3M LTIP Choice Program Analysis

In September 2014, 3M announced a change to its Long Term Incentive Program (LTIP).  Beginning in 2015, you gained the ability to choose one of five combinations of Restricted Stock Units (RSUs) and employee stock options for your award.  It may feel like you just made this election, but this is a choice that you need to make every year you are eligible for LTIP.  If you do not make an election, you will receive 100% RSUs – the default choice.  This represents a change from the previous default of 50% RSUs and 50% stock options.

The focus of this article is to provide you with a better understanding of how different choices will influence the value of your long-term incentive compensation, and to create a process to help you make an informed decision based upon your personal financial situation.  Please be sure to scroll to the bottom of this article for a link to a video of Matt and Jonathan discussing this change in more detail.

History of the Long Term Incentive Plan

Prior to 2007, 3M’s LTIP for most employees consisted only of employee stock options.  The benefit to a company awarding stock options changed in 2006 when new accounting standards forced companies to record a financial accounting expense for options at the grant date.  This change introduced a new uncertainty in financial accounting, as companies were required to place a value on an asset that has an unknown value, and may even be worthless, in the future.  As a result, 3M, along with many Fortune 500 companies, introduced RSUs as part of their long-term incentive compensation.  RSUs have always been required to be expensed at the grant date.

The use of RSUs has increased every year since 2007.  With an LTIP emphasizing RSUs, 3M can limit the uncertainty of compensation-related expenses, reduce dilution to existing shareholders and maintain a compensation structure competitive with peer companies.

The Fundamentals of RSUs and Stock Options

Understanding the fundamentals that are unique to RSUs and stock options and how they create value can help us evaluate how each type of award fits within your personal situation (Table 1).  An RSU entitles you to a share of 3M stock at the vesting date at which time the share can be held or sold.  Stock Options give you the right to purchase a share of 3M stock at a predetermined (“strike”) price in the future.  As long as 3M’s share price is greater than zero, an RSU will always have value, but an option will only have value when the share price is above the strike price.  Because options can expire with no value, they are riskier than RSUs.  Conversely, options allow more potential reward than RSUs because there may be an opportunity to buy shares in the future at a price lower than the stock’s prevailing market price.

Other fundamental differences include vesting schedules, expiration terms, dividends, and taxation.  Both options and RSUs have three-year vesting schedules, but options become one-third vested each year and RSUs fully vest only after the third year.  Options expire ten years from the grant date while RSUs have no expiration.  RSUs entitle you to receive dividends accrued during the vesting period and are paid at the vest date, whereas options do not include the benefit of dividends.

Finally, a note on taxes:  Both non-qualified options and RSUs are taxed as ordinary income – at vesting for RSUs and upon exercise for options.  The time between vesting and expiration provides flexibility as to when the income from options is realized.

Table 1:

Valuation of RSUs and Stock Options

Chart 1 illustrates how RSUs and options create value.  On the date of the grant, options have no value because the strike price equals the market price and the RSU value equals the share price on that day.  Because of the option’s leverage, as the stock price rises the option value increases faster than the RSU value.  If the stock price increases sufficiently, the option value will exceed that of the RSU (See Year 5 in Chart 1).    Stock performance determines the point at which an option’s value will overtake an RSU.   Chart 1 builds on a consistent annual increase in 3M’s stock price, which is never the case in reality.  Annual returns can be above or below the averages in any given year.  To help understand the risk factors it is helpful to examine historical performance.

Chart 1:

During the last 40 years, 3M’s stock has averaged a total return of 11.1% per year including dividends.   Despite the long-term positive performance, there have been periods when returns have been significantly lower and even negative.  Chart 2 provides a summary of those variations in returns.   Since 1970, in 75% of all rolling five-year periods 3M stock returned greater than 5% annually.   In 90% of all rolling ten-year periods, 3M stock returned greater than 5% annually.

Chart 2:

Stock returns tend to be smoother over long periods, but short-term returns can fluctuate greatly as illustrated in Chart 3.  As mentioned, over the past 40 years, 3M stock earned a total return of 11.1% annually.  In the last five years, however, 3M stock has risen over 17% per year, but that came on the heels of a five-year period in which the stock returned less than 2% per year.

Chart 3:

Valuation Comparison using Actual Returns from 2004 to 2014

Return variability determines the magnitude of the value of options and RSUs.  The actual experience of 3M’s 2004 and 2009 LTIP grants reflect these different return patterns (See Chart 4 –RSUs are hypothetical in this example as they were not issued until 2007).

It was nine years before options surpassed the value of RSUs for the 2004 grant (Chart 4), while the 2009 option value eclipsed the RSUs almost immediately (Chart 5).  Because we cannot predict the performance path of 3M’s stock price it is important to understand how the trade-offs between RSUs and options will impact your personal situation before making a decision on an LTIP award.

Chart 4:

Chart 5:

Process for Making a Decision

The first step in making a decision for your LTIP election is to understand the choice.  In our view, a starting point of 100% RSUs is appropriate for most 3M clients.  RSUs present less risk than options and have a higher probability of retaining value regardless of stock performance.  Introducing options into the LTIP mix increases the risk as well as the potential future value of the award.  Before we add options to the mix we want to determine if your personal situation makes it appropriate to accept the higher risk of options, and if so, how much of your LTIP should be allocates to options.

There are four core personal financial factors (Table 2) that we want to consider when choosing an allocation between RSUs and options:  Financial Strength, Expected Cash Needs, Personal Risk Tolerance, and Concentrated Holdings of 3M Stock.  These factors help address how patient you can be in waiting for options to become attractively valued and what other resources are at your disposal while waiting.  A quick case study helps illustrate this point.

Table 2:

Case Study

Consider Bob.  In 2004, Bob was 48 years old with a daughter beginning private college in three years.  He can choose either RSUs or options.  Bob, like everyone else, does not know how 3M stock will perform in the future, but his plan is to pay his daughter’s tuition with his LTIP awards.  The bulk of Bob’s other assets are in retirement accounts giving him little flexibility to source other funds for tuition.  As indicated in our 2004 actual example, options had little to no value for the first eight years following their grant date, while RSUs always had value.  Bob may not have been able to use his LTIP for tuition had he chosen options, while RSUs would have assured him some value to help pay for college.

Fast forward to 2009.  Bob is now 53 years old, his daughter is nearly done with college, and he will be retiring in seven years.  After more years of improving his financial strength and no short-term cash needs anticipated, Bob has the ability to take more risk with options.  He still cannot predict future returns of 3M stock, but he is in a better position to let the long-term probability of higher returns work for him without sacrificing short-term liquidity needs.

Evaluating the Possible Range of Outcomes

The LTIP Choice Program allows participants to choose one of five combinations of RSUs and options. Let’s see how each of the five choices would look under the hypothetical 3% annual return (Chart 6).  As you may expect, the value after ten years increases incrementally with the addition of options.  But, each mix with options still takes almost eight years to exceed the value of 100% RSUs.  The next example shows the results of a hypothetical 5% annual return, with a crossover point of roughly 5 years (Chart 7).  The results of a hypothetical 10% annual return indicate the crossover point drops to 2 years (Chart 8).

Chart 6:

Chart 7:

Chart 8:

 

The trade-off is clear.  If you have the resources and patience to wait for options to become attractively valued, it makes sense to favor options in your decision.  But, if you have a known cash need that may not be met by options in a poor return environment, it may make sense to consider more RSUs as you make your election.

Other Considerations

In addition to your personal financial factors, there are other considerations to evaluate when making your choice.  The flexibility in timing the exercise of options, and when you recognize taxable income, can be especially valuable as you approach retirement.  Options may give you the ability to delay exercise until retirement when you may be in a lower tax bracket.  Further, it is very important to prevent recent events and stock performance from influencing your decision.  In many cases, the prudent choice includes both RSUs and options to diversify the risk in your LTIP.

Conclusion

Since the 2014 LTIP change, you now have a choice in how you receive your LTIP award.  We view this change as an opportunity for you to personalize your LTIP award by balancing the potential and risk of options with the relative defensive nature of RSUs.  While you can do nothing and receive the default choice, we encourage you to be proactive, look at this decision in the context of your total financial situation, and make the choice that is best suited to your needs.

Be sure to understand your goals for this compensation when you make this decision.  Understanding how you plan to use the money and when you plan to use it is critically important.  After you make your decision, be patient and follow through on your plan.  Time can be an important factor in building long-term value from this piece of your compensation.

We hope this article assists you in better understanding the changes to your LTIP compensation as an employee of 3M.  The choice you make is important.  To provide further guidance, PrairieView Partners has developed a more detailed analysis that considers your personal financial situation.   As in past years, we will connect with you individually during the election period to determine which choice is best for your unique needs.

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matt-weier

Matt Weier, Senior Wealth Manager
Director of Investments
Chartered Financial Analyst
Certified Financial Planner®