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Share Option Plans - Trends in the FTSE 250

David Tuch, Deloitte & Touche LLP, Director, 29 March 2006

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This is the fourth in a series of articles focusing on trends in the remuneration of directors of companies in the FTSE 250 (excluding inves...

This is the fourth in a series of articles focusing on trends in the remuneration of directors of companies in the FTSE 250 (excluding investment trusts). Information is taken from annual reports accounts published before 30 June 2005 and, in the case of long-term incentive plans also includes information from shareholder communications on new plans put forward for approval at AGMs up until early July 2005. In the last edition of Executive Compensation Briefing we focused in more detail on deferred annual incentives. In this article we have focused in more detail on share option plans. In future articles in this series we will focus in on other forms of long term incentive plans and on non-executive directors’ remuneration. Standard Share Option Plans The number of share option plans in place in FTSE 250 companies continues to decrease. 29 FTSE 250 companies have replaced the share option plan with an alternative form of long term plan during the year, or will no longer use it for executive directors. 75 per cent of FTSE 250 companies currently have share option plans in place with only 48 per cent of FTSE 250 companies regularly granting options to executive directors compared to 67 per cent of FTSE 250 companies in 2004 and 76 per cent in 2003. The number of new share option plans being implemented has also decreased with eight new plans in FTSE 250 companies introduced during the year. This compares to 14 between July 2003 and July 2004 and 18 between July 2002 and July 2003. The table below shows, as a percentage of the plans currently in place, the year in which these plans were introduced. Introduction of Share Option Plans - % of plans currently in place There have been a higher number of plans amended between July 2004 and July 2005 than in previous years. Share option plans have been amended in 21 FTSE 250 companies compared to 20 between July 2002 and July 2003. However, it should be noted that many of these amendments are minor changes, such as an amendment to allow the use of treasury share, rather than a significant change in the plan design. As indicated above, executive directors do not always participate in the share option plan. In some companies the directors may participate in other long term plans with the share option plan being retained for positions below the board. In other companies the executive directors may be eligible to participate in the plan but will not be granted options on a regular basis. The plan may be used for recruitment purposes or in other specific circumstances. The number of companies where executive directors are eligible to receive awards under both share option plans and other long term plans (including deferred bonus matching plans and co-investment plans) in the same year, has also decreased. Currently, this is the case in 31 per cent of FTSE 250 companies, compared to 37 per cent last year. Even in these companies, in practice, awards will not always be made under both plans in the same year to every director. Around 17 per cent of executive directors in FTSE 250 companies have been granted both options and long term incentive awards in the past financial year. This compares with 15 per cent last year. In some of the companies where awards under both plans are made in the same year, award levels will be scaled back. In some cases there is an overall maximum that may be granted under both plans, with companies retaining the flexibility to grant different proportions under each plan. There continues to be a focus on the key design features of share option plans listed below and companies continue to either amend existing plans in line with best practice guidelines, or introduce new plans incorporating these features. Individual Grant Limits -Annual grant limits are now in place in 75 per cent of FTSE 250 companies. Performance Conditions - In 69 per cent of plans in FTSE 250 companies performance is now measured over the three years following the grant of the options, rather than over a rolling three year period, compared to 60 per cent last year and only 52 per cent the previous year. All of the new plans introduced in the past year, where details are disclosed, measure performance over the three year period from grant. - The number of plans where there is no retesting of performance conditions has risen from 45 per cent to 73 per cent in FTSE 250. None of the new plans introduced over the past year allow re-testing. Exercise of Options - There continues to be an increase in the number of plans where the number of options exercisable is based on the level of performance achieved, rather than the traditional ‘all or nothing’ approach. This is now the case in 54 per cent of the plans currently in operation (where exercise is dependent on performance) in FTSE 250 companies. This compares to 47 per cent last year. Current Practice The following chart illustrates how plans are currently used. Share Option Plans – Current Practice Grant Policy The majority of plans now incorporate an annual individual limit. These limits are commonly expressed as a percentage of salary although some express them as a percentage of earnings or remuneration. The terms ‘earnings’ and ‘remuneration’ can typically be interpreted to include salary and annual bonus. Other elements of remuneration will not normally be included in the definition. The following table shows the annual maximum limit expressed as a percentage of salary. Where the limit is given as earnings, the target annual bonus has been added to the salary and the multiple of earnings then calculated as a percentage of salary. Where the level of grant is calculated using an option valuation methodology the equivalent face value of the grant has been taken. The table shows the ‘typical’ maximum award and the overall annual limit. Almost 40 per cent of share option plans have a higher limit which may be used in exceptional circumstances. It is worth noting that some companies have very highly geared plans and the level of performance required for full vesting may be significantly more stretching than in other plans. Share Option Plans – Annual Grant Limit (% of salary) Annual grant limits have not changed significantly since last year. Actual Award Levels in Last Financial Year The information in the tables above is based on plan limits rather than actual grants made to individuals. The following table shows the range of grants made in the last financial year as a percentage of salary for executive directors, by market capitalisation. Although grants for the top full-time executive tend to be slightly higher than for other executive directors, the differences are not significant. Interestingly, there is also little indication that option grants are lower where performance shares have also been awarded during the year other than in the very largest companies. Share Option Grant as % of Basic Salary by Market Capitalisation - 49 per cent of all executive directors received a share option grant during the year compared to 58 per cent last year. - 16 per cent of executive directors received both an option grant and a performance share plan award during the year which is the same percentage as last year. - 27 per cent of all executive directors did not receive either an option grant or performance share award compared to 23 per cent last year. Performance Conditions Only 2 per cent of FTSE 250 companies do not require performance targets to be met before the options become exercisable, or before options are granted. The number of plans which link the level of vesting to the level of performance achieved continues to increase, in line with investor guidelines which generally support this practice. 54 per cent of plans which incorporate performance measures in FTSE 250 companies use this method compared to 47 per cent last year respectively. 80 per cent of plans introduced in the past year incorporate scaled vesting. In almost three quarters of share option plans EPS is the main performance measure, which is the same proportion as last year. Where all options vest if the performance target is met there has been an increase in the number of FTSE 250 companies using EPS as the performance measure. Where performance is based on TSR the requirement is usually that TSR must be at least equal to the median of a comparator group over a three year period for minimum vesting and typically upper quartile performance will be required for full vesting. In all but one of the new plans introduced during the year EPS is the sole performance measure. None of the new plans use TSR as a measure of performance. The following tables show the performance measures used in plans where all the options vest if the performance target is met and those where the vesting is scaled. Share Option Plans – Performance Measures in Plans Where All Vest 1 these companies may also have an EPS underpin Share Option Plans – Performance Measures in Plans with Scaled Vesting The chart below show the performance measures used in all plans. Share option plans – performance measures in FTSE 250 companies Fixed Performance Period and Re-testing The number of plans where performance is measured over a fixed period from the date of grant continues to increase and all of the new plans introduced over the past year follow investor guidelines in this respect. Currently 69 per cent of plans in FTSE 250 companies measure performance over a fixed period compared to 60 per cent of plans last year and only 52 per cent two years ago. Shareholders continue to apply pressure on the issue of re-testing and the number of plans where there is now no re-testing has decreased significantly. We are aware of at least 19 companies where the re-testing provision has been removed during the year and new plans typically will not include re-testing provisions. Where re-testing is allowed, this will typically be over a further one or two years, although there a small number of FTSE 250 companies allowing re-testing over a longer period and in some cases over the whole life of the option. None of the new plans introduced in the past year allow re-testing. The probability of full vesting is significantly reduced where re-testing is from a fixed base date. The following charts show how many years’ performance may be re-tested over before the options lapse. Within FTSE 250 companies there has been a significant increase in the number of plans where no re-testing is allowed, from 45 per cent last year to 73 per cent this year. Re-testing – % of plans with a Fixed Performance Period - FTSE 250 companies Phantom Option Plans/ SARs Phantom option plans, or share appreciation rights, are plans which pay a cash award related to the increase in share price from the commencement of the plan to the exercise date of the notional share option. Companies use phantom options where conventional share options are not appropriate, such as for overseas executives or where dilution limits would be exceeded if more share options were to be granted. Phantom option plans may also be more appropriate for business units or divisions, where the phantom share price is based on the notional value of the entity, and not the group. These plans are uncommon in FTSE 250 companies and there has been no change in the number of companies operating such plans over the past year. In general these plans are used in one-off situations such as recruitment, or for non-UK directors. Where these plans exist they tend to operate in a very similar way to standard option plans in terms of performance conditions and exercise periods. Equity-settled SARs Equity-settled share appreciation rights allow the exercise of an option to be satisfied by delivering shares with a market value equivalent to the option gain. They are therefore less dilutive than option awards but deliver the same gain. Now that the P&L cost and corporate tax treatment is the same as for option awards and the ABI has clarified its position on equity-settled share appreciation rights we expect to see an increase in the number of companies amending share option plans to facilitate equity-settled SARs. Conclusion The trend from option plans to performance share plans is continuing. However it is rarely clear whether this is driven by the introduction of IFRS 2/FRS 20, the view that share prices will not rise much in the next few years, the apparent preference of some Institutional Investors for performance share plans or that some people simply believe that performance share plans are just “better”. What is clear though is that, just like in 1995 following the publication of the Greenbury Report, share option plans continue to have their place in a significant number of companies. For many of these companies that now also operate performance share plans, participation in the option plan is limited to employees below the main board (and in many cases the next tier of senior executives). What remains critical for companies reviewing their incentive plans is that they give proper consideration as to whether to continue with or even introduce a share option plan and the basis on which such a plan should operate.

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