By James Jordan FIA, Associate and Senior Consulting Actuary at Barnett Waddingham
Executive remuneration is one of the many challenges businesses are facing, and companies are responding in different ways – a number have suspended payment of dividends until the outlook becomes clearer. Many companies have already announced salary cuts and/or adjustments to bonuses, but such adjustments may not be necessary for others.
"In this environment, remuneration committees face the difficult challenge of setting incentives which are appropriate, with targets pitched at levels which are challenging yet still achievable."
The accounting standard IFRS2 requires the fair value of awards to be measured using an option pricing model.
Some thoughts on valuations of share plans and options in the current environment are set out below:
Incentive awards granted after March 2020
Whilst some companies are postponing the grant of new long-term incentives, others are scaling back the level of awards – but many are proceeding as planned. For companies whose shares have fallen in price, the fair value of share options will naturally now be lower than previously anticipated.
Share price volatility is a key assumption in the option pricing model. Generally speaking, the higher the volatility assumption, the higher the value of the awards.
"Determining expected volatility over the future vesting period has always been a subjective area, particularly during times of crisis, and there is a range of reasonable expectations about future volatility."
Companies should consider revising their volatility assumptions, for example where historical volatility may no longer be a suitable guide to future expectations. Market volatility is currently very high but may revert to more normal levels in due course.
Another assumption used in option pricing models is the risk-free rate, and rates (for example on government bonds) are currently near historic lows, which reduces the value of options. Rather than providing a risk-free return, gilts are close to offering a return-free risk!
Total Shareholder Return (TSR) conditions often include averaging periods e.g. three months to date of grant. Due to recent share price falls, the TSR at date of grant may be significantly below the base level set in the averaging period. For awards subject to absolute share price targets, the probability of achieving these targets will have reduced, leading to a reduction in the fair value of the awards. Where performance is assessed with reference to a comparator group of peer companies, the TSR at date of grant may be materially behind or ahead depending on the severity of the Covid-19 impact relative to its peers. Companies may therefore wish to reassess any averaging periods being used in new awards.
Suspension of dividends could have ramifications for TSR targets, particularly if it turns out that some dividends have merely been delayed, with a double payment at some future date. Remuneration committees should also be mindful of the potential for windfall gains if there is a strong recovery in share prices.
Often, long-term incentives plans will include non-market performance measures as well as market related ones. The accounting standards require companies to make an assumption regarding the probability of achieving non-market targets. However, it could difficult to predict the impact of Covid-19 on non-market measures such as Earnings per Share and individual performance targets.
Existing incentives granted before March 2020
For equity-settled awards, fair value is calculated only at the date of grant, so cannot be revisited. However, for cash-settled awards, fair value is remeasured at the end of each reporting period until settled.
Many performance targets set before the crisis erupted may now be unachievable. This includes non-market measures such as Earnings per Share and various individual performance targets, as well as market based performance conditions such as TSR e.g. if share prices have fallen far below absolute share price targets. Where existing options are underwater, executives may be eager to have fresh awards issued at today’s prices.
"However, the crisis will create winners and losers."
Companies that have performed well relative to their comparator groups may well find that their awards are suddenly much more likely to vest and vice versa.
Companies may be considering modification of existing awards, and the accounting implications should be considered carefully.
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