Hot Topic: More Effective Long-Term Incentive · PDF fileHot Topics in Executive Compensation Webinar Series 1 July 17 Getting an “Early Read” on the Coming

Hot Topic: More Effective Long-Term

Incentive Plans Hot Topics in Executive Compensation Webinar Series

© 2013 Aon plc

To protect the confidential and proprietary information included in this material, it may not be disclosed or provided to any third parties

without the approval of Aon Hewitt

Hot Topics in Executive Compensation

Webinar Series www.aon.com/hottopics_execcomp

1

July 17 Getting an “Early Read” on the Coming Year

August 7 Hot Topic: Pay for Performance

August 28 Hot Topic: More Effective Long-Term Incentive Plans

September 18 Hot Topic: Assuring Effective Disclosure

Proprietary & Confidential | Hot Topics in Executive Compensation Webinar | August 28, 2013

http://www.aon.com/human-capital-consulting/thought-leadership/eventsconferences/Hot_Topics_in_Executive_Compensation_Webinar_Series.jsp

Virginia Fischetti

Partner, Aon Hewitt

Today’s Speaker

2 Proprietary & Confidential | Hot Topics in Executive Compensation Webinar | August 28, 2013

3

Today’s Agenda

Section 1 Why Is LTI design a “Hot Topic”?

Section 2 Market Practice Regarding Long-Term Incentives and

Plans for 2013

Section 3 Key Design Parameters, Challenges, and Potential

Pitfalls

Section 4 Case Study


4

Agenda Tracker



Plans for 2013


Pitfalls



Prevalence of performance-based LTI plans has increased: since 2005, we

have seen a shift from options to full value share plans, particularly

performance shares

Why Is LTI Design a “Hot Topic”?


LTI Plan Prevalence

71%

58%

30% 30%

66%

77%

56%

32%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Options Restricted Stock Performance Shares Performance Units

2005 2012



Proxy advisor groups are paying attention to LTI design parameters and have

strong opinions about desired features

Compensation Committees, shareholders and executives care about the

design

– Are goals sufficiently difficult to achieve?

– Can executives influence the outcome of the measure(s) selected?

– Does the benefit of the program outweigh the cost?

– Will executives be rewarded commensurately with performance?

– Are the right employees eligible for the program?

– Are executive interests aligned with those of shareholders? Do they win

together/lose together?



Total Cash and LTI Distribution—Fortune 250 Executive Positions*

* Weighted Average of CEO, CFO, Law, Controller, Human Resources, Group Head and Division Head

** Figures in parenthesis indicate number of companies

Long-term incentives make up the largest (and growing) part of an executive’s

total compensation

2006 (146) 2008 (123) 2010 (92) 2012 (106)

Base Salary 21% 20% 21% 19%

Bonus 22% 22% 20% 22%

Total LTI 57% 58% 59% 59%

% of Net Total

Compensation

100% 100% 100% 100%

2006 (146) 2008 (123) 2010 (92) 2012 (106)

Base Salary $511,672 $533,269 $539,883 $560,910

Bonus $525,009 $594,637 $508,012 $643,798

Total LTI $1,351,840 $1,574,590 $1,543,707 $1,759,685

% of Net Total

Compensation

$2,388,521 $2,702,496 $2,591,602 $2,964,393

8

Agenda Tracker



Plans for 2013


Pitfalls



9

Market Practice Regarding Long-Term Incentives Eligibility

Long-term incentive eligibility has

been declining and is expected to

continue to decline as companies

address impact of results,

affordability of programs and share

pool management

Median Employee Eligibility

Aon Hewitt’s Executive Compensation Policies and Programs 2005 and 2012.


Salary of Lowest

Eligible Employee

Stock

Options

Restricted

Stock

Performance

Shares

Performance

Units

2005 $82,450 $102,800 $132,600 $140,000

2012 $125,000 $115,000 $175,000 $142,748

10

Market Practice Regarding Long-Term Incentives Award Size Determination

Percent totals exceeding 100% indicate multiple responses.

Aon Hewitt’s Executive Compensation Policies and Programs 2005 and 2012.

Method of Determining Number of Shares Awarded to Individuals

Options Restricted Stock Perf. Shares Perf. Units

2005 2012 2005 2012 2005 2012 2005 2012

Individual

Performance

60% 63% n/a n/a n/a n/a n/a n/a

Market Analysis 52% 71% 23% 66% 41% 62% 21% 64%

Predetermined #

of Shares/Units

29% 12% 20% 13% 22% 9% 15% 11%

% of

Midpoint/Salary

32% 26% 24% 32% 30% 34% 56% 34%

Discretion 56% 15% 59% 11% 11% 13% 11% 9%

Market competitive long-term incentive levels have become increasingly

important in determining the size of LTI awards, while discretionary judgment

has decreased

Companies are asking: how much do we need to spend on LTI awards?


Plans for 2013

11

1 Results will not total 100% due to multiple responses


Aspect Prev

Vehicle Use (number of vehicles used

and weighting)

65%

Performance Leverage (threshold and

maximum)

54%

Payout Opportunities (minimum, target

and maximum)

47%

Performance Measures (number of

measures used and weighting)

41%

Eligibility 37%

Administrative Provisions 27%

Review Needed

40% All

Aspects Working

Well 60%

Prevalence of thought regarding current program

design

Aspects of current long-term programs that

organizations may review in 20131

While most companies indicate that their long-term incentive programs are

working well, many feel that aspects of their programs should be reviewed

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Plans for 2013

Design Aspects Anticipated for Review


9%

17%

18%

19%

22%

30%

30%

37%

37%

39%

40%

44%

Forfeiture provisions

Minimum award payout opportunities

Maximum performance levels to trigger maximum payout

Vesting provisions

Maximum award payout opportunities

Threshold performance levels to trigger minimum payout

Use of stock options in annual grants

Number of equity vehicles used to deliver value

Eligibility

Target award payout opportunities

Number of performance measures evaluated

Weight/emphasis of performance-based vs other vehicles

13

Agenda Tracker



Plans for 2013


Pitfalls



Linking Pay and Performance: Overview

Key Design Parameter Overview

Performance Measurement Relative;

Absolute

Performance Measures Total Shareholder Return;

Financial/Strategic

Performance Goal Setting Relative;

Absolute;

Degree of stretch

Pay/Performance Relationship Performance expectation level and payout

opportunity at threshold, target and

maximum


Performance Measurement

Relative Absolute

Definition Company performance

compared to performance of

predetermined peer group

Percentile scale

Relative to median scale

Company performance

compared to goal

Typically multiyear, cumulative

goal

Sum of multiple annual

goals—minority practice

Pros/Cons Adjusts for economic

conditions common to all

peers

Easier to set scale

Provides strategic link

Provides incentive

– Do this/get that

No excuses

Cons May be difficult to construct

good enough peer group

More reward than incentive

Comparing financials often

takes work

Setting fair goals is

challenging

– Achievable, but a stretch

Works Best With… TSR

Return measures

Financial measures

Key strategic measures


Performance Measure

Prevalence

2005 2012

Profit Measures 34% 35%

EPS 23% 25%

EBITDA 7% 6%

Net Income 2% 5%

Operating Income/EBIT 2% 6%

Return Measures 21% 24%

Return on Capital 13% 13%

Return on Net Assets 4% 1%

Return on Equity 3% 6%

EVA/Cash Flow Measures 9% 7%

Cash Flow 5% 7%

EVA 4% 0%

Other Measures

TSR 34% 36%

Revenue 7% 14%

Discretionary 2% 1%

Strategic Goals 2% 1%

16

Market Practice Regarding Long-Term Incentives Performance Measures

The types of measures used in

performance plans have not

changed significantly from 2005 to

2012

There has been a slight decrease

in the use of relative metrics:

In 2005, 50% of companies

reported use of relative metrics

compared to 42% in 2012

Of this group, more tend to use

specific peer groups for

comparison compared to

indices (57% in 2005 vs. 72%

in 2012)


Performance Measures TSR vs. Financial/Strategic


The answer for some may be a combination of relative TSR and absolute

financial results

TSR Financial/Strategic

Pros Measures returns to shareholders

– Better if viewed over several

multiyear periods than one period

Easiest relative measure to use

– Adjusts for economic conditions

– Easier to set goals

Reinforces and rewards strategic

direction

Progress to goal can be measured

quarterly

Clearer line of sight

Can/should be integrated with

annual incentive measures

Cons Has “Cons” of relative measures

Duplicates to some degree

performance impact of other stock-

based elements

Accounting cost often greater than

FMV at grant

Measures performance point-to-point

– Ignores performance between

beginning and end of period

Setting goals will be challenging

Value creation may be product of

more than one measure

Choosing Among Financial/Strategic Measures Framework


Qualitative Quantitative

External Peer Practice

Statistical

Correlation to

Value for Industry

Internal

Business

Strategies/Value

Tree

Statistical

Correlation to

Value for Your

Company

Goal-Setting Evaluation Framework


Multiple inputs are critical to incentive goal-setting process

“External” provides validation of degree of stretch in business plans

“Internal” takes into account company-specific goals for current, mid-term

and long-term periods

Using all inputs leads to balanced pay-for-performance

Relative Absolute

Internal vs. Last Year

(Growth) vs. Business Plan

External vs. Peers

(Historical)

vs. Analyst

Expectations

A Framework

Pay for Performance: Pay Curves

Pay curves do not need to be linear

Use internal and external data to set target, threshold and maximum

Measure the level of incremental pay to incremental performance

Determine ability to forecast and desired degree of risk taking


Performance as % of Target

Pa

y a

s %

of Ta

rge

t

0%

50%

100%

150%

200%

60% 80% 100% 120% 140%

20

Sample Performance Goal Mechanics Absolute Measure

The Absolute Measure goal is set based on expected performance over the

3-year performance period

Vesting of shares is determined at the end of the 3-year period based on

actual performance vs. goal

Performance below threshold expectation level results in no shares vested

Performance above maximum expectation level results in no additional

shares awarded

– 200% is the maximum


Threshold (80% of Goal)

Target (100%)

Maximum (120% of Goal)

% Target Share Award Vested

50% 100% 200% (max)

Sample Performance Goal Mechanics Relative Measure


Payout is determined at the end of the 3-year performance cycle based on

company ranking vs. peers

– When using a market-based relative measure, like TSR, performance

ranking can be calculated over a multi-day period to avoid impact of

extreme short-term stock price movement

Ranking Compared to Peer Group

% Payout

0 to 20th %-ile 0%

21st – 40th %-ile 50%

41st – 60th %-ile 100%

61st – 80th %-ile 150%

81st – 100th %-ile 200%

Payout for a relative measure is

typically determined based on a table

like the one to the right

Payout Table

Potential Pitfalls

Using the same long-term incentive program for several years without review

for current relevance and effectiveness

Maintaining the same design when the company’s business strategy and

priorities are changing

Using measures in the long-term plan that lack line of sight or cannot be

directly influenced by participants

Deciding key long-term incentive design features based on what is done in

the market place rather than what makes sense for your company


Potential Pitfalls

Challenges with goal setting leading to payouts that do not reflect true

company performance

– Goals too hard or too easy

Rewarding for short-term performance through the long-term incentive plan

Following proxy advisor opinions without considering impact on the company

– Absolute vs. relative metrics

– Using similar goals for the short- and long-term plans

– Requiring a performance period of at least 36 months


25

Agenda Tracker



Plans for 2013


Pitfalls



Case Study Challenged by ISS and Glass Lewis

Scenario

MidCo had been public for many years. The current year was a strong

performance year, but the recent history had been challenging. MidCo had not

reviewed or modified it’s long-term incentive performance share program in over

15 years. ISS and Glass Lewis had identified several key features that did not

align with their compensation policies:

The short- and long-term program used the same goals

No relative measure was included in the program

The program was truly a short-term plan, measuring performance over

individual years

There was very little downside risk in the pay for performance curve


Case Study Challenged by ISS and Glass Lewis

Outcome

MidCo needed to balance responding to ISS and Glass Lewis with maintaining a plan that

made sense in light of MidCo’s business strategy. Ultimately, MidCo modified it’s program

design in a way it thought best for the company, partially satisfying ISS and Glass Lewis

and reaching out to investors directly to gain support. The plan was modified as follows:

The plan was changed to truly measure 3-year cumulative performance

The metrics were changed to ones that are linked to the MidCo business strategy and

meaningful and measureable to plan participants

Relative measures were considered and ultimately rejected

– Based on rigorous analysis of absolute and relative performance over six, 3-year

cycles

Downside risk was introduced

The metrics for the long-term plan ultimately were related but distinct from the short-

term program

– Focus is now on growth and returns


Questions

Proprietary & Confidential | Hot Topics in Executive Compensation Webinar | August 28, 2013 28

Hot Topics in Executive Compensation

Webinar Series www.aon.com/hottopics_execcomp

July 17 Getting an “Early Read” on the Coming Year

August 7 Hot Topic: Pay-for-Performance—Getting Alignment Right

August 28 Hot Topic: More Effective Long-Term Incentive Plans

September 18 Hot Topic: Assuring Effective Disclosure

Proprietary & Confidential | Hot Topics in Executive Compensation Webinar | August 28, 2013 29

http://www.aon.com/human-capital-consulting/thought-leadership/eventsconferences/Hot_Topics_in_Executive_Compensation_Webinar_Series.jsp

30

Contact Us

If you have any questions or comments about today’s presentation,

please reach out to us at [email protected].


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About Aon Hewitt

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retirement and health solutions. We advise, design and execute a wide range of solutions that enable

clients to cultivate talent to drive organizational and personal performance and growth, navigate

retirement risk while providing new levels of financial security, and redefine health solutions for greater

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30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information

on Aon Hewitt, please visit www.aonhewitt.com.

© 2013 Aon plc

This document is intended for general information purposes only and should not be construed as advice

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Hot Topic: More Effective Long-Term Incentive · PDF fileHot Topics in Executive Compensation Webinar Series 1 July 17 Getting an “Early Read” on the Coming