Introduction to Executive Compensation: The Fundamentals

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Presented by: Joseph Sorrentino and Steven Hall Jr.
Managing Directors, Steven Hall & Partners

​Are you new to the Executive Compensation management field? Do you want to ensure that you have the fundamental knowledge necessary to establish Executive Compensation plans that will help to attract, motivate and retain the talent necessary to achieve your corporate objectives?

Joseph Sorrentino

What we’re going to talk about today is the environment that we’re facing, as it relates to executive compensation, compensation philosophy and the components of executive compensation, and how they are utilized within a comprehensive program. We’re going to end with some important governance policies that everyone on the line should be aware of. We are also pleased to take questions. We’re going to take some a little bit midway through and then at the end. We will be happy to follow up, individually, with any additional questions that may come.

Executive compensation has a lot of forces that are being pushed and impacted within our internal environment. Obviously, you need to focus from a management perspective on the key objectives of the program. You need to design and implement executive compensation programs, and policies and procedures, that will lead to effective performance that in the end will lead to shareholder value creation.

The board and compensation committee are in charge of overseeing the executive compensation role and approving and recommending the programs and the quantum of pay. We’ve had experiences where management and the compensation committee work very well together. And we’ve had experiences where there’s been some push and pull and challenges. I think, part of making sure that everyone gets to a place that they’re comfortable with, is open communication and understanding what the overall objectives are. We, unfortunately, have quite a few corporate governance advocates that have their own agendas, such as advisory firms that will recommend voting for Say on Pay, which is a non-binding vote, but taken very seriously and has a tremendous impact on how compensation programs have been modified and designed over the last several years. 

Regulators both in general, from an SEC perspective, and specific to some industries such as financial services or healthcare, also have significant influence in terms of an overseeing perspective, and some of the general guidelines and principles. 

You also have to consider the media when designing executive compensation programs. Unfortunately, you don’t see a whole lot of articles on the front page of major publications that talk about how well companies are doing with their executive compensation programs. We tend to see more of a “gotcha”. Our job as consultants is to keep your company out of the headlines of the negative policies that result in negative press. How do we go about doing that? I think it all starts from a philosophy perspective, and any good philosophy will lay out the objectives. 

So it’s pretty common that public companies in the U.S. will talk about attracting, motivating, retaining, and rewarding talent, and alignment of pay for performance.

You’re going to hear a lot of discussion in this webinar about aligning pay and performance and what that really means. Because unfortunately, it means different things for different constituencies. And since the collapse and recession due to the financial markets back in the 2008-2009 timeframe, we’ve seen a lot more discussion around ensuring that the executive compensation programs do not encourage excessive risk-taking. 

Pay mix is a big issue. And because of all the tools in the toolkit and how the programs are designed, there are various decision points that have to be made from a fixed versus variable perspective, short-term versus long-term, and cash versus equity. These mixes are specific to companies in terms of where you may want to position yourself, but also can be unique to an industry and to the lifecycle of an organization.

Pay Positioning: Everyone wants to be competitive with the market. You have to define what that market is. Traditionally, we are going to target median levels of pay, so you hit your performance targets and you’re going to get roughly median payouts compared to the market. It is important to remember that you need flexibility within your program designs. Flexibility can mean doing something unique for a business unit that is focused on something outside of the corporate perspective to incentivize new product development, for example, or a new strategy within the organization. It can mean knowing you need to go above and beyond what the target market median is for certain individuals who are viewed as high demand, strong performers. So when we talk about pay positioning, overall, remembering there has to be flexibility built into the system.

Steven, now, is going to take us through the components of a good executive compensation program, and dive into some of the areas to think about.

Steven Hall Jr.

Thanks, Joe, so when we think about an executive compensation program, there are five buckets that your compensation would fall into: salary, annual incentives or annual bonus, long-term incentives that include long-term equity awards, and can include some long-term cash awards, and retirement benefits. These are your 401k, senior executive retirement plans that typically will go above and beyond the 401k, and in very rare circumstances, pension-type plans for executives. Finally, we look at other benefits and perquisites. These are diminishing and are almost nonexistent but they would include things like the company car, your healthcare, health club dues, and for generally only CEOs, use of the corporate aircraft.

When we think about each one of those different buckets, and what they do to attract, retain and motivate your current executives, we laid out what we thought each of the different elements did for that. You’ll notice that salary, annual incentives, and long-term incentives, generally, have high to moderate ratings. Where that deviates would be your salary. That’s not a highly motivational factor, because it’s not going to change mid-year unless you have a change in responsibilities or promotions. Typically changes to your salary happen on an annual basis, after that big, long annual review is done. 

Likewise, if you look at annual incentives, we have rated it moderate for retention. I don’t know that any executive wouldn’t jump ship for another offer that might be better just because they’re waiting on the bonus to peg out. While it definitely helps retain and keep them there, any company that wants that individual is going to make them an offer that would incorporate any sort of bonus they’re leaving behind. 

And finally, while long-term incentives have a high to moderate rating for motivation, the reason we put in that moderate is you can get awards that are time-based or service-vested restricted stock awards. And there are some in the governance community who don’t view these as paying for performance. They view them akin to base salary. Although we don’t think that’s completely fair, there’s still stock price movement to consider, and the value of those awards are subject to that movement. As you can see down at the bottom, the retirement benefits and the other benefits and perquisites are typically low to moderate in terms of attracting, retaining and motivating employees. Like I said, perquisites are almost all gone. So they don’t do much for either of these three categories. 

We’re going to take a look now at base salary. I think everyone’s pretty familiar with how base salary works. It’s what is set at the beginning of the year for each of these executives. It provides a stable source of income that even if no bonus is paid, and all your equity awards become worthless, you have enough money to pay the mortgage and pay for the kid’s tuition. It is generally a small percentage of overall compensation. You’ll see those in proxy statements where pie charts indicate what part of total compensation is made up of either fixed or base salary. 

It’s very small, but it has a lasting impact on all the other pieces of compensation because your base salary is used to set your target bonus and is generally used to set your target long-term incentives, as these are set up as a percentage of salary. So any change that you make to the salary is going to resonate through the rest of the program. It is very rare to see a salary go up, but any of these target percentages come down. So, an increase in your base salary will increase your target bonus, and typically will increase your long-term incentive target. Adjustments to base salary are typically not made on the fly during the year. You will usually see them being made after an annual review is done, or after there’s some promotion or significant change in responsibilities for the executive. 

Another thing to consider with base salary is the disclosure. So for your top executives, they’re going to show up in the proxy statement under the compensation discussion and analysis report. And we find that having a rationale for where your base salaries are set can be a useful opening dialogue with either your shareholders or some of the advisory firms. Stating that you are pegging to a certain percentile in the market can be helpful; defending that positioning is definitely helpful. And all of this should be considered in good times, but certainly in bad. If your performance is not matching those of your competitors, you may want to have a further discussion or defense of why you set pay the way it is. 

And the final thing to consider is the 162(m) million-dollar cap. Under 162(m), companies can’t take a tax deduction for compensation that is not performance-based over this $1 million threshold. And that excludes your CFO, but it will include your CEO and other proxy officers. The one thing to consider is while base salary does not count as performance-based, neither do things like the time-vested restricted stock awards that we’ll talk about in the future. So when you’re setting your base salary, if you have it set at a million dollars, anything above and beyond that, that is not performance-based, you won’t be able to take a tax deduction on. We’ll go a little bit more into 162(m), in the annual incentive sections. 

Now let’s talk about some annual incentives or your annual bonus.This is the compensation that you get paid at the end of the year for the one-year performance period. We typically see that companies and compensation committees like to focus executives using the annual incentive plan by picking specific metrics that they think are going to help grow the business, and will follow the business plan that’s been approved by the board of directors. The best annual incentive plans, typically are ones that follow the approved business plan in lockstep. It’s good for communication both internally and externally. 

The other feature of a bonus plan is that opportunities are listed as a percentage of base salary. So as I mentioned before, as your base salary increases, typically your target bonus will be increasing. When we look at the different metrics that companies have been selecting, earnings is by far the most prevalent. The study that this is referencing looked at almost 900 companies with revenues between one and five billion dollars. We find that over 87% of companies are using some form of earnings. This can be operating income, your different EBID, EBIDAs, ETS, and earnings per share. After that prevalence drops pretty quickly for things like revenue. 

Individual performance can be anything from one or two different goals that you give an individual all the way to an individual executive scorecard with many different metrics that focus both on their own performance, as well as maybe divisions that they have supervisory roles to. 

The very last metric that we listed on this chart is stock performance. Only 3% of companies mentioned that they use some form of stock performance in their annual bonus plan. As the 3% indicates, it’s very rare to see something like that. We typically would like to look for metrics that we think executives have the ability to influence over a one-year period. And stock price performance can be a bit of a lagging indicator for changes that are being made within a company. 

Now comes the fun part, which is goal setting. It is probably one of the most difficult and complicated processes that you see a committee go through, and management go through as well. When the downturn happened back in 2008-2009, it really flipped a bunch of plans where there were zero payouts, even though executives were working hard to keep their head above water or keep the company’s head above water. But it provided an environment where it was very difficult to forecast future performance, not just for one year, but in some cases we were hearing where a company couldn’t predict where they would be in six months. So, we found a lot of different ways that problem was being handled, with multiple shorter plans that were only looking at three to six-month periods. We’ve moved back to looking at annual performance. I think some of that budgeting has gotten better.

Generally, we look for goals to be realistic and motivational. And as I’ve mentioned before, they should reflect the company’s business plan that’s already been worked on and approved by the board of directors, and to definitely be cognizant of any communication that’s being provided outside to Wall Street or other stakeholders in the company. If there’s going to be a drastic change from the previous year’s performance, I think that requires a little bit of communication from the company and the board, both internally and externally. So that there’s not a surprise if there either is or is not a payout, because performance was worse than last year or significantly better than last year. 

Also, you need to keep an eye on what else is happening in your specific industry, at what your direct competitors are doing. While that shouldn’t dictate what you do, it is probably helpful to know as you’re designing your plans. This way, there are no surprises in the future, one way or another.

Finally, larger shareholders and proxy advisory firms are really pushing for more disclosure on goals. They’re looking for specifics. So what was the target? What were the performance minimums and maximums? Companies have been reluctant to disclose this in the past, citing that it would do harm to them and take away competitive advantage. I find there is a lot more pushback now from these different shareholders and advisory firms. They want it in the proxy, and they want to see it.

Additionally, a lot of these firms are also doing their own pay-for-performance analysis on your plan. So while you may think that you’ve set a great goal and that your performance justifies the level of payout that you’re providing, you also now have these other firms, such as ISS, and Glass Lewis, performing their own pay for performance. They’re not necessarily using the performance metrics that you’ve picked or the goals that you’ve set, and they’re giving you a grade as to how you are doing compared to your performance. You have to keep in mind that you have other eyes looking over your shoulder at your plan.

Joseph Sorrentino

I think communication here is key both internally, so that you set appropriate expectations for your management team, and externally. You need to look backward to what historical levels look like, and look forward to what projections are, both communicated to the outside world as well as internally. Also, looking around in terms of industry averages, and at direct competitors where data is available is key. This can help in terms of justifying the goals that were set when you are discussing the annual incentive plan in your proxy and with your major shareholders.

Steven Hall Jr.

So as I mentioned with annual incentives, this idea of your target, it’s set as a percentage of your base salary. You would typically see something around 100% of base salary for a CEO of a corporation. But there are also different markers set up for performance below target, as well as above target. Those are your minimum and threshold on the low end, which is the lowest amount of performance that you would be willing to pay a bonus for. If you set the operating income at $100 for the year, just to do easy math, at what point would you not want to be paying a bonus to these executives? So you set that as your threshold, and then you would pay a bonus that is less than target. Usually it’s between 25 and 50%. 

On the other side, you have maximum performances. If they knocked it out of the park, and did a really great job, at some point, you’re going to stop paying for additional performance. This would be viewed as exceptional performance. You typically see a maximum somewhere between 150% and 200% of the base salary. And like I said, you’re not going to pay for any additional performance. This is a bit of a risk mitigator. This way executives aren’t pushing too fast, too hard and trying to do too much. That may be viewed as risky behavior either internally or externally. 

With those three different outcomes, there’s a general rule of thumb as to the probability of attainment, you should be hitting your minimum or threshold performance, nine out of ten times. While not a slam dunk that you’re always going to make that performance metric, it should be easy enough to generally achieve nine out of ten years.

With maximum, we think that’s something that generally you hit one out of every ten years. It should be a difficult mark to hit, but on the average of ten years, you’ll find that the company is achieving the goal at least once. With the other remaining eight years, typically it’ll be between that threshold and maximum. You generally like to see that the payouts are really clustered around that target payout level. 

Joseph Sorrentino

We spend a lot of time with clients in terms of setting the right goals. If you look back in history, and a plan has not paid out for a number of years, then you’re really questioning the incentives of the plan for participants. On the flip side, if there is maximum payouts being reached three years in a row, for example, then you’re likely to start getting some pushback from your board and your compensation committee. They may be asking if the goals are set too low. Now in some cases, it may be that the management is just doing a superior job, and they’ve been exceptional over this timeframe. As a practitioner, looking back and understanding the history of the payouts for your short-term bonus plan is helpful. You need to evaluate your plan to discover if it is truly working, or if it needs improvements. 

Steven Hall Jr.

We took that idea and put it into chart form. This would be a pretty typical payout curve for an annual bonus plan. In this case, we’re probably looking at something based on earnings tied to the different performance levels on the x-axis. In this situation, to go back to my last example, you had to at least achieve $90 of operating income to start receiving a bonus. In this case, it would be 50% of the target bonus. When you get up to that $100 of operating income, you receive your target bonus. And if you’re able to overachieve and get $110 of operating income, you’re gonna get paid 200% of your target bonus. You can see that the slope of the payout, after target, increased. So for every added dollar of operating income, you were getting almost twice as much added bonus than you were between the threshold and target positioning. 

Joseph Sorrentino

The theory there is a dollar earned is harder to achieve when you’re above target. So each incremental dollar is more valuable to the participants.

Steven Hall Jr.

Now, as we’ve talked about, in the past, there’s been some difficulty with goal setting. And I think one way that companies can handle that is by using an alternative payout curve, like the one shown here. In this case, you see that the target payout area is spread out into a range. Also, payouts start much earlier. Here they start at 80% of target performance and pay all the way up to 120% of target performance. The reason for doing this is that if you’re having difficulty with goal setting, if there are some unexpected moves, and you’re not sure how those are going to relate to financial performance, you might want to give yourself a little bit of leeway, both up and down, so that your plan doesn’t lose its motivation mid-year for the executives. And finally, as I mentioned before,162(m) is a very important consideration for your annual bonus plan. Typically, we find the companies want to make sure that their bonuses are 162(m) compliant.

Here, we listed five main criteria that the plan needs to have in order to achieve

162(m) compliance. The incentive plan needs to be approved by shareholders. It needs to have objective performance criteria. These criteria need to be set up by the outside and independent directors on an annual basis. The compensation committee needs to verify in writing, the amounts that were paid and the goals that were achieved. This is typically done in the proxy statement under the compensation discussion and analysis report. 

Also, one important factor is that the plans can only provide for negative discretion. The compensation committee only has the ability to decide on its own to reduce a bonus payment. They cannot go in after a plan has been set and has an outcome and decided to increase that payment. They would lose their 162(m) compliance in that situation. Finally, the plan must be evaluated and approved every five years by shareholders. And with that, we will take a brief pause and see if there are any questions.

Leslie O’Connell

Our first question, how do you see discretion used in annual incentive programs?

Steven Hall Jr.

In general, you’ll find that companies are only using this sort of negative discretion.  They want to make sure that they keep their 162(m) compliance. One way that you can work around this is doing something called a plan within a plan. The way that would work is you would set a maximum payout that is allowed under the plan, if certain performance criteria are met. Then you would use a different formula to figure out the exact payout that’s going to be made, as long as it is less than the original maximum. They’re a little bit more complex, but we definitely see those as a way to provide for positive discretion by making the second plan within the plan. 

Joseph Sorrentino

With positive discretion you’re really subjecting yourself to increased scrutiny from your institutional shareholders and from advisory firms, they see the negative connotation there. If they see discretion, they assume it’s really just because the goals weren’t hit, and you wanted to make sure that you paid your executives. It’s kind of a tails I win and heads I win concept. I think if there is a strong rationale for increasing the bonus payout, you really have to do a good job of telling your story in the proxy. And try and be as clear as possible as to why it was critical to make this adjustment. 

Leslie O’Connell

Okay, next question, do you lose the tax exemption on the entire salary or just the amount over $1 million?

Joseph Sorrentino

It is just the amount over one million dollars. It’s also important to remember as we transition to the long-term that, as Steven talked about earlier, plain vanilla time-vested restricted stock also does not count. So when you think about what your basis is, for your proxy officers, versus that million dollars, it’s not just salary. It’s also any time-vested restricted stock that vests in that year. Many companies, particularly very large firms, have gotten comfortable with having salaries over a million dollars. So the GE’s of the world, have salaries for the CEO in excess of a million dollars at this point. So they’re comfortable with losing that tax deduction. The idea is that competitiveness is more important than losing that little bit. And it’s not really meaningful, but it’s a signifier and indicator.

Leslie O’Connell

What would be your top three pieces of advice to compensation committee members approaching a possible change in control such as the sale of a company in the next 12 months?

Joseph Sorrentino

Number one is understanding the potential payouts due to your management team. That’s going to take a lot of work internally from the HR staff to gather all the relevant materials, such as employment agreements, severance documents, and equity awards. Try and develop what you’re afraid of is the “holy cow” number. You’re going to see large numbers with major M&A deals. However, it is absolutely imperative from the HR team and consultant perspective, that the comp committee understands the quantum and they understand by individual what it means. 

Number two is to look at an assessment of internal versus external. So, what is our agreement, what are the severance multiples? And what does that look like versus the market? Are there any shortfalls there? Are our policies, programs and provisions related to change in control? Is that competitive?

Number three is understanding your retention risks, and who potentially could go during various merger transactions and deals. You may need to do something special to ensure that you have the glue in place to keep your critical talent, both before the deal and then during the transition period, because it may be easier for someone to jump ship during a transition period. It’s absolutely imperative to make sure that you have a strong retention program in place. 

Steven Hall Jr.

You also need to keep focused on your current plan, because we’ve seen deals evaporate, and you don’t want to be left with things that you did not provide for in the current year. Executives might still have a bit of that retention worry because the deal didn’t go through. So just making sure that whatever plan was in place prior to an announcement of a deal, is still running and still operational, is also important.

Joseph Sorrentino

With that, we’ll move on and talk about long-term incentives. Long-term incentives, I think, are the most critical component of executive pay these days. It has the highest weighting. If you think about the mix, 50 to 60% of a CEOs pay is made up of long-term incentives. Direct reports below the CEO are 40 to 60%, I’d say. A whole lot is riding on the design of the long-term incentive program. Just in terms of setting the stage, LTI are awards that are earned and paid based on the achievement of goals over a period exceeding one year. Goals can be stock price or business performance. Usually, we’re talking about equity here, but there are some firms, for a variety of reasons, who use cash. The purpose and the objectives are similar to what we stated at the beginning of the webinar when we talked about compensation philosophy. We want to attract, retain, motivate and to align the interests of executives and shareholders. We also want to focus participants on the critical performance criteria. Competitiveness of pay is super critical since LTI is such a large component, and this is really your wealth creation vehicle.

When we think about the long-term, we’re basically thinking about three types. And those are appreciation vehicles, such as stock options or stock-settled appreciation rights (SARs). These are awards where there’s only value delivered to the participant if the stock grows from the date of grant. So there’ll be an exercise price for an option. If the stock goes down, that’s when we talk about underwater stock options, when the exercise price is greater than the current stock price. SARs work the same way in theory as options, but when they’re settled for stock, you’re only delivering the profit in shares. So they’re less dilutive than options.

Time-vested full-value vehicles are restricted stock or restricted stock units. These vest just plain vanilla over time. Usually, we see a three or four-year timeframe, either on the anniversaries of the grant date, or Cliff 100% at the end of a certain time period. 

And then we have performance-vested vehicles. These usually are similar. It’s a share or a unit. So very similar to a restricted stock, but you need to do something in addition to the time component. You need to hit some sort of performance criteria. 

I want to spend a few seconds on the pros and cons of each of these types of vehicles. With stock options, you have alignment with shareholders, and  they’re easier to communicate, both internally and externally. You have leverage, in that options are not worth as much of a share because they’re only an appreciation vehicle. So you need to grant more of them. Let’s say you were trying to grant $1,000 worth and your stock price was $10, you could grant just 100 restricted stock, but you would have to grant more than 100 stock options to create equivalent value. Also, it’s fixed from an expense perspective. That means that companies are taking a Black Scholes or a binomial valuation to expense these over the vesting period. So there’s not any variability in there, in terms of what the expense is going to be.

On the negative side, something as a firm we don’t agree with, but there are, primarily ISS and Glass Lewis, proxy advisory firms who don’t view options as being performance-based. They are under the impression that a rising tide raises all ships. Therefore, with stock options, unless they’re premium priced so that it’s set as an exercise price that’s greater than the price on the date of grant, or if there are performance kickers within the option itself so that it needs to vest not just over time, but also based on performance, then you’re not going to get credit for having a performance award, through just plain vanilla stock options. 

They’re not tied explicitly to the company’s financial performance. As Steven mentioned, you often have a lag in terms of operational performance versus stock price. In most cases, you don’t have that immediate kind of performance alignment based on operations or what you’re accomplishing in your accounting statements. There’s dilution. 

On the downside, you have to grant more options with the restricted stock. From a leverage perspective, the downside is that you’re now diluting your shareholders more than you would with a full-value share. And then unfortunately, options are still expensed as long as they vest. So you may see no value as a participant, if the options never go above the strike price. However, the company is still taking an expense. Restricted stock has some similar pros as options in terms of they are easy to communicate, and it’s a fixed expense. Where we see restricted stocks used primarily is when there is a strong focus on retention.

They are highly positive from a retention perspective, because you’re going to get them as long as you are an employee in good standing. Unless the company goes bankrupt, they’re going to be worth something. They may be worth less than what they were on the date of the grant, but they’re still going to be worth something. So that helps from a retention perspective. It is aligned with shareholders in that if the stock price goes up from the date of grant until vesting, you’re going to have more than what you would have had. 

On the negative side, it can be viewed as “pay for pulse”. So again, if you’re there for three years, you’re going to get your stock award vesting. You’re also not tied to company financial performance. Also, there is not that leverage, so if you really exceed stock price performance, over time, you’re usually better off with options, because you’re going to have more of them. 

Performance-vesting awards is the area that we’ve seen the most movement over the last few years, as companies are increasingly focused on aligning pay for performance. With these awards again, you actually have to do something. The fact that there’s performance associated with these awards, make them pretty popular from an investment community perspective. You have a fixed expense, in most cases, if the performance goals are subject to operational performance. So if you don’t meet those goals, then you will be able to recover an expense, unless you’re talking about stock price as the metric. In most cases, you’re talking about an award that is less dilutive than options. The negatives here: it can be difficult to set the performance criteria with all the challenges that are associated with setting goals for short term plans that Steven mentioned earlier. Multiply that by a factor of ten when you’re talking about setting goals over what is typically a three year long-term performance period, and if you don’t do a good job in goal setting, your retention value goes away. Then these things are going to be viewed as worthless by your participants, and that’s a problem.

We also talked about the expense issue, it’s a market condition, which in essence is something based on stock price, or total shareholder return, and you cannot reverse the expense here. So there’s a possibility that you’re using an inefficient vehicle from an accounting perspective. If we look at the mix, for long-term incentives, you’ll see in the pie charts here, the one on the left, the primary vehicle is performance-based at 41%, 37% in time-vested restricted stock, and 22% in stock options. 

Most companies are using two or three vehicles. Only 22% are using just one. The majority are using two. I think that indicates long-term incentive vehicles have different positives depending on what you’re trying to achieve, and usually, you’re trying to achieve multiple objectives. You really need more than one vehicle to make sure that you’re hitting all of your goals, from a retention perspective, from an owner’s perspective and in aligning pay for performance.

When we talk about metrics for performance awards, it should be aligned with the business strategy. Very similar to our discussions on annual incentives, they should reflect the key drivers of corporate and shareholder value. It’s important to think about the metrics and which performance criteria would create the clear line of sight for your employees to really focus their efforts and map their accountability. Metrics take the form of either absolute or relative. 

Absolute metrics can be viewed negatively by shareholders, because you’re not looking at it from a relative basis. Absolute metrics are just based on the goal setting, internally. Relative metrics are viewed more positively because they are compared to some segment of the market. They can also help because they serve as the plug, when you can’t predict the absolute metrics. If we look at metrics versus our database here, the most common is one performance metric in the CEO long-term incentive plan. TSR/stock price is the most predominant metric there with earnings a little bit behind. And then you’ll see it’s primarily their stock price or earnings is the vast majority. 

Relative TSR is the most popular LTI metric, and it’s been increasing over the last five to ten years. We’re starting to see what I would call a little bit of a plateau with the usage of relative TSR. Companies are really thinking about it, because they may have had some negative experiences related to the fact that it’s not really in the direct control of management. Getting the comparative group right can be challenging. And again, you have that inefficiency from an accounting perspective. But shareholders love it.

Other things to think about: With 162(m), options and performance-vested shares  qualify as performance-based, but restricted stock does not. Change of control is a huge issue in terms of what’s going to vest, and what the conditions are under which it will vest. We’ve seen practices evolve over time, where now double triggers are predominant in the market, which means not only does the change take place, but there needs to be a loss of your job as well. In the past, single trigger was pretty common, which was just the change of control itself had to take place, not a loss of job. We’ve definitely seen that change over time.

Benefits and perquisites: there’s not a whole lot going on here. Companies have gotten rid of most of the irritants. What’s remaining now for proxy officers, and what we’re seeing in the public companies is that perks are there that support health and productivity of the executives, except for the corporate aircraft issue, which most CEOs will tell you will be pried away from their dying hands. That’s the one that has the most stickiness in terms of prevalence, but even that is less than a majority, if you look at a good section of companies. 

SERPs are retirement plans focused on just senior executives. That being said, access or restoration plans, which just remove the cap from a qualified plan in terms of the compensation that’s allowed to be covered, are fine. We haven’t really seen any change there. We have seen tremendous movement in terms of decline in severance multiples, elimination of excise tax gross-ups related to 280G, and double triggers.

I know we only have a few minutes, so Steven is going to touch on a  few important governance policies.

Steven Hall Jr.

Really quickly I’m going to talk about share ownership guidelines. This is basically the level of stock ownership that you require from your executives. This is defined as a multiple base salary. So again, going back to that salary playing a big part, we typically see that CEOs have something like a six times base salary that gets viewed as robust. And the requirements for direct reports have ranged from one to three times base salary. You generally count shares as owned outright, as well as that unvested service- based restricted stock. Typically, you would not find unvested options, or really any options and unvested performance shares, counting towards that number. The last thing to note here is that before an executive reaches that goal, it’s not uncommon for a company to require them to hold on to a certain percentage of after tax shares, after they vest, so that they make their way towards that goal. 

On the next slide, we will discuss clawbacks. This is the idea that if there’s a financial restatement, and the bonus that was paid out should have been lower than what was actually paid, the company will go after that additional bonus from the executives. It’s included in the Dodd-Frank Act, but has been delayed in implementation. There is a potential it will get repealed under the new administration, but so far, we haven’t heard anything on it. A lot of companies have already had their own plans set up mainly for good governance practices, not in terms of reacting to Dodd-Frank. 

Most of these plans are probably going to have to be revised if Dodd-Frank regulation gets passed because there are differences in what types of performance restatements would trigger a clawback, as well as how long-term incentives are viewed, and how they will be treated under a Dodd-Frank compliant clawback. So we’re looking for additional movement as the FTC figures out what they’re doing. 

Finally, before taking any closing questions, I’m going to leave you with a bit of a cliffhanger. What you see here are three Dodd-Frank compensation-related regulations. The first one of which you’ve probably heard a lot about in the press regarding CEO pay ratio, this is the disclosure that would require the company to disclose the median pay of its employee. So the median employee’s pay, which has never been disclosed anywhere before, is disclosed as a ratio to the CEO total compensation. These ratios are out there and have been calculated in general by various organizations. However, we have not seen specific company disclosures. It is required for the 2018 proxy, absent some sort of legislative repeal. 

The other two regulations: pay for performance disclosure, and hedging policy, have been sitting here in limbo since 2015. Similar to the clawback issue, we have a law that has passed the House. It’s called the financial Choice Act, which was approved in June. Prognosticators are saying it’s not going to pass the Senate without any sort of significant modification. But as of now, it’s been proposed and approved through the House and would repeal pay ratio, and other compensation related Dodd Frank, including even annual Say on Pay. We’ll try and keep you updated on how the regulations shake out. And we’re happy to take any other questions. 

Leslie O’Connell

Next question, can you talk about the interplay between financial objectives and less objective MBOs in annual incentives? How have you guided on accurately assessing these?

Joseph Sorrentino

It’s a challenge that a lot of our clients are dealing with. It’s a little different depending on who you’re talking about within the organization. For the CEO, many companies have taken the tack that it’s going to be 100% financial, and the other MBOs are just part of being a CEO. If there are individual performance criteria, it tends to be things that are specific, and no more than 20% or 25% of the total bonus opportunity. For executives below the CEO, you’re more likely to see 25% or so in individual performance. The important thing to understand is that if you’re not clear in terms of what is going to result in performance, and how you define the way you’re measuring it, it will be viewed as a slush fund. That is going to be problematic when you’re talking to your shareholders, or when proxy advisory firms are trying to understand what you’re doing.

Leslie O’Connell

So last question, do you see a common approach in terms of what metrics are applied where PSUs are provided?

Steven Hall Jr.

It varies, I think, total shareholder return is the darling of the ISS’ and Glass Lewis’ of the world. And you definitely see a large percentage of these PSU plans that are focused 100% on relative total shareholder return. They typically use something like percentile ranking for their threshold target and maximum performance. If you step away from the total shareholder return, I think the other big ones would be earnings over a three-year period. In those situations, it’s not uncommon to find that the performance period is sort of broken up into three one-year periods, where maybe it is a little easier to do goal setting than to set up a cumulative three-year operating income number that has to be achieved. That can sometimes be problematic.

Joseph Sorrentino

One potential pitfall here to think about, if you’re using the same metrics for your short-term plan and your long-term plan, you’re going to get some negative feedback in terms of what is being called double dipping. That is basically getting paid out on the two separate plans for the same metric. We usually advise our clients that they use different metrics for the long-term than what they’re using for the short-term. We advise using long-term in addition to earnings, which is usually some sort of compound annual growth rate, and TSR that we’ve talked about a lot. We’re seeing an increasing number of companies look at return measures, return on capital, return on assets, return on capital employed, ROIC. These are increasingly being used as a way to not focus on stock price, but try and get to the underlying drivers of what’s really going to move with price.

Leslie O’Connell

Great. Well, I just wanted to close out the session. Thank you, Joe and Steven, great presentation.