Paying for Performance: Priority #1 - Towers Watson

© 2011 Towers Watson. All rights reserved.

Paying for Performance: Priority #1The Changing Landscape of Total Rewards

Laura Sejen and David Seitz

December 8, 2011

© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.

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Getting Pay for Performance Right: A Business Imperative for Employees at All Levels


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The market: Economic uncertainty continuesMerit pay remains relatively flat

U.S. Merit Budget Increases*

Year Executive Management ExemptNonexempt

SalariedNonexempt

Hourly

2008 3.7% 3.5% 3.5% 3.5% 3.4%

2009 3.3% 2.9% 2.8% 2.8% 2.8%

2010 3.0% 2.8% 2.8% 2.7% 2.7%

2011P 3.0% 3.0% 3.0% 2.9% 2.8%

2012F 3.0% 3.0% 3.0% 3.0% 3.0%

Salary increases still well below

2008 levels

*Data represents median merit increases. Includes participants providing no merit increases.P: Projected for 2011/F: Forecast for 2012. Source: Towers Watson Data Services.

Canada Merit Budget Increases*

Year Executive Management ProfessionalAdministrative/

Support Hourly

2008 3.5% 3.4% 3.3% 3.2% 3.0%

2009 3.2% 2.9% 2.8% 2.8% 2.8%

2010 2.5% 2.5% 2.7% 2.6% 2.5%

2011P 3.0% 3.0% 3.0% 3.0% 2.9%

2012F 3.0% 3.0% 3.0% 3.0% 3.0%


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The market: Economic volatility continuesShort-term incentive funding expected to drop from 2010 to 2011

After an improvement from the lows of 2007 – 2009, funding exceeded 100% last year, but is expected to drop this year

2005 2006 2007 2008 2009 2010 2011P

Average Funding (as a Percent of Target)

91% 102% 78% 82% 88% 111% 101%

Source: Towers Watson 2011 Talent Management and Rewards Survey. P = Projected.


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The market: Changing conditions and working hoursEmployees are working more

65% of employers think employees have been working more hours than normal over the past three years

53% expect this to continue over the next three years This is especially true for senior managers and professionals

Employees Have Been Working More Hours Than Normal Over the Past Three

Years

Employees Will Be Expected to Work More Hours Than Normal Over the Next Three Years

Employees Have Been Using Less of Their Vacation Days or Personal Time Off Over the Past Three

YearsEmployers 65% 53% 31%Employees Senior and middle managers 57% 47% 44%

First-line supervisors and team leaders 35% 32% 27%Professional individual contributors 46% 40% 30%Administrative/clerical/manual 37% 33% 24%Exempt 50% 43% 33%Non-exempt 35% 31% 25%

Source: Towers Watson 2011 Talent Management and Rewards Survey.


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Attraction drivers among broad-based employees The role of compensation

All Employees High-Potential Employees

Rank Employers Employees Rank Employers Employees

1 Base pay Job security 1 Challenging work Job security

2 Organization’s mission, vision and values

Base pay 2 Career development opportunities

Base pay

3 Organization’s reputation as a great place to work

Health care benefits 3 Organization’s mission, vision and values

Career development opportunities

4 Career development opportunities

Length of commute 4 Base pay Promotion opportunity

5 Challenging work Vacation/PTO 5 Organization’s financial performance

Health care benefits

Employers underestimate the importance of “fundamentals” to attracting employees —even top talent



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Retention drivers among broad-based employeesThe role of compensation

All Employees Top Performing Employees

Rank Employers Employees Rank Employers Employees

1 Base pay Work-related stress

1 Promotion opportunity Work-related stress

2 Promotion opportunity Base pay 2 Career development opportunities

Promotion opportunity

3 Relationship w/supervisor

Promotion opportunity 3 Base pay Base pay

4 Career development opportunities

Trust/confidence in management

4 Relationship w/ supervisor

Trust/confidence in management

5 Work-related stress

Incentive pay opportunity

5 Incentive pay opportunity

Length of commute

Employers do not completely understand what would cause employees to leave —especially the best employees



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Segmentation opportunity Differentiating talent management and reward programs

ProgramNot

DifferentiatedCritical-Skill Employees High-Potentials Top Performers

Base pay 34% 45% 39% 57%

Short-term incentives 47% 26% 27% 49%

Long-term incentives 53% 25% 29% 37%

Coaching or mentoring 42% 15% 55% 29%

Recognition programs 74% 9% 11% 24%

Recruiting and selection 50% 46% 23% 17%

Career pathing and planning 47% 19% 51% 32%

Employee learning and development 58% 21% 37% 27%

Leadership development 31% 16% 65% 40%

Succession management 30% 26% 65% 44%

Organizations that invest more resources on targeted groups than other groups

Source: Towers Watson 2011 Talent Management and Rewards Survey. Numbers in bold indicated differentiated strategy for identified group.


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Merit pay differentiation Room for improvement

Given the importance of the fundamental forms of reward, pay differentiation is one mechanism to segment high performers

Organizations are differentiating merit pay increases based on performance

What Is the Average Merit Increase as a Percentage of Salary for Each Employee Group at Your Organization:

High-Performing Organizations

Low-Performing Organizations

Employees who did not meet expectations 0.0% 0.0%

Employees who partially met expectations 1.0% 0.7%

Employees who met expectations 2.8% 2.5%

Employees who exceeded expectations 4.0% 3.1%

Employees who far exceed expectations 5.0% 4.5%



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Short-term incentive differentiation Room for improvement

Organizations are differentiating short-term incentive payouts on individual employee performance relative to target funding levels —but there is still opportunity to do more

Target Funding Actual FundingEmployees who did not meet expectations 0% 0%

Employees who partially met expectations 60% 74%

Employees who met expectations 100% 100%

Employees who exceeded expectations 112% 112%

Employees who far exceed expectations 133% 128%

Differentiation* 2.2 1.7

Although organizations target payouts so that top performers will receive 120% more than employees who only partially meet expectations, they typically only get about 70% more

*The ratio of payouts to employees who far exceed expectations relative to those who partially met expectations.Source: Towers Watson 2011 Talent Management and Rewards Survey.


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Segmentation and differentiationExecution is critical

The importance of segmentation and differentiation needs to be socialized throughout the organization

Employees already recognize their organizations’ failure to execute these programs well

In the current market, employers cannot be all things to all people: achieving more meaningful differentials in increases will require that companies raise their game in terms of segmenting the workforce and executing on differentiation

Fewer than half of all employees report that high-performing employees are rewarded for their performance



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Execution is criticalThe role of the manager

Managers are the front line in delivering most programs or changes Managers have limited flexibility to adjust programs and apply policies

to create a compelling employee experience Organizations are very mixed in their views on managerial

effectiveness in executing reward and talent programs

Managers Execute Program Well % of Companies That Agree

Base pay 43%

Short-term incentives 49%

Long-term incentives 32%

Sales force compensation 59%

Recognition 35%

Competencies 40%

Career management 14%



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Execution is criticalMonitoring program effectiveness

Among Rewards programs, organizations are focused on monitoring STI and base pay programs, followed by sales force compensation, LTI and recognition

Formally monitoring the effectiveness of reward and talent programs supports data-driven adjustments to their design or implementation

Organization Monitors Program Implementation to Ensure Consistency with Program Objectives and Guidelines % of Companies That Agree

Base pay 72%

Short-term incentives 75%

Long-term incentives 54%

Sales force compensation 64%

Recognition 46%

Leadership development 77%

Competencies 54%

Career management 26%

Learning and development 49%



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Making differentiation and segmentation more meaningful Five steps your organization can take

1. Clearly communicate your compensation philosophy to both managers and employees

2. Review rewards plan objectives and design to ensure they align with your pay-for-performance philosophy

3. Reinforce effective performance management practices — these are critical to significantly differentiating pay based on performance

4. Issue guidance on base pay increases and STI awards for specific results achieved

5. Monitor programs: Ensure managers realize desired differentiation relative to performance


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Why Effective Pay-for-Performance Programs Are Critical for Senior Leaders


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Pay-for-performance alignment is likely to be the issue in executive compensation in 2012

Despite the fact that 98% of companies received majority support for their pay programs in 2011 say-on-pay votes… Many compensation committees are concerned that shareholder support for

pay programs might fall below an 80% support level There is a looming concern that lawsuits may proliferate against directors

whose companies fail say-on-pay votes Forthcoming SEC rules under Dodd-Frank are likely to bring added scrutiny

to the issue Possible disconnect between corporate earnings and stock performance may

add fuel to the fire

Companies are continuing to proactively plan for year two of say-on-pay and are enhancing their processes, and not just where shareholder support was lacking or less than anticipated in 2011


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Shareholder concerns about pay for performance were apparent in this year’s say-on-pay votes

37 companies failed to get majority support for their say-on-pay proposals Pay-for-performance disconnect provoked highest opposition

Key Concerns Raised by Institutional Shareholder Services (ISS) atCompanies that Received Majority Votes Against Say-on-Pay Proposals

Peer Group Benchmarking

Severance/CIC Arrangements

Non-Performance-Based Pay

Compensation CommitteeCommunication and Effectiveness

Pay-for-Performance Disconnect

Note: Based on Towers Watson’s review of ISS reports; categories and ratings are as designated by ISS when making vote recommendation for say-on-pay proposals.

8%

8%

13%

19%

78%

14%

60%

11%

46%

19%

51%

32%

76%

35%

3%

High Concern Medium Concern Low Concern


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Mix of TDC

The total pay mix for senior executives continues to evolve toward more performance-based plans

TDC Levels

Source: Towers Watson 2011 Compensation Data Bank; median revenue = $5 billion.

Long-TermIncentive

Opportunity$4.3 million

Target Bonus$1.2 millionBase Salary$1.0 million

Median Total Direct Compensation (TDC) for CEOs

BaseSalary

Target Bonus

Long-TermIncentive Opportunity

16% 18%

66%

84%Variable PFP


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Forthcoming SEC rules are likely to bring even more scrutiny

Proposed regulations under Section 953 of Dodd-Frank were expected to be published in 2011 SEC delay makes it unlikely the rules will take effect for the 2012 proxy

season Proposed rules will provide guidance on where the SEC is headed

Key issues Will a particular disclosure be mandated, such as pay compared to one-year

total shareholder return (TSR)? Will compensation “actually paid” be defined as the Total Compensation

reported in the proxy, or something else?

To prepare for this new disclosure, companies may want to perform analyses on their own approach to defining pay, performance metrics and a time frame for measuring performance


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The issue could take on greater urgency if market volatility triggers a disconnect with shareholder returns

Year-to-Date Earnings Growth vs. Total Shareholder Return (S&P 500)

25th Percentile Median 75th PercentileEPS Growth 7% 21% 54% TSR -13% 1% 12%


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To ensure proper design and alignment, companies need to look at pay and performance from multiple dimensions

Performance Perspective Summary

Performance Against Plan

Annual incentive plan

Long-term incentive plan

Trend Analysis

Plan payouts over time

Performance over time: incentive plan metrics

Performance over time: other relevant metrics

Alignment Analysis

Actual performance vs. market standards

Goals vs. market standards

Pay outcome vs. performance outcome

Other Considerations

Strategic achievements

Disclosure/proxy advisor concerns

Nonrecurring impacts

Overall Assessment

Favorable

Caution

Concern

Neutral


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Pay/performance monitoring — A continuum of approaches

Less complex

Measure historical pay

and performance

Monitor historical incentive payouts

More complex

Relate historical

payouts to historical

performance


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Analyzing historical incentive payouts — Is our variable pay plan really variable?

Company A: Low-Risk Incentive Company B: High-Risk IncentiveIncentive Payouts (% of Target)

Year Year

Incentive Payouts (% of Target)

100%

0% 0%

50%

150%

06 07 08 09 10

100% 100% 100% 100% 100%

06 07 08 09 10


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Another way of looking at it — Incentive payouts in relation to company financial performance

14%15%

12%

9% 8% 8%9%

15%14%

10%

0%

5%

10%

15%

20%

1 2 3 4 5 6 7 8 9 10

Annual Incentives as a Percentage of Pretax IncomeIncentive Payouts (% of Pretax Income)

Year

Year-Over-Year ChangeYear Pretax Income Incentive Pool

1 +12% +8%2 +10% +9%3 -10% +8%

01 10090302 0504 0706 08


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But, conventional measurement approaches are often a mismatch

How much pay has been delivered? How has the company performed?

Pay 2008 2009 2010Performance 2008 2009 2010

A better approach compares pay actually delivered to actual performance

Some companies are now measuring historical pay and performance

2008 2009 2010 2011 2012 2013

Historical Performance Future Pay Opportunity


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TGT

SVU

GPS

LTD

ODP

SPLS

KSS

JCP

COST

BBY

WAG

HD

LOW

KR

SWY

CVS

SHLD

WMT

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%3 Year TSR Percentile Rank

Top

5 To

tal

Rea

lizab

le P

ay P

erce

ntile

Ran

k

Top Five Executives

ABC

XYZ

XYZ

XYZ

XYZ

XYZ

XYZ

XYZ

Some companies also look at realizable pay in comparison to relative total shareholder return (TSR)


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A thoughtful process for selecting performance metrics is critical, for both annual and long-term incentives

Performance metrics used vary significantly by company size and industry

Performance Metrics in Long-Term Plans — Percent Used Overall

Source: Towers Watson 2011 CDB – LTI Database.

35%

22%18% 17%

10% 9% 8%

TSR EPS Revenue ROIC Net Income EBIT Cashflow


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Key issues to consider in evaluating pay-for-performance alignment

Historical Perspective Are we prepared for the increased scrutiny? What are we doing today to measure and monitor our pay-for-performance

alignment? Are we certain that we have the correct alignment today? Are management

and the compensation committee comfortable with the process and outcomes?

How will we disclose our pay-for-performance alignment in the proxy to help shareholders understand the key links?

Looking ahead (incentive plan design perspective) Have we considered the key incentive plan design issues? Are we using the right performance measures? Do our performance targets have the appropriate degree of stretch? Is the plan leverage appropriate for our industry and historical performance

patterns?


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Questions?

Laura [email protected]

David [email protected]

For more information, visit our new blog atwww.towerswatson.com/newsletters/executive-pay-matters