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Total Exposure in Executive Compensation

Total Exposure in Executive Compensation. Melissa L. Means, Vice President Pearl Meyer & Partners 132 Turnpike Road, Suite 300 Southborough, MA 01772 (508) 630-1487. Agenda. The State of Executive Compensation Executive Compensation Tools New Executive Compensation Tools Case Studies

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Total Exposure in Executive Compensation

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  1. Total Exposure in Executive Compensation Melissa L. Means, Vice President Pearl Meyer & Partners 132 Turnpike Road, Suite 300 Southborough, MA 01772 (508) 630-1487

  2. Agenda • The State of Executive Compensation • Executive Compensation Tools • New Executive Compensation Tools • Case Studies • Conclusion

  3. The State of Executive Compensation

  4. The State of Executive Compensation • Interested parties • Recent issues in the Spotlight • Changing Landscape • Topics of Interest

  5. Interested Parties • Regulatory groups • Institutional shareholders • Shareholder activist groups • General public (shareholders) • Media

  6. Former Tyco CEO Dennis Kozlowski “The Tyco Tryst” Former Disney President Michael Ovitz “The Disney Disaster” Former Home Depot CEO Robert Nardelli “The Nardelli Two-Step” Former NYSE CEO Dick Grasso “The Grasso Fiasco” Former GE CEO Jack Welch “The Welch Whoops” Former Enron CEO Jeffrey Skilling “The Enron End Run” Recent Issues in the Spotlight

  7. Changing Landscape • Stock option expensing (SFAS 123R) • No longer a footnote expense • Shift in LTI instruments used • Greater institutional shareholder oversight • Manage equity grant practices • Push for pay for performance • Independent compensation consultants • Emerging good governance practices • Performance metrics • Ownership guidelines • Dynamic pay models • Disclosure • Expanded disclosure

  8. Topics of Interest • Supplemental retirement plans (SERP) • Supplemental benefits and perquisites • Severance arrangements - employment & change in control agreements • Tax gross-ups • Pay for performance

  9. Executive Compensation Tools

  10. Primary Executive Compensation Assessment Tools • Competitive analysis • Compares compensation to competitive data (survey and proxy data) • Provides comparison of target compensation • Tally sheets (or some form of) • Tally up total direct compensation (TDC) typically at target • Provides payout information of various programs: • Retirement plans • Deferred comp plan • Severance arrangements

  11. Challenges with Current Tools • Does not provide a complete picture of an executive compensation package • Provides “static”, point-in-time snapshot of the amount of compensation to be delivered typically at target • May encourage “competitive compensation” programs not necessarily performance-based compensation • Not focused on what an executive could earn

  12. New Executive Compensation Tools • Economic Impact Analysis (EIA) • Incremental Pay & Performance Alignment Analysis

  13. New Executive Compensation Tools Economic Impact Analysis (EIA)

  14. EIA Approach • Illustrates the compensation opportunity for each component and in total over a period of time • Dynamic, not static assessment • Shows the relationship between pay and performance in terms of company financial and stock price performance • Simulates potential results of a compensation program • Serves as an alternative way of reviewing executive compensation packages

  15. EIA Graphics

  16. EIA Graphics and Charts

  17. Helps Assess • Whether a program has the appropriate performance-orientation • If there is to much focus on company vs. stock price performance or vice-versa • If incentive opportunities are appropriately aligned (payouts vs. performance achievement) • If the current compensation mix is appropriate • If the program is to heavily weighted towards time-based awards • If incentive programs, as designed, support the business strategy and its corresponding time horizon

  18. Potential Outcomes • Redesign of various compensation programs including changes to: • Amounts paid to executives • Mix of instruments in the program • Performance metrics and goal-setting • Incentive / payout opportunities • The compensation strategy/philosophy

  19. Key Discussion Points 4.) Is an incremental change in potential TDC of 9.7% (btw the 30th and 70th percentile for company performance only) enough incentive to drive executive behaviors on company performance? 5.) Is enough of the TDC package driven by company performance? 1.) Is this to much compensation for a CEO performing between the 10th - 20th percentile for company and stock price performance? 2.) Is this an appropriate amount of compensation for a CEO performing at the 50th percentile for company and stock price performance? 3.) Is this an appropriate amount of compensation for a CEO performing between the 80th - 90th percentile for company and stock price performance? 6.) Is an incremental change in potential TDC of 67% (btw the 30th and 70th percentile for stock price performance only) an appropriate amount of incentive to drive executive behaviors? 7.) Is an appropriate amount of the TDC package driven by stock price performance? 8.) Is the mix between company and stock price performance appropriate? 9.) Does this compensation program have a true pay-for-performance orientation? 10.) What behaviors does this type of compensation program drive?

  20. Assumptions • Used to forecast potential performance outcomes for the compensation program (mean and standard deviations) • Are very important and can substantially impact outcomes • Typically analyze the following: • Look Back – historical performance of the firm • Look Around • Historical performance of a peer group of firms • Historical performance of a specific industry • Historical performance of an Index • Look Forward – Value Line’s forecasted performance • Expected Value –annualized expected return using the Black-Scholes model • Management Estimates • Each component is evaluated using an appropriate time period

  21. New Executive Compensation Tools Incremental Pay & Performance Alignment Analysis

  22. Purpose • Compares total potential total direct compensation (TDC) to the incremental market value created for shareholders • Reflects a reasonably aligned pay and performance orientation

  23. Helps Assess • The relationship of total potential payouts for executives as compared to the incremental market value delivered to shareholders • The orientation of the lines: • Rise and run • Inverse relationship • Amount of compensation delivered

  24. Different Alignment • Reflects differently aligned pay and performance orientations

  25. Case Study #1

  26. About Firm A • Information about Firm A: • Life Sciences firm with ~ 8,000 employees • Revenues ~$1B; Market cap ~$3B • Historical revenue growth 5-10%

  27. Compensation Program • Compensation Program for the CEO:

  28. Assumptions • Firm A only uses financial performance for its STI plan • Threshold and maximum performance range +/-10-15% of target for STI plan • Evaluated the following to determine appropriate growth assumptions: • Look back - One year historical TSR for 10 years • Average return - 12%, standard deviation – 20% • Look around - One year historical avg TSR over 20 years for Dow Jones and S&P • Average return – 10%, standard deviation – 15% • Assumptions: • Used the combined Index return (10%) and standard deviation (15%) • Simulated TSR results for 3 & 7 year periods (restricted stock & options) • Achievement on all financial performance metrics are at the same level

  29. Base Salary • CEO • Salary - $800,000 Base salary is not impacted by company or stock price performance; therefore it is one-dimensional

  30. Total Cash Compensation • CEO • Salary - $800,000 • STI: • Min – 0% • Target STI – 100% • Max STI – 250% Total cash compensation is impacted by company performance only; therefore the graphic moves from left to right. Potential value ranges from $800K-$2.75M

  31. Restricted Stock • CEO • Salary - $800,000 • STI: • Min – 0% • Target STI – 100% • Max STI – 250% • Restricted Stock: • 70,000 shares • Vests in 3 years Restricted stock is impacted by stock price performance only; therefore the graphic moves from right to left. Potential value ranges from $2.5M-$5.5M

  32. Stock Options • CEO • Salary - $800,000 • STI: • Min – 0% • Target STI – 100% • Max STI – 250% • Restricted Stock: • 70,000 shares • Vests in 3 years • Options: • 160,000 options • 7 year term Stock options are impacted by stock price performance only; therefore the graphic moves from right to left. Potential value ranges from $0-15M

  33. Total Direct Compensation • CEO • Salary - $800,000 • STI: • Min – 0% • Target STI – 100% • Max STI – 250% • Restricted Stock: • 70,000 shares • Vests in 3 years • Options: • 160,000 options • 7 year term Total direct compensation is impacted by both company and stock price performance. Overall, this program is more oriented towards stock price performance than company performance

  34. Key Discussion Points 4.) Is an incremental change in potential TDC of 9.7% (btw the 30th and 70th percentile for company performance only) enough incentive to drive executive behaviors on company performance? 5.) Is enough of the TDC package driven by company performance? 1.) Is this to much compensation for a CEO performing between the 10th - 20th percentile for company and stock price performance? 2.) Is this an appropriate amount of compensation for a CEO performing at the 50th percentile for company and stock price performance? 3.) Is this an appropriate amount of compensation for a CEO performing between the 80th - 90th percentile for company and stock price performance? 6.) Is an incremental change in potential TDC of 67% (btw the 30th and 70th percentile for stock price performance only) an appropriate amount of incentive to drive executive behaviors? 7.) Is an appropriate amount of the TDC package driven by stock price performance? 8.) Is the mix between company and stock price performance appropriate? 9.) Does this compensation program have a true pay-for-performance orientation? 10.) What behaviors does this type of compensation program drive?

  35. Stock & 10th & 10th & 10th & 50th & 50th & 50th & 90th & 90th & 90th & Company 10th 50th 90th 10th 50th 90th 10th 50th 90th Performance Mix of Pay • Stock options are the primary vehicle with the largest potential value based on stock price performance • Stock options make up 4% of the total direct compensation (TDC) value assuming a 10th percentile stock price performance and 62% of the value assuming a 90th percentile stock price performance

  36. Incremental Pay & Performance Alignment Analysis • Total potential value of the CEO’s total direct compensation (TDC) and incremental wealth creation for shareholders • Over a 5 year period: • Firm A will pay the CEO between $19M to $104M • In turn, Firm A’s market value will return up to ~$4 billion in incremental market value to shareholders

  37. Findings and Outcomes • Findings: • STI plan allows for threshold level payouts below last year’s performance achievement level • Results from using +/-10-15% to set thresholds and maximums • Minimum orientation of pay programs to company financial performance • Financial performance metrics used only in STI plan • Outcomes: • Adjusted STI plan so thresholds and maximums are set more appropriately each year specific to targets for the year • Eliminates potential for threshold payouts for performance below last year • Implemented new performance-based LTI plan • LTI awards now reflect options, time- and performance-based restricted stock

  38. Case Study #2

  39. About Firm B • Information about Firm B: • Semiconductor Equipment firm with ~ 2,500 employees • Revenues ~$500M; Market cap ~$800M • Cyclical industry – 3 year cycles • 2006 was an outstanding performance year

  40. Compensation Program • Compensation Program for the CEO:

  41. Assumptions • Financial Performance Assumptions: • Used Firm B’s historical EPS mean (10%) and standard deviation (35%) • Simulated EPS results for 1 and 3 year periods for the STI and MTI • Achievement on Corp EPS assumed at the same level for both STI & MTI • Stock Price Performance Assumptions: • Firm B uses stock price performance for both the MTI and LTI • Evaluated the following to determine appropriate growth assumptions:

  42. Base Salary • CEO • Salary - $400,000 Base salary is not impacted by company or stock price performance; therefore it is one-dimensional

  43. Total Cash Compensation • CEO • Salary - $400,000 • STI: • Min – 0% • Target STI – 70% • Max STI – 210% Total cash compensation is impacted by company performance only; therefore the graphic moves from left to right. Potential payout ranges from $400K-$1.2M

  44. Mid-Term Incentive • CEO • Salary - $400,000 • STI: • Min – 0% • Target STI – 70% • Max STI – 210% • MTI: • Min MTI – 0 shares • Target MTI – 8,000 • Max MTI – 15,000 The Mid-Term Incentive plan is impacted by both company and stock price performance; therefore the graphic moves up the center. Potential value ranges from $0-$1.2M

  45. Stock Options • CEO • Salary - $400,000 • STI: • Min – 0% • Target STI – 70% • Max STI – 210% • MTI: • Min MTI – 0 shares • Target MTI – 8,000 • Max MTI – 15,000 • Options – 45,000 Stock options are impacted by stock price performance only; therefore the graphic moves from right to left. Potential value ranges from $0-$4.5M

  46. Total Direct Compensation • CEO • Salary - $400,000 • STI: • Min – 0% • Target STI – 70% • Max STI – 210% • MTI: • Min MTI – 0 shares • Target MTI – 8,000 • Max MTI – 15,000 • Options – 45,000 Total direct compensation is impacted by both company and stock price performance. This program is more equally-oriented towards company and stock price performance

  47. Key Discussion Points 4.) Is an incremental change in potential TDC of 9.7% (btw the 30th and 70th percentile for company performance only) enough incentive to drive executive behaviors on company performance? 5.) Is enough of the TDC package driven by company performance? 1.) Is this to much compensation for a CEO performing between the 10th - 20th percentile for company and stock price performance? 2.) Is this an appropriate amount of compensation for a CEO performing at the 50th percentile for company and stock price performance? 3.) Is this an appropriate amount of compensation for a CEO performing between the 80th - 90th percentile for company and stock price performance? 6.) Is an incremental change in potential TDC of 67% (btw the 30th and 70th percentile for stock price performance only) an appropriate amount of incentive to drive executive behaviors? 7.) Is an appropriate amount of the TDC package driven by stock price performance? 8.) Is the mix between company and stock price performance appropriate? 9.) Does this compensation program have a true pay-for-performance orientation? 10.) What behaviors does this type of compensation program drive?

  48. Mix of Pay • Stock options are the primary vehicle with the largest potential value based on stock price performance • Stock options make up 11% of TDC value assuming a 10th percentile stock price performance and 65% of the value assuming a 90th percentile stock price performance

  49. Incremental Pay & Performance Alignment Analysis • Total potential value of TDC and incremental wealth creation for shareholders • Over a 7 year period: • Firm B will pay the CEO between $3.3M to $43.6M • In turn, Firm B’s market value will return up to ~$1.5 billion in incremental market value to shareholders

  50. Findings and Outcomes • Findings: • Executive compensation program aligns with how the program was designed and provides the intended results • In years when company is not performing – no payouts • In years when company is performing – target payouts • In years when company is outperforming – maximum payouts • Outcomes: • No changes were made to the existing executive compensation program

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