Author: Elayne Demby

Progressive Corp.’s top 650 employees get annual restricted-stock awards of 20 percent of pay. Until last year, mid- to senior-level employees of the holding company for the Progressive Insurer Group got annual stock-option grants. Microsoft and Amazon.com, both broad-based options pioneers, also now give restricted stock rather than options. In fact, dropping options in favor of restricted stock is becoming a popular move.

    A 2003 PricewaterhouseCoopers human resource services survey shows that 15 percent more companies use restricted stock than in 2002. But switching from options to restricted stock is not necessarily all that easy to pull off. “The problem is that companies tend to look to what everyone else is doing,” says Blair Jones, senior vice president of Sibson Consulting in New York. The reality is that, for some companies, restricted stock is not an appropriate compensation tool, she says. While restricted stock may be the right thing for Microsoft–a mature, established company that pays dividends–it may not be the right move for a start-up company in a high-growth industry. The impact on employees and the strategic goals and objectives of the stock-compensation program must be fully assessed before a change is made, experts say.

    Progressive, which has 25,000 employees and is located in Cleveland, likes to have entrepreneurial managers who are not afraid to take risks. But senior management also has felt that option holders might take unnecessarily excessive risks to drive up stock prices. “We did our own study of corporate governance in the wake of accounting scandals and concluded that restricted-stock awards better align employee interests with those of shareholders,” says Progressive treasurer Tom King, noting that the change is not a defensive move to salvage underwater options. All outstanding options are still “in the money,” with share prices above strike prices.

    Employees have not objected to the change. “They understand the trade-offs,” including less risk for less gain, King says. In addition, restricted stockholders share in Progressive’s $.10 per share annual dividend and have voting rights–two things they did not have with options. Furthermore, the value of equity compensation remains the same. For example, if Progressive stock trades at $75 per share, then, under the old plan, an employee making $100,000 would have received approximately 500 options with a market value of $20,000, King says. Today, that employee would receive approximately 250 shares still worth $20,000. After three years, the new awards vest at a rate of one-third a year, with the 30 most senior level employees’ awards vesting only after the attainment of corporate growth targets. All awards are fully expensed in the company’s financial statements over the life of the grant.

    A spokesperson for Microsoft says that restricted stock is now a better way of attracting and retaining the best employees and aligning the interests of its 50,000 employees with those of shareholders. “Employees all have the opportunity to receive stock awards, be an owner, and share in the success of the company,” he says. The company would not discuss further information about the plan.

    Whether restricted stock is right for employees depends on age and risk tolerance, experts say. For risk-averse employees, restricted stock has notable advantages now that holdings of underwater options are common. “Restricted stock is always worth something,” says William Gerek, global director for the Hay Group’s executive compensation practice in Chicago. When share price drops below option strike price, options are worthless to employees. But if restricted stock is worth $30 on grant date, and share price drops to $22, the stock is still worth $22, says Scott Olsen, a principal and head of PricewaterhouseCoopers’ human resource services compensation practice in New York. Unlike options, restricted-stock awards require no employee cash outlays, Gerek says. Employees can get dividend income, even prior to vesting. The dividends are taxed at ordinary income tax rates until vesting, and thereafter at 15 percent.

    But while restricted stock has less risk, it also has fewer opportunities than stock options, Olsen points out. There is less chance of becoming an overnight multimillionaire, the very thing that appealed to thousands of innovative, entrepreneurial individuals during the technology boom. The smaller size of restricted-stock grants may also lead to misunderstandings. “Some employees focus on the numbers and see that where they once got 10,000 options, they are now getting 1,500 restricted shares,” Jones says. But restricted stock is a sure thing and less speculative than options, and thus is worth more. This fact must be communicated to employees before a switch, she says.

    Employees also are in less control of their tax destiny. They don’t pay taxes on options until they are exercised, so there is control. But restricted stock is a tax certainty that is included in income on vesting, Olsen says. Some overseas jurisdictions even tax restricted stock upon grant. Employers can delay taxation by issuing “restricted-stock units,” a contractual promise to issue shares at some future date after they are vested. Microsoft uses restricted-stock units, Jones says. Employees can also elect to be taxed within 30 days of grant date under Internal Revenue Code section 83(b). The theory is that taxes will be lower at that time than they will be after vesting, Jones says. But, she warns, employees cannot get taxes back if the stock falls in value or is forfeited.

    Restricted stock is also more appropriate for certain types of firms and certain industries. In high-turnover industries, it is more effective in retaining rank-and-file workers. “Stock options were never much of a retention tool; they basically retained employees until they vested, then they’d cash in and leave,” Gerek says. Until vested, employees are disinclined to leave a firm and leave restricted stock behind even if stock prices have fallen, Olsen says. But stock options are better for start-up firms and companies where cash flow is a problem. “Stock options are much more motivating than restricted stock,” Olsen says. And whether restricted stock or stock options should be granted depends on the level of the employee as well. Restricted-stock awards may be a better form of motivational equity compensation for the rank and file, Olsen says, but senior management still should have a component of their compensation based on performance.

    While investors generally favor restricted stock, they will scrutinize any switch. Institutional Shareholder Services recommended that its 700 clients vote yes on the Microsoft change, but the California Public Employees Retirement System voted its proxy shares against it, stating that the company did not provide enough information about the plan. The plan passed anyway. The AFL-CIO’s office of investment management, which oversees more than $400 billion in union pension funds across the country, says that restricted stock is an appropriate compensation tool for senior executives only if vesting is performance based.

    Depending on corporate strategic goals and employee level, a compensation package can have both restricted stock and stock options, Olsen says. The Financial Accounting Standards Board’s proposal to expense stock options beginning in 2005 can, in a sense, be considered a good thing, experts say. “One reason that stock options pulled out ahead of the pack was their favorable accounting treatment,” Gerek says. Options were granted primarily because they were viewed as “free,” Jones says. Once expensing becomes mandatory, however, then the comparison becomes one of “apples to apples,” Gerek says, and the decision can be based on what is truly the best compensation strategy for the company.

    There is no one-size-fits-all approach to equity-based compensation, experts say. “Look at all equity compensation vehicles and see which makes the most sense for your company, your employees and your investors,” Gerek says. While overall levels of pay are relevant in comparing yourself to peers, how that compensation is delivered should vary from company to company. Factors such as employee age and corporate culture should be taken into consideration.

    One company that is going its own way is Dell Inc., which intends to grant 50 percent fewer stock options to its approximately 44,000 employees than it did last year. It has no plans to replace the options with restricted stock or anything else. For the year ended January 31, 2003, the company granted 84 million stock options. It plans to issue approximately 44 million for the year ending January 31, 2004. Senior management believes that stock options are less effective than they were in the late 1990s, says spokesman Michael Maher. “We found that, given the marketplace for hiring and retaining employees, we aren’t required to issue as many options to hire people or keep them,” he says.

Workforce Management, January 2004, pp. 60-62 — Subscribe Now!

After the collapse of several prominent companies, many led by high-pricedoutsider CEOs, some question the assumptions on which executive searches and paypolicies were based in the last decade.

    “It’s now perceived that if a company is doing well, it’s because ofthe CEO, but empirical research shows that who the CEO is doesn’t matter indetermining the performance of a company in terms of long-term stock performanceor financial returns,” says Rakesh Khurana, an assistant professor at HarvardBusiness School and author of Searching for a Corporate Savior: The IrrationalQuest for Charismatic CEOs. It was the “war for talent” mind-set that onlythe right CEO can lead a company to prosperity that drove CEO salaries throughthe roof, he says.

    “There’s no empirical support for the war for talent, and it borders onthe irrational to think that just because someone did well at one organization,they will do well at another,” says Khurana. For example, he says, GE managersrecruited to other companies have generally not delivered on their originalexpectations, although they did very well during their tenures at GE.

    “John Trani went from GE to being CEO of The Stanley Works, and his onlysolution to that company’s many problems was to pursue financial gymnastics byattempting to move the company’s legal headquarters to Bermuda to avoid payingU.S. income taxes,” says Khurana. Gary Wendt went from being CEO of GE CapitalServices to CEO of Conseco, Inc., in June 2000, and by October 2002, Moody’sreported that Conseco was on the edge of bankruptcy. Wendt was removed from hisjob as CEO at that time.

    AT&T, Kodak, Xerox, and Polaroid, says Khurana, all went to the outsideto find “savior CEOs.” But none of these companies fared well. “Theproblems of these companies had nothing to do with the CEO,” he says, “andno matter what messiah they brought in, it was not going to solve thoseunderlying problems.”

    Xerox’s underlying problems had more to do with people sending each othere-mails and not sending each other copies than with its corporate leadership.”AT&T was a formerly regulated monopoly with a declining core market.Michael Armstrong was brought in from Hughes Electronics as CEO, and after $162billion in acquisitions that were later divested, AT&T is still a formerlyregulated monopoly in a declining core market,” he says.

    “Outsider CEOs,” says Khurana, “have actually proven to be quitedestructive to many companies in terms of the pay they expropriated from thefirms they went to and the severance packages they were able to negotiate, whichamounted to ‘heads I win, tails I win.’ ” He says the destruction alsoincluded unnecessarily large layoffs and a lack of investment in people.

    There are exceptions to every rule, including this one about outsiders faringpoorly. Outsider Lou Gerstner is generally credited with reviving IBM, whereasinsider Jacques Nasser’s CEO tenure at Ford is viewed by many on Wall Streetas an abysmal failure.

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Infuriated IBM employees are still fuming over the company’s May 1999conversion from a traditional pension plan to a cash balance plan. Kathi Cooper,a business controls adviser, was so incensed that she filed a federal lawsuitalleging age discrimination. “They reduced our benefits to give them to theyounger workers–that’s age discrimination,” she says. Janet Krueger, wholeft IBM after the conversion, thought she could retire with a comfortablepension, but her plans evaporated after she saw her opening account balance inthe cash balance plan. “It doesn’t take a rocket scientist to figure outthat an account balance equal to less than one year’s salary would nottranslate into an annuity equal to one-third my salary in 8 to 10 years,”Krueger says.

Cash balance plans exploded on the pension scene in the late 1980s, when Bankof Boston unveiled a brash new plan combining the attributes of a pension planand a 401(k) plan. Benefits are expressed as “accounts” and credited withcontributions and interest annually, but the employer remains on the hook forall contributions. Companies rushed to adopt these new plans that allowemployees to better “see” their benefits. But cash balance plans became thecenter of a storm of controversy when some companies reduced future benefitaccruals as part of the conversion.

The squall began in 1999, when the Wall Street Journal began reporting on thereduction of employees’ expected pensions–sometimes by more than 50 percentafter conversion. After IBM announced its conversion, thousands of IBM workersflooded the media and Congress with stories of promised benefits that were beingstripped away. The computer giant got a reputation as the poster-child for badcash balance conversions, says David Certner, director of federal affairs forAARP in Washington, D.C. IBM won’t comment on the incident.

The plans are still dogged by controversy. The Treasury Department and IRSrecently withdrew controversial proposed regulations on age discrimination inthe plans, and are seeking comment until July 27 on how to write new rules.

Despite all that, many companies–including FedEx andDelta–either haverecently announced plans that they are converting or are looking closely at thepossibility of doing so. In a recent Deloitte & Touche survey, 43 percent ofrespondents indicated that they are considering changes to their defined benefitplans. Twenty-eight percent indicated that they are thinking about converting toa cash account (i.e., cash balance) type of formula.

Proponents of cash balance plans argue that today’s mobile workforce has noappreciation for a plan designed to provide significant benefits only after 20or 30 years. Traditional “final average pay” plans are generally uselessrecruitment tools for younger workers, and equally as bad for inducingunmotivated older workers to move on. “Cash balance plans are very appealingto employers because they are easy for employees to understand and appreciateand they also work better in a total compensation approach,” says KarenSalinaro, a consultant with Towers Perrin in New York.

Defined benefit plans are also complex to run and have high administrativecosts, including steep Pension Benefit Guaranty Corporation premiums. Employersview cash balance plans as a way to get some return on their investment–acritical issue in an economic climate where once wildly overfunded plans haveturned into bottomless money pits. “With traditional plans, a lot of employersare saying, ‘We’re spending a lot of money on a plan that employees don’tunderstand and don’t appreciate,’” says Larry Sher, director of researchat Buck Consultants in New York. “It’s hard for employees to appreciate afinal average pay plan because the only way they can begin to evaluate what thebenefit is worth at any point in their career and how it will change over timeis to hire an actuary to do the calculations for them. The average employeecannot do the computations on his own.”

Cash balance plans also can save companies a lot of money. Effective June 30,2003, Delta, for example, will change its retirement plan for non-pilot U.S.employees from a traditional defined benefit plan to a cash balance plan. Theairline says that the new plan structure is expected to reduce the company’sexpenses significantly this year, and by about $500 million in the next fiveyears. “As Delta works to recover from the current financial crisis, thecompany must act to control the high and rapidly growing cost of retirementbenefits while protecting the interests of Delta people,” says Bob Colman,executive vice president, human resources. “Unless these steps are taken,Delta’s retirement expenses would increase at an unsustainable rate. The newcash balance program is competitive with programs at other leading companiesinside and outside our industry. It also is more flexible and more portable thanthe current plan.”

Though cash balance plans have been lampooned in some media as greedycorporate cash grabs, the reality is that the plans don’t save most companiesmuch money. According to a 2000 Watson Wyatt study, the average employer costsavings was just 1.4 percent–not 20 to 50 percent–after simultaneousenhancements to 401(k) plans are factored in.

If the decision is made to convert, then strong and effective employeecommunication is essential, experts say. “If there’s a good communicationprogram, it’s less likely that employees will feel disenfranchised and sue,”Sher says. Negative publicity has led to plaintiffs’ filing class-actionlawsuits. IBM, Xerox, Bank of America, Georgia-Pacific, AT&T, and Onan foundthemselves embroiled in litigation over their cash balance plan conversions. Nowcompanies take steps to keep employees happy. “We took into consideration thelessons learned from those who came before us. We did not want to fall into thecategory of those who did not do it right or did not treat employees right, butwe needed to do this to be competitive,” says Sandra Munoz, manager ofcommunications at FedEx.

Experts agree that a cash balance plan conversion should not be used to hideor disguise a reduction in benefits. “Most negative press regarding cashbalance plans has been related to situations where the value of benefits hasbeen cut back and there has not been an adequate explanation or rationale forwhy it was done,” says Suzanne McAndrew, a principal with Towers Perrin in NewYork. If a decision is made to reduce benefits, then it is important to be openwith employees about the reduction in future retirement benefits, Sher andMcAndrew say. “If you either have to reduce what you are spending on yourdefined benefit program or feel it’s appropriate to redistribute the benefitdollars to a broader portion of your workforce, then be honest about it andexplain why,” Sher says.

And if benefits are cut, it is important that management is not seen asgaining from it. “The problem is that employees have been watching their owncompensation and benefits being reduced, while they see the CEO’s compensationand benefits package skyrocket through the roof,” says Karen Friedman,director of policy strategy for the Pension Rights Center in Washington D.C. “It’sa transfer of wealth within the company off the backs of working people to thepockets of senior management.” It is particularly galling to employees, shesays, that pension-plan surpluses are used to inflate the bottom line ofconsolidated financials and that senior executives’ incomes go up as pensionbenefits for the rank and file go down. “By reducing employees’ benefits,they were reducing liabilities under the pension plan and were able to recordlarger pension income on balance sheets, which added to the company profits andincreased CEO compensation,” Friedman says. “CEO compensation went upbecause they reduced the pensions of their older workers.” Cooper adds: “Cashbalance plan conversions are nothing more than a grab from the rank and file tosenior executives. IBM executives are using vapor profits from the pension trustso that they can reward themselves millions more in bonuses.”

Employee advocates are already screaming foul over Delta’s plannedconversion. The company may be looking to save money on the retirement plan forits rank and file, but it’s spending the savings on its senior management’sretirement plans. The company set up special retirement trusts for its top 33executives to protect their non-qualified retirement benefits from the risk ofbankruptcy. These executives will have their pension benefits fully funded by2004, and will also be reimbursed for the taxes they will incur as a result.Delta chief executive officer Leo Mullen’s trust got $8.24 million for theyear ended 2002 alone.

Sher agrees that the negative backlash against cash balance plans is relatedto employees’ perception that senior management enriched themselves atemployees’ expense. “If you do have to cut benefits, and management isinsulating itself from the cutbacks, then this will not work,” he notes.Companies must review senior executives’ entire compensation package beforeconversion to see if there is any increase in income on financial statementsresulting from the conversion that can affect senior executives’ pay orbonuses, Towers Perrin consultant Salinaro says.

Much of the controversy is also the result of a company’s failure to giveadequate transition provisions. “The real issue, and why there has been suchan uproar from employees, is not the plan design itself but the conversion,”Certner says. Traditional plans provide minimal benefits at the beginning of acareer and extremely high benefits at the end. “So if you put in 10 or 15years at the lower benefit levels and the formula is changed so that there areno longer those high benefit accruals, you won’t be happy,” he says.

Employee advocates say conversions with “wear-away” periods areparticularly troublesome. This happens when opening balances in cash balanceaccounts are set below benefits accrued under the traditional plan. Becauseaccrued benefits cannot be reduced, older employees receive no new meaningfulbenefit accruals under the cash balance plan until their account balance exceedstheir frozen accrued benefit under the traditional pension plan. “This kind ofsituation where an older worker essentially ‘runs in place’ for years isexactly what the age-discrimination laws for pensions were enacted to address,”Certner says.

To combat this issue, companies should carefully review various transitionstrategies, Sher says. One approach offers employees the right to choose betweenthe old and the new plan formulas for a limited period. Memphis-based FedEx isgiving the 137,000 workers covered by its corporate pension plan the option toeither stay under the old plan formula or change to the new cash balance planformula. Employees will have to make their decisions between June 2 and August29 of this year.

But this approach can cause problems down the line. “What happens in thefuture when an employee stays longer than he thought he would and discovers thathe has $200,000 less because he chose the cash balance formula as opposed to thefinal average pay plan?” asks Joyce Meyer, a principal with Gardner Carton& Douglas, a law firm based in Chicago with a nationally recognized practicein employee benefits.

Some companies have given all current employees the right to have benefitscalculated under both formulas on retirement and get the greater of the two.This is the approach that Eastman Kodak used when it converted to a cash balanceplan, and the only one that employee advocates such as Friedman believe is just.But while offering choice is seen as being fair to all employees, Salinaro says,it is the most expensive and difficult to administer on a long-term basis.

Delta is giving employees a seven-year transition period. Individualsemployed on June 30, 2003, can have their benefits calculated under both plansand choose whichever is greater if they retire before June 30, 2010. Employeeshired after June 30, 2003, will be eligible for the cash balance benefit only.As a result of this transition, current employees who retire within the nextseven years will see no adverse impact on their retirement-income benefit, saysDelta spokesperson John Kennedy. Delta employees who qualify for a subsidizedearly-retirement benefit in the next seven years can lock in that benefit on theday it vests and then get cash balance plan benefits afterwards. That means theywill earn more in pension benefits than they would have under the old plan.

Meyer says that employees must understand that further changes to the planare possible–including termination or freezing of benefits. To head offpotential lawsuits, she says that the fact that actual benefits can besignificantly different from what the models show should be explained. It alsomust be made clear to employees that they have no guarantee of futureemployment.

Federal Express is freezing its traditional defined benefit plan accruals asof May 31, 2003, although salary increases will continue to be used to determinebenefits. If an employee opts to move into the cash balance formula, then newbenefits will be accrued in that format as of June 1, 2003. Employees who chooseto remain under the old formula will have their benefits computed as if therehad been no conversion. FedEx is offering this option as a way of attracting newemployees, but knows it must be fair to long-term employees, Munoz says. To helpemployees choose, last February the company started an extensive six-montheducation campaign. “We will be giving employees a lot of information,including online tools, so that they have the information they need to maketheir choice,” Munoz says.

She believes that while younger, more mobile employees will see the benefitsof moving to the cash balance plan formula, many of FedEx’s older employeesmay be better off as well. The company’s current plan takes into account only25 years of service in computing benefits, she explains. So if an employee hasclose to or more than 25 years of service, she can switch to the cash balanceplan formula and walk away with more than she would have under the traditionalplan.

But the success of a conversion can be outside the control of any humanresources manager. “If employees do not trust management and think thateverything you do is to enrich management, then it doesn’t matter what you do,”Sher says. Some employees may never come on board for any type of cash balanceplan conversion that reduces benefits in any way because of past managementdecisions. “The reality is that baby boomers are getting ready to retire, andcompanies don’t want to let go of the money in the pension plans,” Coopersays, “because that will make operating profits look bad and they won’t gettheir big bonuses.” Given the glut of boomers nearing retirement, she saysthat companies are realizing that they will have to pay millions out of theirpension plans. But cash balance plan conversions are purposely designed to holdon to the money to make corporate bottom lines look better, she says. “Theydon’t want to sit down and write checks, and with a cash balance planconversion, they don’t have to let go of the money.”

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