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Accounting for Stock Options: Actuaries Needed

Accounting For Stock Options: Actuaries Needed

Are stock options the new gold rush for actuaries? There is evidence that points in that direction.

Employee stock options have been receiving a great deal of attention lately in the U.S. financial press, as the looming effective date of FAS123(R) forces corporations to recognize the current cost of stock option grants. Despite keen competition from other finance professionals, a small but growing number of actuaries are successfully leveraging their rigorous actuarial training and technical skills to claim a stake in this emerging field. Among them is Sean Scrol, president of Valtrinsic LLC, an actuarial consulting firm that specializes in stock option valuation and plan design work.

Scrol, ASA, MAAA, FCA has worked with FAS 123 since 1997 when companies began disclosing the fair value of their employee stock options. For the past eight years, he has consulted with companies on option plan valuation, accounting for non-employee options, and conversion and plan design issues. More recently, he has been helping companies prepare for the new FAS 123(R) standard. Here's what he has to say about the growing opportunities for actuaries in this rapidly evolving area.

Who are the current players in the field of stock compensation consulting and how do actuaries fit in?

Right now, it's a bit of a gold rush with lots of existing and new players getting into the field. For example, a number of academics, usually from math or finance, are positioning themselves as masters of valuation models and techniques and are heavily focused on selling proprietary custom models. At the same time, established outsourcing software providers, such as Equity Edge and Transcentive, have also responded to market demands by adding more valuation and accounting functionality to their large administrative systems. The new modules are fairly basic and straightforward, however, and are really only appropriate for a company that needs a few tools to supplement their in-house valuation process. (Interestingly, many of the new players with their roots in academia have some sort of partnership relationship with the various outsourcing providers.)

In terms of more experienced players, the Big 4 accounting firms and some of the smaller accounting firms have built up practices around the original FAS 123 valuation requirements and so have six to eight years experience with these valuations. However, in the post Sarbanes-Oxley world, these firms can't perform this work for their own audit clients. The fallout from this is that the smaller firms are basically getting out of this field and the Big 4 are positioning themselves to offer this as part of their consulting services to non-audit clients. Also, traditional compensation consultants are trying to make a play for this work as well. The biggest hurdle they face is that executive compensation consulting historically has been largely a qualitative discipline. Executive comp consultants in general don't have the training or background for these technical valuations.

In contrast, actuaries are ideally suited to make an impact here. Not only do we have the technical knowledge, skills, and experience of applying sophisticated mathematical models, we have the broad business and consulting background needed to help companies with their practical business needs.

Where do actuaries add the most value in the process?

There are two important ways actuaries add value. The first is that we understand how much more goes into a valuation than just running a mathematical model or a piece of software. Think about the practical realities any actuary has lived through of collecting voluminous amounts of data that are invariably incomplete and contain inconsistencies. Think about what's involved in actually justifying assumptions to clients and auditors. And think about what's involved in properly documenting results and then having to communicate and explain them to clients and others. Valuation is an involved process that is a core competency of actuaries. Many of the other players entering this field aren't prepared for this and many companies are going to be disappointed with the results and the service they get.

The other crucial value we bring is that we actually understand these complex formulas and mathematical modeling in general. That seems like an obvious thing to say, but there are lots of mistakes being made as complex models are rapidly getting deployed by people with little training or background. Worse, in some cases, important mistakes are going unnoticed. Just the clarity and knowledge we bring to the table sets us apart.

Speaking of models, which models seem to be gaining the most acceptance in light of the new accounting rules?

Certainly the models that have been getting the most attention for the last two years have been lattice models such as the binomial model. Most companies are looking into lattice models to see if they should make the switch. However, it's still a Black-Scholes world right now. Well over 95 percent of all companies are still using Black-Scholes. Despite the high profile attention they have been getting, most companies are slowly learning that lattice models aren't fundamentally different from Black-Scholes. Under the same set of assumptions, the two models give you the same answer. The advantage of lattice models is that they can incorporate a greater range and complexity of assumptions than traditional Black-Scholes models. The discovery process the world is going through right now is seeing which companies really need valuation assumptions that are refined and complex enough to warrant the switch to lattice models.

The other family of models that's quietly expanding in popularity is Monte Carlo simulations. These are especially useful for complex equity awards that are difficult to value. Awards where the terms, such as exercise price or the number of shares to be granted, depend on the movement in the company's share price fall into this category. I have been wondering for quite some time about whether auditors would accept the use of Monte Carlo simulations for accounting results. If you're not careful about the number and range of scenarios you use in a Monte Carlo simulation, then you could have two actuaries go off and come back with different results. To my surprise, we haven't been encountering any significant push-back from auditors on the use of Monte Carlo simulations.

There's been a spirited debate in recent years about whether standard actuarial pension mathematics adequately reflects modern financial economic theory. Is there a similar debate in the valuation of stock options?

Fortunately, history puts us on the right side of the issue this time. Black, Scholes, and Merton published their seminal paper in 1972. The Cox, Ross and Rubenstein binomial model was published in 1979. And then there was the huge explosion in financial economic theory throughout the 80s and 90s, which also coincided with the development and spread of computer technology. So, we're entering the field of stock option valuations with over 30 years of powerful history behind us. Pension valuation, unfortunately, is burdened with the legacy of having been codified in the early 70s before the great developments of the last 30 years. Of course, another 30 years from now we might look back at stock options valuation and see equally significant and unforeseen changes, but I plan to be retired by then so I don't concern myself too much with that possibility.

In terms of current practice, how does the valuation of stock options differ from the valuation of pensions and other retirement benefits?

The biggest difference is the lack of a true-up to the valuation. Each year a pension plan gets re-valued and there are "actuarial" gains and losses based on how actual experience deviated from prior assumptions. The gains and losses, of course, get amortized over future years. In theory, over the course of many years these amortizations will force the cumulative expense to equal the actual benefits paid under the plan. There is nothing like this for stock options.

Stock options, in general, are valued only once at the date of grant. The resulting expense is amortized over the vesting period of the options, but is not "trued-up" based on actual experience in future years. As you can imagine, this puts a great deal of focus on valuation assumption setting. It will be interesting to see how the world reacts in the future when the actual gains realized by option holders looks nothing like the initial valuation made at the grant date. The experts know that these numbers won't and aren't supposed to be the same, but, as we all know, the rest of the world doesn't always think the way we'd like them to.

What preparation do actuaries need then to work with stock compensation plans?

Completing the actuarial exams, especially exam 6, already provides a very good start. There are a few areas, however, that merit additional attention. Taxation, for example. The tax effects of various stock compensation awards for the individual employee or executive is a big factor in plan design. Much more so than for pensions or other traditional employee benefit plans. While actuaries don't need to become tax experts to work in this field, they do need to become familiar with several tax rules. More importantly, they need to learn how to incorporate general tax planning into plan design.

In the short term, actuaries need to brush up on some general fundamental accounting topics, including balance sheet accounts. Many of the recent changes are leading to general accounting issues. For example, grants of restricted stock units rather than traditional restricted stock shares are becoming increasingly popular. There is a debate going on right now about how to reflect stock units in the calculation of diluted earnings per share given that no shares are actually issued until vesting. Most of these types of questions will get resolved over the next year or so, but in the meantime practitioners need to be prepared to engage in these kinds of discussions.

Can you give us examples of how the new accounting and tax rules are affecting, say, stock compensation plan designs?

The biggest change this year has been the migration to performance awards. These can be restricted stock, options or other equity awards where the vesting isn't just based on completing a certain amount of service with the company, three-year vesting for example. Performance awards are based on achieving particular targets such as 10 percent revenue growth over the next two years or increasing market share by 5 percent. You could grant such awards in the past, but the tax and accounting rules were relatively unfavorable for these. The new rules have changed that and we're seeing an explosion in performance awards this year.

The other big change this year is the migration from options to stock-settled stock appreciation rights (SARs). Economically these have the same value to the employees and they generate the same accounting expense for the company as options. The advantage for employees is that, unlike options, stock-settled SARs require no upfront cash outlay (i.e. it's a "cashless" exercise). The advantage for companies is that exercise of stock-settled SARs triggers the issuance of less shares than exercise of options. This slows the "burn rate" for share utilization and makes the authorized pool of available shares last longer. As with performance awards, you could grant these types of awards in the past, but the old rules were unfavorable for SARs.

How do you see this field evolving over the next few years?

I think of the evolution in terms of plan design. The old rules didn't treat all types of awards equally and everything got heavily skewed towards traditional plain vanilla options. Traditional options produced no explicit accounting expense under the old rules while every other type of award did. It's not surprising then that options became the dominant form of equity compensation. The new rules have effectively changed all that by leveling the playing field. The immediate reaction, of course, has been a shift away from traditional options. What we're seeing this year and probably into next year is companies reaching for the low-hanging fruit, such as performance awards and stock-settled SARs. All the work involved in ramping-up for the new valuation and expensing requirements doesn't really allow for more in-depth analysis.

My prediction is that two or three years out we'll see more creative and interesting plan designs. The new rules are forcing companies to answer questions they really haven't addressed before. They're having to address what the true value of all these awards is, which designs really serve our company goals, what the perceived value of these awards to employees is, and are we creating the right incentives? The understanding and insight that comes from addressing these questions takes time to develop and time to permeate throughout an organization. I don't think anyone can fully predict what designs might come out of all this analysis.

What do you see as the biggest challenge for actuaries entering this field at this juncture?

Most consulting actuaries, especially pension actuaries, have spent their entire careers in well established and highly structured fields. They aren't used to dynamic, undefined and rapidly changing areas. Years from now, "best practices," standard plan designs and agreed upon procedures will be established. Right now, however, is like the opening of the old West back when it was the Wild West. It's new land waiting for development.

I want to emphasize that this isn't a question of skills; it's a need to change the mindset. Actuaries have a well earned reputation for being conservative. Sometimes pension actuaries act like Moses came down from the mountain with three rather than two tablets. The third contained all the ERISA funding rules. It's important that we don't let this mindset hold us back because, the truth is, we really are the only players out there who can offer a complete package to companies.

Alan Parikh is consulting actuary for Mercer Human Resource Consulting. Sean Scrol is president of Valtrinsic LLC.