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March 2014
design
Pitfall #1 - Pay and performance relationship is your performance line too steep?
Does your incentive plan act as if it has an on/off switch? Over the past several years has the plan either paid out at maximum or not paid out at all, while hardly ever paying out at target levels? If this sounds like your companys incentive plan, then the slope of the payout line might be too steep and deserve further investigation. Payout line description/definition: Performance-based incentive plans commonly have a defined relationship between performance (whether a financial or a non-financial measure) and incentive payouts. This is often referred to as the payout line and can be calculated using a line formula (y = mx + b). The slope of the payout line or the mx can be measured and graphed. It is a critical element of plan design that is often overlooked or misunderstood. Some incentive plans have the same payout line slope across threshold, target and maximum while other plans use several different slopes between the performance levels. Graph 1, on page 3, provides an example of a companys incentive plan payout line compared to common practice within the companys industry. In this case, the incentive plans primary measure is net income and the associated incentive pool payouts are shown. The performance line, labeled current practice, is much steeper than the line labeled common practice.
regulatory
5 ISS Goverance QuickScore 2.0: another reset by ISS 7 Equity plans go public too
hot topics
9 Total shareholder return the metric, the shortfalls and the possible solutions 11 New from Hay Group Executive compensation 2013: data, trends and strategies
My short term incentive plan is broken! Three common pitfalls to avoid in design
By Dana Martin and Kevin McLaren
Is your short term incentive plan broken? This is a question that you may need to consider if you are charged with reviewing or redesigning your companys annual incentive plan. Based on Hay Groups research and experience in the assessment of incentive programs, we discuss our list of three common traps to avoid when designing or deciding upon an incentive plan.
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only incremental changes in performance. While payouts from incentive plans commonly range from 0 percent to 200 percent of target payout, performance ranges are often much narrower. Accordingly, in a plan with a very steep performance line, an incremental change in performance leads to a disproportionate change in incentive payouts. range is so narrow within a plan with a steep performance line, it often becomes apparent to executives early in the year whether or not the plan will pay out. Both outcomes (whether no payout or a maximum payout) can lead to less than optimal motivation. whack Extremely steep payout lines can lead to outcomes that can under reward and over reward performance, almost never getting it right.
Benchmark your payout line against industry and competitors Incentive plan information is widely available via compensation surveys and publicly disclosed information. Graph your lines and compare the slopes against competitors and/ or broad industry (see Graph 2: Benchmarking the payout line). Understand the differences between your companys plan and the market and be able to explain why there are differences.
Pitfall #2 Rigid definitions of performance that do not control for unpredictable external factors
The past five years have shown that setting meaningful goals in an uncertain economy can be very challenging, and that actual performance can be heavily impacted by unpredictable external factors. Public companies in particular feel this pain, since making adjustments to goals in the middle of a performance cycle can void the income tax deductibility of certain incentive payments under a shareholder-approved plan.
Typical outcomes
What to do?
Graph the payout line and test the upper and
lower limits It is very difficult to really judge the payout line effectively without graphing it (see Graph 1: MIP performance vs payout). Once graphed, review the slope and test the appropriateness of payouts at the threshold level and the maximum level. Ask yourself if the relationship is reasonable and defensible. (summarized immediately below) provides typical odds of attainment. If your company is far off from this standard, is there a reason why? Look at your incentive plan payments over the last five to ten years and determine if they align with customary chances of attainment. If your plan is not aligned, it may be because the slope is too steep.
An inability or unwillingness to adjust measured performance or to exercise negative discretion in determining payouts can have a potentially damaging effect on incentive alignment. Without such judgment, earned pay can reflect an outdated understanding of an environment that disregards both windfalls and constraints under which performance was achieved. Controlling the impact of positive and negative external factors is an important element of plan design to ensure that a company is incentivizing the maximum contribution to core performance, and rewarding associated outcomes. When persistently negative factors are allowed to materially influence plan payouts, retention issues are likely to arise. The ability to control the impact of external factors on incentive plan goals and payouts can be provided (1) through the definition of the metric, or (2) through the definition of adjustments.
Probability Threshold
Target
Maximum
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$6,000,000
$5,000,000
MIP Payout
$4,000,000
$3,000,000
$2,000,000
$1,000,000
$130,000,000
$140,000,000
$150,000,000
$160,000,000
$170,000,000
$180,000,000
$190,000,000
$200,000,000
$210,000,000
250%
Payout as % of target
200%
150%
100%
50%
0% 70% 75% 80% 85% 90% 95% 100% 105% 110% 115% 120% 125% 130%
Performance as % of target
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Example: Consider a globally dependent business with a significant amount of operations in developing nations. In reviewing its past three years of performance, the company noted that fluctuations in exchange rates have had a material impact on measured profitability. The compensation committee may choose not to hold executives accountable for managing currency risk by defining and measuring performance on a constant currency basis, using exchange rates for translation in effect for the same prior year period (effectively eliminating the impact of currency fluctuations during the current year). Alternatively, the committee may choose to hold executives partially accountable by adjusting measured results for certain one-time currency-related items, such as charges related to currency devaluation and hyperinflationary accounting.
What to do?
Review the historic impact of one-time gains
and losses or extraordinary items on measured performance and associated payouts It is important that companies understand where their plans may be vulnerable to external pressure, the frequency with which such factors present themselves, and the sensitivity of the plans payouts. the incentive plan A metric itself may explicitly define what an executive is and is not accountable for. Consider the items included in the definition of the metric, whether and the extent to which such items are within the control of the executive, and whether such items are relevant to determining core company performance. to incentive plan metrics Most companies use an adjusted performance measure (e.g., adjusted EBITDA, adjusted operating income, etc.) Adjustments to such measures are often broadly defined in underlying plan documentation, allowing the compensation committee to exercise judgment in determining whether to include or exclude certain items. Common adjustments to measured performance generally exclude the impact of acquisition and integration-related costs, restructuring costs and asset impairments.
When an incentive plan does not evolve with the direction of the company, some common problems may include:
The incentive plan does not motivate executives
to reach the newly established company goals, or worse, the plan motivates behaviors that work against (or are counter to) the companys strategy. longer connected to a companys goals. Consider a company that has been historically focused on profitability while growth is key under its new strategy. If the incentive plan does not evolve with the new strategy, there can be an inherent misalignment between the objectives of the company and stakeholders and way executives are incented. than supporting strategy. Incentive plans are best designed to support strategy and not to lead strategy. Without a clear company direction an incentive plan often becomes a cash delivery system and not a tool that drives performance.
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should review the incentive plan against company strategy on an annual basis, making sure that incentive measures and goals are still relevant. A review may range from an assessment of measures (and their associated weightings) to a wholesale review of the entire plan.
regulatory
strategy, it is critical that the company first establish its strategy and then design its incentive plan to support the strategy. Designing an incentive plan in opposite order often leads to a disconnect between the plan and desired outcomes. Todays organizations are more agile than ever, able to adapt their businesses to rapidly changing markets and volatile economic conditions. Combined with greater scrutiny on pay-for-performance, it is imperative that companies continually review the design of all their incentive plans. Such reviews should be conducted with a focus on balancing business needs and strategy with market practices, while actively soliciting feedback from the compensation committee, the board of directors, and plan participants.
Dana Martin and Kevin McLaren are consultants in Hay Groups US executive compensation practice. You can reach Dana at +1.312.228.1824 or dana.martin@haygroup.com. You can reach Kevin at +1.312.228.1826 or kevin.mclaren@haygroup.com. n
For US companies, QuickScore 2.0 scores (overall and by pillar) are provided on a 1-10 scale and use a decile comparison relative to other US companies within the applicable index. Thus, a company with strong governance overall may receive only an average score if other companies in its comparative index score even better.
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Alignment between executive pay and total
shareholder return (TSR) Consistent with ISS 2014 voting policy updates, QuickScore 2.0 examines the relative degree of alignment (RDA) between the companys annualized three-year pay percentile rank, and annualized three-year TSR rank, relative to the ISS determined peer companies. whether a companys most recent say-on-pay proposal received shareholder support that was below approval levels within the companys 4-digit GICS group and current market index (e.g., S&P 500, Russell 3000).
information regarding governance structures and practices, but do not impact scoring, policy, and
better align QuickScore questions with ISS voting provide event-driven updates to a companys
The following are identified as zero-weight factors within QuickScore 2.0. While the considerations are intended by ISS to provide insight into governance structures and practices, they are presented for informational purposes without impacting a companys score.
Board gender diversity ISS presents information
QuickScore 2.0 incorporates the following new factors in the scoring calculations:
Excessive director tenure QuickScore 2.0
regarding the number of female directors on a companys board, as well as the relative proportion of male to female directors on the board. committee QuickScore 2.0 offers information on the number of financial experts (per the ISS definition of financial expert) that serve on the boards audit committee. Most US public companies have at least one financial expert on their audit committee to comply with stock exchange listing requirements. generally should have no fewer than six directors and no more than 15. A board comprised of between nine and 12 directors is considered to be of optimal size by ISS. one- and three-year executive pay and total shareholder return. This approach was utilized in QuickScore 1.0, using a 40 percent/60 percent weighted average calculation of one- and three-year RDA. members of the majority shareholder, executives, or former executives of the company (within last five years), the percentage of the board that is composed of current or former employees of the company, and the length of any employment agreement with the CEO.
analyzes the proportion of non-executive directors on the board who have lengthy tenure. ISS has categorized tenure of more than nine years to be potentially compromising to a directors independence and will negatively factor this into weightings depending on the proportion of directors with such tenure. regarding what percentage of directors received less than average levels of shareholder approval upon election. ISS position is that opposition to a board member typically signifies a perceived lack of accountability, responsiveness, independence, and/ or competence on the part of the targeted director. The QuickScore 2.0 analysis considers directors receiving less than 95 percent shareholder approval. 2.0 considers the average size of outside director compensation at a company as a multiple of the median of the companys ISS-determined peer group for the same time period. In calculating average director pay, ISS uses total compensation reported for each director in the companys proxy statement.
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ISS has committed to update a companys QuickScore throughout the year based on publicly available information (e.g., 8-K filings). Changes to a companys governance structure identified by ISS will be integrated into that companys QuickScore on an ongoing basis. This differs from ISS approach under QuickScore 1.0 where scores remained unchanged during the period between annual meetings.
Outlook
It remains to be seen whether the QuickScore 2.0 methodology will have more staying power than the various other governance risk indicator measurement systems that ISS has introduced over the past few years. QuickScore 2.0 likely will face some of the same criticisms as its predecessors, given that companies continue to lack the necessary information to calculate QuickScores independent of ISS and the ongoing reliance on relative measurement using the peer group identified by ISS. While ISS has indicated a desire to better correlate QuickScores with its proxy voting policies, QuickScore ratings still will not be directly taken into account when ISS makes its proxy voting recommendations. A further limitation of QuickScore 2.0 is that possible responses to each question are limited to a few QuickScoreprovided alternatives, which limits ISS ability to factor in an individual companys circumstances in scoring the companys governance practices and assessing risk. In view of these potential concerns, we would expect further tweaking by ISS next year.
Tim Bartlett is a consultant in Hay Groups US executive compensation practice. You can reach him at +1.816.329.4956 or tim.bartlett@haygroup.com. n
March 2014 Accordingly, to ensure compliance, it is important to determine whether any existing compensation arrangements become subject to section 162(m). All post-IPO compensation arrangements for covered employees are subject to the cap.
Performance-based grants
A company going public should, prior to IPO, register with the Securities and Exchange Commission (SEC) the shares that will be issued under the new plan on a Form S-8. The board should reserve for issuance sufficient shares so that it need not seek shareholder approval of an increase in the share pool for preferably at least three years. The new plan also may include an evergreen clause which provides for a set or formulaic annual increase in the share pool. However, this approach should be carefully considered by the board as too large of an evergreen increase ultimately could impact governance evaluations by proxy advisory firms.
Section 16 of the Exchange Act
Rule 16b-3 provides an exemption to Section 16 of the Securities Exchange Act of 1934 that requires certain profits obtained through the purchase and sale of company stock by beneficial owners, officers or directors be recoverable by the issuer. In order to grant to directors of the company, the most common and practical method of meeting the exemption is to obtain approval of the grant/award by a committee of the board composed solely of two or more nonemployee directors. However, there have been instances where a private company plan was not modified to allow for such a committee to administer the plan, so the grants had to satisfy other criteria to meet the exemption (e.g., subject to a six-month holding period or shareholder approval) or the profits would be recoverable by the company. From a practical perspective, the consequences of any such omission may negatively impact executive and director performance at a time when companies are very concerned about aligning company performance with executive compensation. Section 162(m) compliance Internal Revenue Code section 162(m) imposes a million-dollar cap on the deductibility of compensation that a public company may pay to its CEO and the next three highest-paid officers (excluding the CFO) during a taxable year. However, there is an exemption for performance-based compensation if certain requirements are satisfied. Because executives potentially subject to section 162(m) commonly receive more than one million dollars in annual compensation (and much of it is subject to the terms of an equity plan), it is very important that a public company plan contain the necessary language in order to satisfy the requirements of 162(m). Although section 162(m) does not apply to certain compensation arranged pre-IPO which is paid during a companys reliance period following the IPO, determining the reliance period is not a simple matter.
As companies move toward the goal of aligning company performance and executive compensation, compensation committees are charged with developing objective, measurable standards against which executive performance can be evaluated. Such performance-based grants also are required to satisfy section 162(m), as discussed above. The general rule for what constitutes an objective standard is whether a third party would be able to determine whether the criterion was satisfied. Accordingly, the public company plan needs to provide the compensation committee with discretion in determining the appropriate performance standards in making awards.
Shareholder scrutiny
Private-company plans are not under the same scrutiny, whether by a broad group of shareholders, proxy advisors, regulators, the press, or the general public. However, once a company goes public, many more eyes are focused on compensation design and practices. Proxy advisory firms, such as ISS and Glass Lewis, will often recommend against a plan if it has terms that are deemed unfavorable to shareholders such as repricing, discounted options or high share usage. A public company needs to engage shareholders, ensuring the plans provisions make sense for the company while considering shareholder sensitivities.
Although more common in certain industry sectors, an employee stock purchase plan (ESPP) is another vehicle that a board should consider before the company goes public. An ESPP allows employees to purchase company stock at a discount, and can afford favorable tax treatment to the employee-purchaser so long as certain statutory requirements are satisfied. Accordingly, a broad range of employees tend to participate in them, increasing their interest in the companys performance.
10b5-1 trading plan
The Executive Edition Upon an IPO, a company and its insiders become subject to SEC Rule 10b-5 which prohibits trading by insiders on the basis of material nonpublic information. Because trading windows vary from company to company based on dates of company report filings and certain announcements that constitute material non-public information, company insiders may have very limited time periods within which they may sell shares acquired through equity plans. However, compliance with a 10b5-1 trading plan shields the insider from SEC actions for violation of Rule 10b-5. A 10b5-1 plan allows an insider to trade shares at any time so long as all of the requirements of the rule are satisfied. Although a Form 4 must be filed for the transaction, the company can adequately address shareholder concerns regarding the timing of the transaction by noting in the Form 4 that it happened automatically via a trading plan rather than due to an announcement or other insider information. In addition, as a company goes public, it should establish certain procedures and requirements that any person establishing a 10b5-1 plan must follow and satisfy, such as:
company approval typically through its law
March 2014
hot topics
department before any trading plan may become effective; trading plan and any transaction made under such plan; times that trading plans could be established;
Total shareholder return the metric, the shortfalls and the possible solutions
By Peter Lemperis
Following the 2008 collapse of the global economy, we have seen an increased focus on using total shareholder return (TSR) as a mechanism to correlate executive compensation and performance as companies looked to share price in the economic recovery. By 2012, Hay Groups study of CEO pay for The Wall Street Journal found that 47 percent of the largest 300 companies identified TSR as the most prevalent long-term incentive metric.
open trading windows which would be the only rules regarding disclosure of trading plans; and
limiting trades outside of a plan (if an executive has established a trading plan). Setting limitations reduces the public perception of insider trading and will stave off SEC attention on misuse of these plans. A well-constructed IPO includes adoption of one or more new equity plans. If correctly adopted and administered from the effective date of the IPO, a company could save itself and its executives much time and money that would otherwise would be expended in defending disclosures, or worse, addressing concerns raised by the SEC against the firm and/or its executives.
Josephine Gartrell is a consultant in Hay Groups US executive compensation practice. You can reach her at +1.949.251.5442 or josephine.gartrell@haygroup.com. n
Calculation of TSR
On a basic level, TSR is calculated as a percent and concentrates on share price growth and dividends paid: TSR = (ending share price beginning share price + dividends)/beginning share price In general, a negative TSR implies that the share price has fallen from the beginning point to the end point while a positive TSR implies that share price has increased from the beginning point to the end point. Proxy advisory services like Institutional Shareholder Services and Glass Lewis use an adjusted calculation whereby dividends are reinvested in additional shares.
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Negative TSR: over time or where payouts are based on relative TSR
In the above scenario, the executive management team would receive payouts based upon year-toyear increases in TSR; however, the five-year TSR still remains negative. If a relative TSR metric is used, executives of companies with consistently negative annual shareholder returns can qualify for large payouts dependent on the comparative performance of their peer groups. In this circumstance, executives can benefit financially while the organization and shareholders experience negative return. Companies that utilize relative TSR as a performance metric increasingly are considering various alternatives in the event that TSR is negative, including: (1) making the payout subject to a cap, (2) adding an addendum that requires positive shareholder return over multiple years or (3) allowing the board of directors to exercise downward discretion.
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As the example shows, company B engaged in a financial strategy that had a much higher risk of failure than comparable company A. Company B took on more risk to achieve the same level of return. To provide further insight into overall performance here, a TSR metric could be supplemented with a return on equity/assets metric.
Conclusions
If certain plan design features are considered in the use of TSR for measuring performance, shareholders will win at a higher rate in the long-term. To develop an effective incentive plan using TSR that meets organizational goals, companies should:
Evaluate the share price at the starting position to
New from Hay Group Executive compensation 2013: data, trends and strategies
Companies and their shareholders are in the midst of an evolution in executive pay program design. The more effectively a company communicates with its shareholders, the more opportunity it will have to share the nuances in its programs, especially in those elements that support the organization culturally or strategically. Ideally, this conversation should improve the health of the company, helping offset some of the rigidity that the advisory services have imposed on pay program design and decision-making by allowing the companys risks and opportunities to drive the process. This important information furnishes data on market changes from 20112012 with commentary on the emerging trends and their implications for the future of executive compensation. Hay Groups practical conclusions about the implications of significant trends can inform a companys discussions about the many aspects of this complex topic. Hay Group is pleased to offer you our research and insights in this digital volume which will be particularly valuable to boards of directors trying to assess where their companies stand in relation to others and seeking guidance for navigating CEO compensation and disclosure in 2013 and beyond. To read Executive compensation 2013, go to: http://www.haygroup.com/downloads/us/exec_ comp_2013v2.pdf. n
gauge whether value is being recaptured due to an overall market recovery or whether value is being added as a result of strategic initiatives. (whether in the award agreement or lodged through discretion in the compensation committee), in evaluating relative TSR, to limit or reduce awards if shareholders are losing value.
equity or return on capital metric because TSR cannot accurately account for risk-adjusted return. Supplementing TSR with additional performance metrics can allow shareholders to look beyond share price and consider the effectiveness of organizational resource usage. TSR is not a silver bullet; however, if structured properly and evaluated in conjunction with the above considerations, it can be an important tool in aligning corporate performance with executive compensation.
Peter Lemperis is a consultant in Hay Groups US executive compensation practice. You can reach him at +1.312.228.1845 or peter.lemperis@haygroup.com. n
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Hay Group is a global management consulting firm that works with leaders to transform strategy into reality. We develop talent, organize people to be more effective and motivate them to perform at their best. Our focus is on making change happen and helping people and organizations realize their potential. We have over 3000 employees working in 87 offices in 49 countries. Our clients are from the private, public and notfor-profit sectors, across every major industry. For more information please contact your local office through www.haygroup.com
Contacts
Irv Becker US National Practice Leader, Executive Compensation New York 215.861.2495 Irv.Becker@haygroup.com
James Otto Atlanta 404.575.8740 James.Otto@haygroup.com Brian Tobin Chicago 312.228.1847 Brian.Tobin@haygroup.com Cory Morrow Dallas 469.232.3826 Cory.Morrow@haygroup.com Tim Bartlett Kansas City 816.329.4956 Tim.Bartlett@haygroup.com Garry Teesdale Los Angeles 949.251.5429 Garry.Teesdale@haygroup.com
David Wise New England 201.557.8406 David.Wise@haygroup.com Marty Somelofske New York Metro 201.557.8405 Marty.Somelofske@haygroup.com Matthew Kleger Philadelphia 215.861.2341 Matthew.Kleger@haygroup.com Brandon Cherry San Francisco 415.644.3737 Brandon.Cherry@haygroup.com Greg Kopp Washington DC Metro 703.841.3118 Gregory.Kopp@haygroup.com
General Inquiries
Bill Gerek Editor, US Regulatory Expertise Leader Chicago 312.228.1814 Bill.Gerek@haygroup.com execedition@haygroup.com