Stock options are not dead — but they no longer dominate executive compensation. Indeed, in compensation committees’ ongoing efforts to tie executives’ pay to company performance, such committees are taking a “portfolio” approach to compensation.

Along with recent moves to shift responsibility for the structure of compensation packages from management to compensation committees and boards, there is a greater emphasis on ownership requirements for top executives and the tying of bonuses to corporate performance metrics rather than to stock prices.

The central problem with options is that stock prices are often a function of market conditions rather than the efforts of individual executives. During boom times, as was the case prior to 2001, share prices can rise sharply for reasons that do not bear a close relationship to an executive’s performance. But, points out John Hughes, associate partner in Toronto with Deloitte & Touche LLP: “If there’s a lousy market, options don’t help an executive who did great work.”

When the technology bubble burst — effectively proving that executives have less to do with stock prices than market trends do — backdating scandals created even more trouble for companies that used stock options. As well, says Bill Mackenzie, director of special projects for the Canadian Coalition for Good Governance in Toronto, new disclosure rules caused “bellyaching” from institutional investors worried about dilution caused by large grants of options. It was at this point that, he says, “Executives agreed: ‘We’re not going to pay ourselves less, but we will pay ourselves differently’.”

After the excesses of the 1990s, the use of options has “stabilized and is focused only on the top executives,” says Lisa Slipp, worldwide partner of executive remuneration at Mercer Human Resources Consulting in Toronto. Options tend to be used only for long-term incentive plans.

These factors have ushered in a new period in which companies create compensation packages that are more diversified. “At first, restricted stock replaced the frowned-upon options,” says Hughes. In fact, he describes stock options as a “step backward.”

Options and their cousins, stock appreciation rights (SARs), reward an executive in the event that share prices increase after the options are issued. On the reverse side of the equation, executives do not take a hit if the share price declines. Should the price tank, the executive can opt not to cash in the options. But if the options expire before the share price recovers, the executive does not receive a bonus.

In terms of providing leadership incentives, then, options and SARs promote riskier behaviour: if an innovation proves profitable, the executive benefits. If the results of taking the risk are negative, the executive loses only part of his or her bonus, while shareholders may lose far more.

In the search for alternatives, the compensation committees of Canada’s largest issuers are increasingly making use of other classes of shares, including restricted share units (RSUs), deferred share units (DSUs) and performance share units (PSUs). Used together with stock options, they provide mid- and long-term incentives that also keep an executive’s compensation portfolio diversified.

DSUs are phantom shares in the purest sense. Many firms offer their executives the option to take part or all of their annual bonus in DSUs, which can be cashed in at the end of the executive’s tenure. This has the effect of tying the executive’s bonus to both rising and falling markets. DSUs are acquired at market value but do not represent any equity. There are no performance thresholds and dividends are reinvested in more phantom shares.

RSUs and PSUs are closer to phantom shares than to options. RSUs are units that are tied to the market price of shares and are awarded based on performance. PSUs are granted to an executive when the company achieves predetermined performance goals, whether measured as total income, return on equity, profit per share or other methods of assessing corporate results.

These share types can be subject to several preconditions, based on individual and division performance, that determine the number of shares issued. The disclosure of the exact structure of such rewards was one of the main bones of contention when the Canadian Securities Administrators proposed changes to executive compensation disclosure. Many issuers in the U.S. have refused to disclose their conditions for performance-based compensation after the Securities and Exchange Commission made it part of required disclosure at the beginning of 2006. (See page 29.)

@page_break@In any case, the widespread use of stock options is likely to continue. Stock options remain popular for smaller firms and start-ups.

“It’s misleading to say that stock options are dead,” says Bob Levasseur, senior consultant on executive compensation for Watson Wyatt Worldwide in Toronto. “They are not dead and they are not going to die. [In Canada,] they are the only vehicle that give executives a tax advantage.”

In the U.S., stock grants are making a comeback as a replacement for stock options, but differences in tax rules make using such grants in Canada an unattractive alternative. Instead, Canadian firms rely on PSUs.

In terms of taxation, PSUs are essentially options or SARs , but with an exercise price that is much lower than market value: like options, they are subject to the same capital gains treatment. But PSUs have their pros and cons. Many aspects of a company’s performance can be linked to the payout on a PSU, thus achieving the goal of tying executive performance to compensation. On the other hand, the complex features of these shares can make it very difficult for an executive to know where he or she stands. This can result in eroding the motivational aspects of incentives, what Levasseur describes as a “line of sight” problem.

One of the advantages of options is that executives need only check the ticker to know what is coming their way. That is in sharp contrast to the alternative classes of unvested shares, which change in value according to a wide number of criteria. That can make the status of more than a third of an executive’s annual compensation unknown.

Compensation committees are trying to address these issues. For example, the shares might not vest for several years but their value might be disclosed or determined at the end of one year. IE