Inflation and Long-Term Incentives: 5 Things You Need to Consider

Inflation has hovered near a 40-year high for several months now, causing ripple effects across the economy. The effect of inflation hasn’t been this relevant to running a business for decades, pre-dating the broad use of equity compensation that we see today. With rising prices on everyone’s mind, how should you weigh the current environment in your planning and strategy for cash and equity compensation? Here are five major considerations to factor into this year’s decisions.

1. Increasing compensation budgets means more share usage

Inflation is, by definition, a general increase in the prices for everything. That includes the cost of everyday staples like groceries and fuel, business costs like raw materials, and even the cost of labor in the form of compensation.

The rising cost of finding, attracting, and retaining talent across all levels and industries means that budgets are going to inflate over time as well. As a result, share usage will rise and share pools will be depleted faster unless stock prices keep up with compensation growth. In a negative stock market like we’ve seen so far in 2022, this effect is compounded.

Open up your share pool and forecasting models and take a critical look at the assumptions you use. Headcount growth, benchmarked equity values and their growth, and the range of likely stock price scenarios may all look very different than they did a year ago. And all of these inputs can have material effects on how you need to manage your share pool going forward.

2. Inflation causes value to be lost over time

The effect of inflation should also be examined from a recipient view. Start with the fundamental finance principle that a dollar today is worth more than a dollar tomorrow.[1] It reflects the fact that a dollar loses its purchasing power over time—and higher inflation means that dollar loses its purchasing power faster.

What does this mean in practice? Say a company issues a long-term cash award valued at $100,000 at grant with three-year cliff vesting, and the inflation rate is 10% per year. We can value this award much like valuing a bond, using basic principles of time value of money: $100,000/(1+10%)^3 years. This implies a present value of only about $75,000 on that $100,000 award.

As you might imagine, recipients want to maximize the value of their award and may not be happy about inflation eating away the grant’s purchasing power. If there’s a lot of uncertainty over the amount of inflation, shorter-term vesting—or even pegging long-term cash compensation amounts to an inflation index like the CPI—may be more attractive.

Let’s contrast that with an equity-settled award. Typically, an equity grant targets a certain number of shares based on their value today. Flowing through the same logic, at the end of three years, the employee receives 1,000 shares in the company instead of cash. The main difference is that the grantee receives an asset whose value fluctuates up or down in response to the inflation rate and other market factors.

On first glance, this doesn’t look good for cash-based awards. But there’s no such thing as a free lunch, and equity grants have risks of their own. This brings us to the next consideration.

3. The impact of inflation is not the same for everyone

The intuitive reaction is that long-term cash awards are bad during times of inflation and equity-settled awards can help to mitigate the associated risk. Even so, it’s worth analyzing your award structure holistically. If a real estate company is benefiting from the increase in housing prices, an equity-settled award likely will mitigate a lot of the risk associated with inflation. As a result, recipients would rather have an equity-settled grant. Likewise, a company mining gold may greatly benefit from inflation because many investors look at gold as a hedge against inflation.

On the flip side, an airline is likely facing difficulties from higher fuel costs. In this case, inflation may affect the underlying equity more than a cash award. It’s a completely different set of risks—not necessarily bigger, just different. As a result, it’s important to ask, “How will inflation impact our business as a whole, and therefore how will it impact our award programs?”

Cash may have higher inflation risk, but it will also provide stability and predictability that equity cannot. Conversely, equity awards may be an inherently riskier asset, but their value can (and in some cases should) grow with inflation.

4. Goal-setting is harder amid pricing and cost uncertainty

Coming back to the company perspective, a whole set of unique risks confront performance equity awards in particular. A major challenge, in addition to all of the general ones we discussed already, is the difficulty of setting goals in a highly uncertain inflationary environment.

These challenges apply to nearly any type of goal. For top-line financial goals, your revenue performance is going to depend not just on raw demand and your ability to meet it, but also on how effectively you manage your pricing strategies in an inflationary environment. For bottom-line metrics, you also layer in uncertainties around costs, with your own suppliers’ price challenges and potential supply chain issues combining with a rising cost of talent.

One goal-setting strategy long used in higher-growth or volatile industries is to set three annual goals instead of a single three-year goal for performance awards. There are multiple ways to do this: set all goals upfront, delay out-year goal-setting until the start of that respective year, or set out-years as a pre-fixed percentage above prior year actuals. Each has its own governance, incentive, and accounting pros and cons. If you’re considering such a shift, we’re happy to discuss it with you.

5. Relative performance metrics can be inflation-neutral

There’s one goal-setting strategy that doesn’t require any sort of accurate forecast of company revenues and costs. That strategy is to use relative metrics.

The most common relative metric is relative TSR, which most public companies use in some form. Relative TSR is essentially inflation-neutral. Your stock price and that of your (well-selected) peer companies should be equally impacted by inflation. The objective in a relative TSR award is simply to outperform those peers who are facing exactly the same macro challenges as your firm, whatever those challenges may be.

Relative performance metrics needn’t be strictly limited to TSR. Even financial metrics like revenue growth, earnings growth, or return on invested capital may be defined relative to a group of similarly situated peer companies. These awards come with their own implementation nuances to consider, but can be an elegant way to avoid relying on accurate long-term forecasts amid uncertainty.

So, what does this mean for us?

Inflation is top of mind around the world. As we enter a potentially extended period in which people and companies are significantly affected by rising prices, it’s critical to consider all of the potential impacts on your long-term incentive programs. These include planning and budgeting, goal-setting, calibrating the purchasing power that recipients realize from their grants, and more.

As always, we welcome questions and conversations about particular challenges you’re facing. Please feel free to contact us.

[1] We often say there are five fundamental principles of finance: (1) money is good, (2) more money is better, (3) money today is better than money tomorrow, (4) certain money is better than risky money, and (5) money in bad times is better than the same amount of money in good times. The rest of a finance degree is primarily math supporting and using these rules applied to different assets.