Problem 1 - Evaluating a compensation plan

Lifestyle, Inc., a manufacturer and distributor of health and beauty products, made the following disclosure about its compensation program:

Our compensation philosophy is based on two simple principles: (1) We pay for performance and (2) management cannot benefit unless our shareholders benefit first. Executive compensation at Lifestyle consists of three elements: base salary, bonus, and stock awards. Frankly, we see base salaries and the underlying value of restricted stock as what you have to pay to get people in the doorfixed costs, if you will. Incentives, in the form of annual cash bonuses and gains tied to increases in the price of our stock, are the performance drivers of our pay equationthe variable costs.

The first element is base salary. Our philosophy is to peg salary levels at median competitive levels. In other words, we pay salaries that are sufficient to attract and retain the level of talent we require.

The second element of our executive compensation is our bonus plan. This plan is based on management by objectives. Each year, the compensation committee approves objectives and performance measures for the corporation, our divisions, and our key individual managers. At year end, bonuses are paid on the basis of measurable performance against these objectives.

The third element of our executive compensation program is stock incentives, namely, restricted stock and stock options.

Our restricted stock program is very straightforward. Stock option grants are made each year at market value. Our options vest over time periods of two to six years to encourage long-term equity holding by management.

In 1998, we instituted an innovative stock incentive plan called the Stock Option Exchange Program. Under this program, management can purchase stock options by exchanging other forms of compensation, such as the annual bonus or restricted stock, for the options. The price charged for the options is determined by an independent investment banker using pricing mechanics.

Our compensation committee is made up entirely of independent outside directors. We have no interlocking directorates, in which I serve on the compensation committee of one of my director's companies and he or she serves on mine. The compensation committee uses outside advisers chosen independently to ensure that recommendations are fair to all shareholders.

Required Evaluate this incentive compensation plan.