“What the Top Compensation Consultants Are NOW Telling Compensation Committees” March 18, 2004 Presented by: Peter T. Chingos

“What the Top Compensation Consultants Are NOW Telling Compensation Committees”

March 18, 2004

Presented by:Peter T. Chingos

Mercer Human Resource Consulting 2G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt

Hot Topics: What We’ll Cover Today

Pay for performance

– Current environment

– Best practices

– Common pitfalls

The future of equity

– Current environment

– Evaluating equity plans

– Trends and directions

– Common pitfalls

CEO Benefits

What every compensation committee should do now


Pay for Performance: Current Environment Several forces are driving a renewed emphasis on pay for performance

Shareholder Objectives:• Reduce share usage• Manage overhang• Respond to pressure from

institutional shareholders (e.g., Calpers, ISS, etc.)

Marketplace Objectives:• Continue to attract and retain

talent• Continue to pay for performance• Respond to underwater options

and greater volatility in pay

Executive Compensation

Program Design

Executive Compensation

Program Design

Corporate Governance:• Ensure full and transparent

disclosure• Adhere to stock ownership and

holding requirements• Commit to excellent corporate

governance practices

Financial Objectives:• Reduce potential option expense • Control EPS impact


Pay for Performance: Best PracticesCompensation committees are demanding changesin traditional compensation philosophy and pay position

Today’s Common Practice Best Practice for the Future

Total Target Opportunity

Cash at or above median; long-term incentives at 60 – 75 %ile

Median; let performance drive compensation higher

Performance Targets Internally focused Set commensurate with pay position

Investor Focus “If we hit our targets, we are delivering results to investors”

“Will our internal targets meet investor expectations?”

Leverage Limited testing of payout sensitivity and probability

Testing of payouts at various performance levels

Market Data Data used without performance context

Data used to validate both pay and performance

Peer Group Different peers used for pay and performance

Same peers used for pay and performance

Total Compensation Focus on cash and equity Focus on cash, equity, and other benefits and programs (SERP, deferred compensation, etc.)


Pay for Performance: Best Practices Compensation positioning must be set within the context of performance

Company A vs. 15-Company Peer Group

2003 2001 - 2003Percentile Percentile

Performance Measure 25th 50th 75th

Revenue Growth

EPS Growth

Operating Income Growth

Return on Total Capital

Total Shareholder Return

Overall

= Company A position relative to peer group

25th 50th 75th


Pay for Performance: Best Practices Companies must ask whether the relationship between pay and performance is directionally correct

75th

25th

Median

75thMedian

Low Pay - High Performance

Financial Performance Versus Peers

Total Compensation

High Pay - Low Performance

Low Pay - Low Performance

High Pay - High Performance

Use a consistent peer group for pay and performance comparisons

Shift from internal to external focus

Maintain defensible pay and performance relationships


Pay for Performance: Common PitfallsCompanies should move away from these common mistakes

Guaranteed multi-year incentive payments or equity grants

Mega-grants, especially those with limited performance link

Overly generous severance or change in control payments

Aggressive SERPs and deferred compensation programs

Evergreen, or perpetual contracts that essentially mandate a severance payment to terminate


The Future of Equity: Current EnvironmentCompanies are asking hard-hitting questions about their historic equity practices

Does the FAS 123 expense equal the perceived value to employees?

Do other compensation vehicles offer better alignment among…

Do other compensation vehicles deliver value more efficiently?

Payout probability

ExpensePerceived

value


The Future of Equity: Evaluating Equity PlansLong-term incentives are evolving

Today Future

Stock Options The primary long-term incentive Eligibility very deep and broad

Significant reduction or elimination of stock options

Equity used more selectively Instead of options, more cash or

outright take-away for those whose participation is limited

Performance Shares/Units

Performance shares and units used with mixed results

Difficulty setting long-term targets

Annual milestone opportunity over three-year period

Restricted Stock Limited to middle and lower management

A portion of core long-term incentive award (e.g., 25%)

Global Programs US long-term incentive practices exported globally

Long-term incentives more locally driven


The Future of Equity: Evaluating Equity Plans Performance-based awards – FAS 123 levels the playing field

Equity Program Current Thinking

Traditional stock options Cost and perceived value are out of alignment

Performance-based stock options– Performance-accelerated– Performance-contingent– Indexed

Cost and perceived value are way out of alignment

Performance shares and performance units Make great sense Difficult to set credible goals

– Many using relative financial measures and TSR

– Others using annual milestones over three years

Restricted stock and performance-accelerated restricted stock

Compromise between service-based and performance-based vesting


The Future of Equity: Evaluating Equity PlansThe role of restricted stock is changing

Limited use in “E” suite Recruiting/special recognition awards

Becoming part of core LTI (i.e., 25%)

Perceived as “give away” by shareholders Future service requirement and retention hook

Differentiate grant by performance (front-end)

“Once only” retention Discontinue “once only” every 3 years

Sporadic use for middle and lower management

Feather into core program – longer vesting Replacement for stock options as core plan

for middle management and below

Cost vs. perceived value is aligned Perceived value high

162(m) disqualified Career vesting for Top 5

FuturePast


The Future of Equity: Trends and Directions2004 changes: First 100 Companies’ proxy data*

Preliminary 2004 data indicates a 15.7% drop in the overall value of long-term incentive grants for CEOs at median

– In 2003, median option values for CEOs decreased from $3.4 million in 2002 to $2.7 million in 2003

– Restricted stock at median increased from $0.9 million to $1.5 million

New models are starting to emerge

– Balanced portfolio – shifting long-term incentives from stock options to other full-value plans (e.g., restricted stock, performance shares/units)

– Shifting from long-term to short-term with mandatory deferral

– Offering choice – let employees choose among options, restricted stock and/or performance shares

– Replacing stock options with cash

– Limiting eligibility

*Findings from analysis of first 100 companies to file of a total sample of 350, which will be reported in the Wall Street Journal


The Future of Equity: Common PitfallsShareholder approval of new plans is a key to success

No cancellations and reissues without shareholder approval

No evergreen provisions

No reloads

No discounted options

Provide for a minimum vesting period in the plan

Identify the maximum number of shares by element that can be granted

Discuss holding period requirements and stock ownership guidelines


CEO Benefits:Potentially costly enhancements

Typical Benefits Enhancements

Retirement SERP 2.0% final average pay (base +

bonus) x years of service offset by qualified plan and Social Security

Inclusion of LTI Additional service credit Subsidized early retirement or

lump sum discount rate Secured funding arrangements

with gross-up for taxes

Deferred Compensation

Salary + 100% annual bonus Interest rate tied to investment

options or fixed

Above market interest rate

Investment options with floor rate

Deferral period extends beyond termination of employment

Life Insurance 200% - 300% of pay Post-retirement coverage Gross-up for gift and income

taxes


What Every Compensation Committee Should Do Now

Test whether you are really sticking to your compensation philosophy

Move from an internal view of pay for performance to external comparisons

View compensation holistically (i.e., cash, equity, benefits, perks, etc.)

Avoid surprises – test performance sensitivity at the beginning of the performance period

Remember that capital accumulation occurs over a career, not a quarter

Documents

“What the Top Compensation Consultants Are NOW Telling Compensation Committees” March 18, 2004 Presented by: Peter T. Chingos