Accounting for Continued Vesting Upon Retirement
June 29, 2021
In the article “ Retirement Eligible Employee and LTI: Accounting and Valuation Considerations,” Terry Adamson and Andy Restaino of Technical Compensation Advisors explain how equity awards are accounted for when they allow for continued vesting upon retirement and the award recipient is eligible to retire. I knew that this would cause the expense for the award to be recognized in full in the period of grant, but the article highlighted for me that these provisions could also reduce the fair value of the award.
Let’s Review How Expense Recognition Works
When an equity award that provides for accelerated or continued vesting upon retirement is granted to a retirement eligible employee, the stated service-based vesting conditions in the award are considered “non-substantive.” This is because the award is likely to vest regardless of whether the award holder sticks around through the vesting dates.
If the award recipient isn’t yet eligible to retire at grant but is expected to become eligible to retire before the stated vesting date, this will shorten the period that expense is recognized to the time from grant until the award holder achieves retirement eligibility. For example, if an RSU vests over four years, but the award holder is expected to become eligible to retire in three years (and the RSU provides for accelerated or continued vesting upon retirement), the expense for the RSU is recognized over the three years in which the employee becomes eligible to retire.
Accelerated vs. Continued Vesting
Whether vesting is accelerated or continues upon retirement doesn’t change how expense is recognized (at least for service-based awards). But there is an important difference between these two outcomes. When vesting is accelerated upon retirement, retirees can immediately sell their now vested award shares. In the event of continued vesting, however, retirees are not able to sell their award shares until the original vesting period has elapsed.
Thus, when vesting is continued upon retirement, retirees are essentially subject to a required holding period, even though their awards are not subject to a substantial risk of forfeiture. As Terry and Andy explain in the article, this is akin to an award that is subject to a post-vesting holding period.
When full value awards are subject to post-vesting holding periods, an illiquidity discount can be applied to the fair value. Because the shares can’t be sold during the holding period, they are worth less than shares purchased on the open market, which are freely tradeable. Terry and Andy posit that, because the continued vesting requirement functions as a holding period, an illiquidity discount can also be applied to awards that provide for continued vesting upon retirement when they are granted to retirement-eligible employees (or employees who will become eligible to retire in advance of the stated vesting dates).
What About Performance-Based Awards?
The accounting treatment for performance-based awards that provide for continued vesting upon retirement is a little more complicated. When granted to a retirement-eligible employee, the service-based vesting conditions are non-substantive but there is still a risk of forfeiture due to failure to meet the performance conditions. Thus, the company will recognize the full amount of expense for the award in the period of grant but will adjust the amount of expense that is recognized for the expected outcome of the performance conditions and will continue to adjust the expense as expectations change, until the award is settled.
Here, again, however, the continued vesting requirement serves as a holding period, preventing the retiree from selling the award shares until the end of the service and performance period. Thus, the same illiquidity discount that can be applied to service-based awards can be applied to performance-based awards as well.
What About Stock Options?
Although the fair value of full value awards is the full value of the underlying stock (less any applicable discounts, such as the illiquidity discount described herein), the fair value of stock options is determined using an option pricing model, which incorporates the expected life of the option (i.e., the period from grant to exercise).
Where vesting is continued upon retirement, retirees will be unable to exercise their options until the vesting period has elapsed. This should be considered when determining the expected life of the option. Because the expected life will already reflect the period during which the option cannot be exercised, it is not appropriate to apply an illiquidity discount for this period.
How Does the Illiquidity Discount Affect Proxy Disclosures?
When equity awards are reported in the Summary Compensation and Grants of Plan-Based Awards tables in the proxy statement, the value reported for the grant is generally equal to the fair value computed for accounting purposes. Thus, at least theoretically, any illiquidity discount applied to the award fair value also reduces the value of the award for proxy disclosure purposes.
Terry and Andy note however, that this could, in practice, be problematic. For example, say that Executive A and Executive B receive RSU awards that are subject to the same terms and conditions, but Executive A is eligible to retire and Executive B is not. Assuming that both grants provide for continued vesting upon retirement, an illiquidity discount is applied to the fair value of Executive A’s grant but not to Executive B’s grant. Disclosing two different fair values for the same grant in the company’s proxy statement might be viewed suspiciously. Terry and Andy recommend consulting your legal advisors for guidance on which value should be disclosed.
For more information, read the article “ Retirement Eligible Employee and LTI: Accounting and Valuation Considerations” by Terry Adamson and Andy Restaino of Technical Compensation Advisors.