Golden Parachute Gross-Ups May Be Unnecessary for Many Executives

Watson Wyatt research suggests companies should perform their own calculations before granting this benefit

By James Scannella and Steve Seelig

Compensation committees have been reexamining their non-core compensation elements under the brighter light shone by the recent changes to the Securities and Exchange Commission (SEC) proxy disclosure rules. Severance and change-in-control (CIC) benefits seem to be attracting the most criticism these days, so many companies are reevaluating the business purpose and effectiveness of those first.

The current financial crisis is bringing about many changes in executive compensation, either voluntarily or through legislation. Watson Wyatt expects the pressure on compensation committees to rethink their executives’ compensation packages to continue. Our perspective is that, even without legislative mandates, companies that do not voluntarily reduce potential pay under non-core compensation programs may be forced to reduce the core cash and stock incentives essential to a properly functioning “pay for performance” model. We’ve previously made the case that companies should “protect the core” (Watson Wyatt Insider, March 2008).

Why we questioned the prevailing wisdom about gross-ups
Reviewing severance and CIC programs involves a tricky balancing act. On the one hand, the board wants the executive cadre to focus on the best interests of shareholders in evaluating an offer for the company or a proposed merger, without being distracted by the possibility of dismissal. But the board does not want the CIC benefits program to be unnecessarily generous or inappropriate. These programs have traditionally included severance, good-reason termination payments and CIC payments, often supplemented by a tax gross-up to cover any golden parachute excise tax. Boards need to ask: “Are all these payments necessary to keep executives focused on the task at hand?”

In particular, we focus on gross-ups on CIC excise taxes. Our research strongly suggests these benefits do not provide any measurable return on their costs. We believe our study is the first to challenge what has become a prevalent practice for most major companies. We do not expect the current financial crisis to change our conclusion, for reasons we discuss later.

Our study questions whether tax gross-ups at a CIC are necessary to protect executives from the inequities of the golden parachute rules. A 2008 proxy statement for a Fortune 500 company summed up the argument favoring such gross-ups as follows:

While the excise tax is seemingly evenhanded, the excise tax can discriminate against long-serving employees in favor of new hires, against individuals who do not exercise options in favor of those who do and against those who elect to defer compensation in favor of those who do not.

But do the economics justify the cost? What if CEOs who didn’t exercise their stock options took home more after-tax compensation than those who did? Our thinking is that CEOs who hold more options also receive a deal premium at a CIC on a higher number of shares compared with those who exercised and sold early. So for these executives, their total equity cash payout from the deal might surpass any excise taxes.

The answer: Of the 10 companies and chief executive officers we studied, 90 percent of the CEOs earned more by holding on to their options than by exercising early to avoid excise taxes. So companies that provided gross-ups to executives were unnecessarily spending significant amounts of money. And because these dollars come out of the proceeds from the sale, they are taken directly from shareholders’ pockets.

Our methodology
We identified 10 companies in 10 distinct industries and selected the CEO whose total direct compensation was closest to the industry median. We then gave each CEO a “split identity” and estimated the option gain and overall compensation over the last eight years to both identities:

• Option holder: In this scenario, CEOs hold on to their vested options for future exercise as long as possible. Because they do not monetize their options at the first vesting opportunity, their incentives are generally far more aligned with those of shareholders.
   
• Early exerciser: These “alter ego” CEOs liquidate their options as soon as they are 25 percent in the money and vested, thereby reducing their potential equity gains at a CIC.

According to their proxies, these companies provided a tax gross-up for any golden parachute excise taxes due at a CIC — still a prevalent practice, according to recent proxy disclosures. For both option holders and early exercisers, we used their option grants awarded from 2000 forward and assumed a stock price transition from actual 2000 value to actual 2008 value. We assumed a CIC date of Jan. 1, 2008, and a deal premium that reflects real marketplace practices specific to mergers and acquisitions in each industry. We assumed both the option holder and the exerciser cash out their options on the CIC date.

After calculating whether the executive earned more as an option holder or early exerciser, we determined the cost to the company and to each shareholder of providing the tax gross-up. We assumed the buyer would take into account the added cost for the excise tax in negotiating the purchase price, so this cost would be borne directly by shareholders.

Most option holders earn more
Figure 1 illustrates that in all but one circumstance, the option holder would have earned more than the early exerciser, despite having to pay an excise tax on the excess parachute payments in all cases. Six of the 10 early exercisers escaped the excise tax by exercising their options on the vesting date (depicted in bold font numbers). In the one circumstance in which the early exerciser fared better, the company’s stock price had steadily declined over the period under review, thus rewarding early option exercise.

Figure 1
Option holder versus early exerciser earnings

Source: Watson Wyatt Worldwide.

Two major variables caused this difference:

• Stock prices trended upward over the years studied, so the intrinsic value (the stock price minus the exercise price) trended higher for option holders.
• Option holders held more options so they received a deal premium on more shares.

Theory versus reality
Figure 1 suggests that compensation committees should undertake a similar analysis for their own executive cadre, based on their specific facts, to determine whether they need excise tax gross-ups to help put all executives on an equal footing. Stated differently, compensation committees should not provide gross-ups based on the theory that the golden parachute rules punish executives — only the calculations will tell.

Figure 2 shows the additional company cost of paying the excise tax, and how the payment comes directly from the pockets of shareholders.

Figure 2
Company/shareholder costs

Source: Watson Wyatt Worldwide.

As Figure 2 shows, excise tax gross-ups can be very expensive due to the circular nature of the required calculation — often $2-$3 for every $1 provided to the executive. Making matters worse, the real cost is borne by shareholders.

Money often better spent elsewhere
Although gross-ups cost much less than CIC benefits, the costs are still significant and the value is often questionable, particularly given the non-cost-effective ratio between dollars spent versus dollars received by the executive. Although these provisions are prevalent in today’s marketplace, compensation committees should reexamine their value.

The CEOs in our sample would have received a significant premium for these options had their company been acquired at prevailing market rates — much more than they would have received had they exercised at vesting. More important, the premium would have given them enough liquidity to pay the golden parachute excise tax themselves and still come out ahead.

For many companies, option holders do not need additional encouragement to act in the company’s best interests by not exercising and selling — their self-interest favors the potential deal premium to be paid on unexercised shares.

The other argument for tax gross-ups is that without their protection, CEOs would be less likely to make deals. But the numbers in Figure 2 help debunk this claim; there is plenty of wealth to be gained by making the deal, even if the CEO pays the excise tax.

The recent market downturn should not change the result
Our study was based on data gathered during a bull market where a significant run-up in stock value drove the results. But would the result be different during a market downturn? Generally speaking, executives with less equity value vesting at a CIC tend to have much lower parachute payments, and many would have either a far smaller excise tax burden or none at all. This makes moot the arguments in support of gross-ups. The only way to ascertain the exposure is to do the calculations.

A careful examination of the necessity of tax gross-ups should be part of a more comprehensive review of all non-core compensation, including severance multiples, executive pension enhancements and full vesting of equity at a CIC. For a complete discussion of these issues, see “Executive Pay: A Proposal to Protect Core Pay-for-Performance Programs,” Watson Wyatt Insider, March 2008 (http://www.watsonwyatt.com/us/pubs/insider/showarticle.asp?ArticleID=18797).