Firms favour share options for staff

The UK Budget last week, which raised national insurance payments by both employers and employees, will encourage firms to look more closely at creative methods of remuneration.

Martin Armstrong, head of the financial services headhunter Armstrong International, says stocks and options can now account for as much as 80% of top packages at US banks three years ago that figure was 30%. 'Power is shifting in favour of management,' he says.

A report last year by JP Morgan Securities found that UK and other European banks were also increasingly using alternatives to cash - notably option schemes - as a means of remunerating staff.

Alberto Gavazzi, a financial services headhunter at Russell Reynolds, confirms that this is the case in Milan. He says Italian banks such as Unicredito have begun offering share options to investment banking staff.

In Paris, Marc de Leyritz, a financial services consultant with Egon Zehnder, also says that cash is losing ground. 'Only 80% of pay is now in cash,' he says.

In France it is stock itself, not stock options, which is on the up. De Leyritz says French bankers dislike options because they are taxed as a part of a salary, even when not yet exercised. In place of options, a Parisian corporate financier is more likely to receive a range of restricted shares with a vesting period of between three and five years.

Andreas Weig, a headhunter at Korn/Ferry, says that in Germany options have become more widespread and now make up to 5% to 10% of a typical senior investment banker's pay. Shares themselves are falling out of favour

Elsewhere, accounting rules have given options a boost. In the UK and the US, as long as options are issued on new stock, they are not generally considered a cost and so do not diminish profits. This is likely to change when the International Accounting Standards Board (IASB) brings in new standards in 2003.

Many US banks already tend to favour stock over options. Critics of options say they incentivise senior managers to worry about the share price more than the long-term health of the company. They add that more junior staff are often unimpressed by options, as they are unable to personally affect the share price anyway.

Options also attract controversy when companies re-price them in response to falls in the share price.

Deutsche Bank is asking its shareholders to authorise the award of options worth €1.8bn ($1.6bn) to its top bankers in the coming two years. The bank has reduced by a third the strike price at which some of its options are exercisable.

Shareholders might sanction the proposals in the name of staff retention. Arguably, however, they have good reason not to. When the strike price of options is reduced in line with the falling share price, managerial incentives are weakened. Institutional investors are particularly irked by it.

Michael McKersie, manager of investment affairs at the Association of British Insurers, says: 'Repricing share options is hardly ever warranted. Most options have a chance of coming into the money eventually. Re-pricing represents a bail-out. If options are issued on a phased basis, there will always be some with a realistic prospect of delivering value.'

In fact, Deutsche Bank's bail-out was not entirely straightforward. The revaluation applies to its Share Appreciation Rights Plan (SAR). This does not provide staff with options to buy actual shares, but gives them the right to receive cash equal to the shares' appreciation above an agreed strike price.

The strike price on 16 million SARs issued in October 2001 and vesting in 2004 was reduced by nearly a third. The number of SARs was also reduced by a third, but the restructuring still leaves staff with an improved prospect of making money.

Deutsche Bank declined to comment on the resetting of the strike price, but the reasons are not hard to find. Its shares have fallen by more than 20% during the past year. The 2001 SARs were so far underwater that bankers were clearly despairing that they would ever resurface.

SARs account for as much as 45% of an individual's pay at the corporate and investment banking arm of Deutsche, headhunters say. By resetting SARs to make them lower than the existing share price, Deutsche has clearly done its employees a favour. It has also maintained incentives: its share price will now have to rise more dramatically if employees are to make the same gains on their reduced holdings.

Resetting has its supporters. Viral Acharya, an assistant professor at the London Business School, says: 'Some resetting is almost always a good thing.' He says that although resetting options reduces managers' incentives to perform, keeping them below water can mean losing prized staff. 'Because investment banking is about people and relationships, the argument for resetting is higher.'

Damien Carnell, a compensation specialist at Towers Perrin, agrees: 'Resetting can be the lesser of two evils. Why lose all your current staff because their options are below water, only to bring in new people and offer them options at the market price?'

Pressure to reset options also reflects a continuing partiality to cash among employees. Jon Terry, an expert in investment banking compensation and benefits at PricewaterhouseCoopers, says bankers get particularly agitated when options are under water. Investment banking options typically vest in only three years, at which point most people cash them immediately, he says.

In other industries options take longer to vest, and holders are more likely to regard them as a long-term investment.