);

e)      The same stock award rule changes providing a more stable accounting platform for performance share awards; and

f)       The scandals associated with stock option back-dating and timing of stock option awards and exercises in the early 2000s.

In order to investigate what (and how much) is being shared in annual proxy statements about executive pay packages and how incentive pay is designed, we conducted a study of the 2012 annual proxy statement disclosures for 200 of the top U.S. companies (based on revenue). This is the fourth year we have conducted this in-depth analysis for the top 200 public companies.

The shift away from stock options and towards performance awards that are earned based on achieving performance goals continued in 2011 and in 2012 as well. For the second consecutive year, the prevalence of grants of performance-based awards exceeded the combined prevalence of time-based stock options and stock appreciation rights (“SARs”). This result is not surprising given the increased focus on pay-for-performance and the influence of SOP.

The collective use of performance-based awards (which includes performance shares, performance share units, performance-based restricted stock, performance stock options, premium stock options, and long-term cash) plans totaled 82% in 2011, up from 77% in 2010, with only 74% of companies granting stock options or SARs. Since 2008, the prevalence of stock option/SAR grants, in total, had declined from 82% to 74% in 2011, whereas the prevalence of performance-based awards had significantly increased in 2011. These figures exclude companies that did not make any LTI grants (two in 2011 and 2010, three in 2009, and five in 2008).

A review of 2012 grants based on SEC Form 4 disclosures for 153 of the top 200 companies (“2012 Preview”) indicates that performance share prevalence increased by an additional two percentage points and stock options and restricted stock prevalence declined by three to four percentage points.

While stock options will continue to be part of a typical LTI program, their role has diminished over the past ten years. We expect that stock options will settle into about 25% of the LTI award, with performance shares comprising 55% by 2015. Performance measures continue to adapt to the business climate and individual company business objectives.