Transcript Officer & Director Compensation Analysis

March 18, 2004
“What the Top Compensation Consultants
Are NOW Telling Compensation Committees”
Presented by:
Peter T. Chingos
Hot Topics: What We’ll Cover Today

Pay for performance
– Current environment
– Best practices
– Common pitfalls

The future of equity
– Current environment
– Evaluating equity plans
– Trends and directions
– Common pitfalls

CEO Benefits

What every compensation committee should do now
Mercer Human Resource Consulting
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Pay for Performance: Current Environment
Several forces are driving a renewed emphasis
on pay for performance
Shareholder Objectives:
• Reduce share usage
• Manage overhang
• Respond to pressure from
institutional shareholders
(e.g., Calpers, ISS, etc.)
Financial Objectives:
• Reduce potential option expense
• Control EPS impact
Executive
Compensation
Program Design
Marketplace Objectives:
• Continue to attract and retain
talent
• Continue to pay for performance
• Respond to underwater options
and greater volatility in pay
Mercer Human Resource Consulting
Corporate Governance:
• Ensure full and transparent
disclosure
• Adhere to stock ownership and
holding requirements
• Commit to excellent corporate
governance practices
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Pay for Performance: Best Practices
Compensation committees are demanding changes
in traditional compensation philosophy and pay position
Today’s Common Practice
Best Practice for the Future
Total Target
Opportunity
Cash at or above median; long- Median; let performance drive
term incentives at 60 – 75 %ile compensation higher
Performance Targets
Internally focused
Set commensurate with pay position
Investor Focus
“If we hit our targets, we are
delivering results to investors”
“Will our internal targets meet
investor expectations?”
Leverage
Limited testing of payout
sensitivity and probability
Testing of payouts at various
performance levels
Market Data
Data used without performance
context
Data used to validate both pay and
performance
Peer Group
Different peers used for pay and Same peers used for pay and
performance
performance
Total Compensation
Focus on cash and equity
Mercer Human Resource Consulting
Focus on cash, equity, and other
benefits and programs (SERP,
deferred compensation, etc.)
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Pay for Performance: Best Practices
Compensation positioning must be set within the context of
performance
Company A vs. 15-Company Peer Group
2003
Percentile
Performance Measure
25th
50th
75th
2001 - 2003
Percentile
25th
50th
75th
Revenue Growth
EPS Growth
Operating Income Growth
Return on Total Capital
Total Shareholder Return
Overall
= Company A position relative to peer group
Mercer Human Resource Consulting
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Pay for Performance: Best Practices
Companies must ask whether the relationship between pay and
performance is directionally correct
75th
Low Pay High Performance
High Pay High Performance
Low Pay Low Performance
High Pay Low Performance
Financial
Performance Median
Versus Peers
25th
Median
75th
Total Compensation

Use a consistent peer group for pay and performance comparisons

Shift from internal to external focus

Maintain defensible pay and performance relationships
Mercer Human Resource Consulting
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Pay for Performance: Common Pitfalls
Companies should move away from these common mistakes

Guaranteed multi-year incentive payments or equity grants

Mega-grants, especially those with limited performance link

Overly generous severance or change in control payments

Aggressive SERPs and deferred compensation programs

Evergreen, or perpetual contracts that essentially mandate a severance
payment to terminate
Mercer Human Resource Consulting
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The Future of Equity: Current Environment
Companies are asking hard-hitting questions
about their historic equity practices
Does the FAS 123 expense equal
the perceived value to employees?
Do other compensation vehicles
deliver value more efficiently?
Do other compensation vehicles
offer better alignment among…
Payout
probability
Mercer Human Resource Consulting
Expense
Perceived
value
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The Future of Equity: Evaluating Equity Plans
Long-term incentives are evolving
Today
Stock Options
Performance
Shares/Units

The primary long-term incentive

Eligibility very deep and broad
Future

Significant reduction or
elimination of stock options

Equity used more selectively

Instead of options, more cash or
outright take-away for those
whose participation is limited

Annual milestone opportunity
over three-year period

Performance shares and units
used with mixed results

Difficulty setting long-term
targets
Restricted Stock

Limited to middle and lower
management

A portion of core long-term
incentive award (e.g., 25%)
Global Programs

US long-term incentive
practices exported globally

Long-term incentives more
locally driven
Mercer Human Resource Consulting
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The Future of Equity: Evaluating Equity Plans
Performance-based awards – FAS 123 levels the playing field
Equity Program
Current Thinking

Traditional stock options

Cost and perceived value are out of
alignment

Performance-based stock options
– Performance-accelerated
– Performance-contingent
– Indexed

Cost and perceived value are way out of
alignment

Performance shares and performance units

Make great sense
Difficult to set credible goals
– Many using relative financial measures
and TSR
– Others using annual milestones over
three years


Restricted stock and performanceaccelerated restricted stock
Mercer Human Resource Consulting

Compromise between service-based and
performance-based vesting
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The Future of Equity: Evaluating Equity Plans
The role of restricted stock is changing
Past

Limited use in “E” suite
Recruiting/special recognition awards

Perceived as “give away” by shareholders


“Once only” retention
Future

Becoming part of core LTI (i.e., 25%)


Future service requirement and retention
hook
Differentiate grant by performance (front-end)

Discontinue “once only” every 3 years
Sporadic use for middle and lower
management


Feather into core program – longer vesting
Replacement for stock options as core plan
for middle management and below

Cost vs. perceived value is aligned

Perceived value high

162(m) disqualified

Career vesting for Top 5

Mercer Human Resource Consulting
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The Future of Equity: Trends and Directions
2004 changes: First 100 Companies’ proxy data*

Preliminary 2004 data indicates a 15.7% drop in the overall value of longterm incentive grants for CEOs at median
– In 2003, median option values for CEOs decreased from $3.4 million in
2002 to $2.7 million in 2003
– Restricted stock at median increased from $0.9 million to $1.5 million

New models are starting to emerge
– Balanced portfolio – shifting long-term incentives from stock options to
other full-value plans (e.g., restricted stock, performance shares/units)
– Shifting from long-term to short-term with mandatory deferral
– Offering choice – let employees choose among options, restricted stock
and/or performance shares
– Replacing stock options with cash
– Limiting eligibility
*Findings from analysis of first 100 companies to file of a total sample of 350, which will be reported in the Wall Street Journal
Mercer Human Resource Consulting
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The Future of Equity: Common Pitfalls
Shareholder approval of new plans is a key to success

No cancellations and reissues without shareholder approval

No evergreen provisions

No reloads

No discounted options

Provide for a minimum vesting period in the plan

Identify the maximum number of shares by element that can be granted

Discuss holding period requirements and stock ownership guidelines
Mercer Human Resource Consulting
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CEO Benefits:
Potentially costly enhancements
Typical Benefits
Retirement
Deferred
Compensation
Life Insurance
Enhancements

SERP

Inclusion of LTI

2.0% final average pay (base +
bonus) x years of service offset
by qualified plan and Social
Security

Additional service credit

Subsidized early retirement or
lump sum discount rate

Secured funding arrangements
with gross-up for taxes

Salary + 100% annual bonus

Above market interest rate

Interest rate tied to investment
options or fixed

Investment options with floor
rate

Deferral period extends beyond
termination of employment

Post-retirement coverage

Gross-up for gift and income
taxes

200% - 300% of pay
Mercer Human Resource Consulting
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What Every Compensation Committee Should Do Now

Test whether you are really sticking to your compensation philosophy

Move from an internal view of pay for performance to external
comparisons

View compensation holistically (i.e., cash, equity, benefits, perks, etc.)


Avoid surprises – test performance sensitivity at the beginning of the
performance period
Remember that capital accumulation occurs over a career, not a quarter
Mercer Human Resource Consulting
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