Running out of options

With company share prices in turmoil around the globe, many senior executives are likely to be wringing their hands as they watch the value of the shares they hold in their employer tumble before their eyes.

Around 78 per cent of FTSE 100 companies’ employee share options have fallen so far that they are now effectively worthless. This is according to a study, published in early December by international legal firm Norton Rose, which found in more than three-quarters of cases the exercise price on Save As You Earn (SAYE) share options offered between 2005 and 2007 is above the current share price.

That said, all-employee share schemes such as SAYE and Share Incentive Plans (Sip) are likely to account for only a small portion of a senior executive’s financial exposure to their employer, due to the low contribution limits on offer.

Employers are likely to look to other tax-efficient HM Revenue and Customs (HMRC) approved schemes such as the Company Share Option Plan (CSOP) or Enterprise Management Incentive (EMI) scheme, along with schemes unapproved by the Revenue, in order to offer real incentivisation to top staff. Some companies may also defer paying part of an executive’s bonus to be paid later in shares.

But while executives need to work within the timing confines of the share plans they are in, they do have opportunities to make real investment decisions, says Watson Wyatt senior consultant in the executive reward team, Sue Bartlett. With unapproved share schemes such as Share Option Plans, once the share option has vested the executive has a choice as to whether or not they exercise the option to buy what they hold.

“That is a real investment decision. It’s a question then of what they think would be the best time to exercise. If you’re the holder of an option, you’re taking no absolute financial risk yourself, until you’ve exercised the option and bought the shares,” she says.

Once the option to buy is exercised, the choice then is whether to hold on to the shares, or to sell straight away.

“In some cases that’s entirely the executive’s choice,” Bartlett says. “But in a lot of cases companies actually require executives to hold a certain number of shares,” she says,

Typically this requirement will be a proportion of their salary. The Watson Wyatt Executive Reward Survey 2008 revealed that 42 per cent of chief executives were required to hold at least 200 per cent of their salary in company shares.

Given the current economic environment and company share performance, executives need to think carefully about the exposure they have to their employer. There is typically little scope for offer prices to be reviewed.

Equiniti senior manager in employee share plan business development, John Daughtrey says: “Once the shares are available the exec would need to consider if they are worth selling as under an option plan they have to pay to exercise. Performance Share Plans are real shares and the participant has to sell sufficient shares to cover tax and social security on the release date.”

For most share plans, the shares or options vest after three years – if performance criteria are met – and then for option plans the option has to be exercised within seven years. For the likes of Performance Share Plans (also known as LTips) the awarded shares can be sold at any time after vesting. However, Bartlett points out that any executive in possession of inside information would have very narrow windows during the year when they can trade in company shares.

Mercer principal Mark Hoble points to the importance of spreading risk. “As a general rule, people don’t exercise options to hold, they exercise options to sell and then reinvest somewhere else,” he says.

Some executives may be more concerned that the performance targets required to trigger allocation of shares or a share option, are unlikely to be met because of the current poor performance of shares.

But Hoble says this will not be the case for all executives in performance related plans. Those schemes for which the performance measures are based on relative performance in their peer group – typically Performance Share Plans – may still be rewarded.

“Even in a down market half of those plans will pay out – just by the way that they’re designed. So if you’re currently performing at the median of a peer group or above, that will trigger a payout,” he says.

Typically Share Option schemes will have performance targets pegged to growth in earnings per share, while Performance Share Plans are more likely to be linked to total shareholder return being at least as good as the median of a comparable group of peers.

Smith and Williamson director Nick Wallis, who specialises in share schemes, throws several other issues into the mix for executives to consider as they weigh up the merits of their company shares.

He says that while previously there were tax advantages in holding onto these shares for at least a few years, the new flat Capital Gains Tax regime has eroded that. Similarly, executives need to bear in mind that following the Pre Budget Report announcements, the income tax rate for those earning over £150,000 will rise to 45 per cent from 2011.

Facts and Figures Financial Planners managing director Simon Webster says there is no one simple answer as to what executives should do with company shares and share options currently.

“It really is a case of looking at the fine print and deciding whether you want to go for it or not. There are all sorts of questions (to consider) regarding share schemes including whether or not you should have your future bound up in terms of your salary, your job security and some of your personal wealth in the finances of one company,” he says.

Despite that Webster says if he were to be offered options in a “decent” company, he would “take them like a shot”, but suggests now is unlikely to be a good time to exercise options because of the current low share prices.

“But I think the short answer is to read the small print and decide very carefully before you put all your eggs in one basket.” njanuary 2009 corporate advisercorporate adviser january 2009Wallis: The new flat Capital Gains Tax regime has eroded tax advantagesfostering understanding of share schemesEncouraging clients to take the emotion out of decisions around employee share schemes is an important part of providing sound advice to senior executives, according to Towry Law wealth adviser Bryan Innes.

Innes says the majority of executives it deals with will have 10 or more different types of company share schemes in place, with options all vesting at different dates.

Executives can often find themselves with a significant part of their investment portfolio anchored in their employer, he says.

“The hardest part is the individual will have shares in

the company and they believe the company is going in a particular direction. You’ve got to take that on board, but it is trying to get them to be less emotional about those shares and to look at what it actually means in terms of their overall financial planning.

“Once you’ve got them to understand that, it’s pretty straight forward. I think that with recent events people are now seeing that no longer can they say that their shares are 100 per cent secure.”

Innes is quick to point out there is no one solution suitable for everyone and individual circumstances need to be taken into account. But he warns that executives need to look at the value of their company shares in the context of their overall financial affairs and to put in place a co-ordinated structure to reduce the overall risk of their financial position if they do have a heavy bias towards their employer.

Types of employee share schemes available to executives

HM Revenue and Customs approved all-employee share schemes

  • Save As You Earn (SAYE) or Sharesave: A savings-based scheme into which employees can make payments of up to £250 a month from post-tax salary. Tax-free bonuses are paid at the end of the contract term and employees have the option to buy shares with the savings at a discounted rate.

  • Share Incentive Plans (Sips): Employees can invest up to £1,500 a year from their pre-tax salary directly in company shares. The employer may offer matching shares if the employee invests and/or free shares

    HM Revenue and Customs approved discretionary share schemes

  • Company Share Option Plan: Selected employees are offered share options, with a minimum of three years required to pass between the grant of the option and the date the option is exercised. There is a limit of £30,000 on the value of shares options per employee.

  • Enterprise Management Incentive: Aimed at smaller companies only. Selected employees are granted share options but with no minimum period of exercise. There is a limit of £120,000 on the value of shares per employee.

    Examples of unapproved employee share schemes

    These schemes do not offer the tax relief available on approved plans, but are more flexible in design.

  • Performance Share Plans or Long Term Incentive Plans (LTip): Selected employees receive free shares after a specified period – generally a minimum of three years – subject to performance conditions being met.

  • Restricted Share Plan: Work in a similar way to LTips, with free shares awarded if the executive stays employed with the firm. There are no performance criteria.

  • Unapproved Share Option Plans: Share options typically exercisable after three years and for up to seven further years – generally subject to performance conditions – typically related to growth in earnings per share.

    For further information see: HMRC – www.hmrc.gov.uk/shareschemes or Ifs ProShare – www.ifsproshare.org