Executive Compensation in the Say-On-Pay Era: Winning the Shareholder Value

© 2011 Towers Watson. All rights reserved.

Executive Compensation in the Say-on-Pay EraWinning the Shareholder Vote — Without Losing the Election

Presenters: Doug Friske, James Kroll, Steven Seelig, Olivia Wakefield

April 7, 2011

© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. towerswatson.com 2

Today’s experts

Doug Friske is the global leader of Towers Watson's Executive Compensation business and is based in Chicago. He has more than 20 years’ experience advising a wide range of organizations on all aspects of executive compensation.

James Kroll is a senior consultant in Towers Watson’s Executive Compensation practice, based in New York. He specializes in corporate governance and executive compensation issues and assists clients with shareholder approval of equity plans, advisory votes on executive pay and other compensation-related governance issues.

Steve Seelig is the executive compensation counsel for Towers Watson’s Research and Information Center in Washington, D.C. His expertise includes the taxation, accounting and legal implications (including SEC disclosure requirements) of all forms of executive compensation and perquisite programs.

Olivia Wakefield is a senior consultant in Towers Watson’s Executive Compensation practice, based in Boston. Specializing in executive compensation programs, she advises clients on topics such as annual and long-term incentive performance metric calibration and plan design, equity pool management and corporate governance.


Current context: Business performance has bounced back to pre-recession levels

0

200

400

600

800

1,000

1,200

1,400

1,600

1/08 3/08 5/08 7/08 9/08 11/08 1/09 3/09 5/09 7/09 9/09 11/09 1/10 3/10 5/10 7/10 9/10 11/10

S&P 500 Composite

-400

-200

0

200

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Q1Y08 Q2Y08 Q3Y08 Q4Y08 Q1Y09 Q2Y09 Q3Y09 Q4Y09 Q1Y10 Q2Y10 Q3Y10 Q4Y10

Cash Flow

Net Income

Net Income and Cash Flow

Source: Standard and Poor’s Compustat® database.


So, what are we seeing as the say-on-pay era unfolds?

Evidence that contemporary pay practices have largely worked….Overwhelming support for pay plans for most companies in the current say-on-pay cycle (at least so far)Pay levels that have returned to mid-2000 levelsIncentive designs that are essentially unchanged in recent yearsContinued correlation between pay and performance

…although companies are continuing to refine their approachesPush back on “poor” pay practicesMore complete and thoughtful disclosureOngoing debate regarding the rigor in goal setting and the role of explicit performance conditions for long-term incentives

It appears that most companies are getting it right, but with shareholders and other constituents paying close attention, the situation can change quickly

and there’s no room for complacence


Now we’ll take a look at where we’ve been — and where we’re headed

Topic PresenterRecent Trends in Pay Levels and Practices: The Tale of the Proxies Olivia Wakefield

What We Know About Say-on-Pay Votes, So Far James Kroll

What’s on the Regulatory Horizon? Steve Seelig

Wrap-up and Q&A Doug Friske

Recent Trends in Pay Levels and PracticesThe Tale of the Proxies

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The sample…

170 Fortune 1000 companies holding annual meetings on or after January 21, 2011 (deadline for required say-on-pay votes under Dodd-Frank) that filed proxies by late March

CEOs (principal executive officers) in the role for the past 36 months

Annual Revenue*

Market Capitalization*

25th Percentile $3,000 $2,80050th Percentile $6,500 $7,90075th Percentile $13,500 $18,200

*In millions of dollars.Source: Standard and Poor’s Compustat® database.


2010 pay levels clearly reflect companies’ improving performance

Pay Element Includes2009 Median

Change2010 Median

ChangeBase salary Annual salary 0% 3%

Total cash compensation (TCC)

Base + bonus (discretionary) + short-term non-equity incentive compensation

3% 17%

Total direct compensation (TDC)

TCC + grant date value for stock options, restricted stock and performance plans

-1% 9%

Source: Towers Watson Executive Compensation Resources.


The total pay mix really hasn’t changed that much


BaseBonusStock OptionsRestricted StockPerformance Plans

22% 19%

14%

23%

22%

2008

41% Cash

59% LTI

20% 21%

15%

22%

22%

2009

43% Cash

57% LTI

24% 19%

15%

19%

23%

2010

42% Cash

58% LTI


What has changed is the long-term incentive mix

Companies may be reacting to the recent volatility in the market and are less comfortable using as many options


Stock OptionsRestricted StockPerformance Plans

39%37%

24%

2008

38%36%

26%

2009

33%41%

26%

2010


Prevalence of performance measures in long-term incentive plans remained fairly constant…

Prevalence of Long-Term Incentive Performance Measures


0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Cash Flow

ROE

Other Non-Financial

Revenue

ROC/ROIC

Operating Income/Margin

TSR

EPS/Net Income

201020092008


…as have annual plan measures for the most part…

Prevalence of Annual Incentive Plan Measures

0% 10% 20% 30% 40% 50% 60% 70%

ROE

ROC/ROIC

Cash Flow

Operating/Strategic

Revenue

Business Unit Performance

Operating Income/Margin

Individual Performance

EPS/Net Income

201020092008



…although a number of companies made adjustments in 2010

For annual plansA quarter (25%) of companies changed the performance measures used for 2010 annual awards from those used in 2009

For LTI plansAlmost as many (24%) changed performance goals used for 2010 LTIawards


Bottom line: Many companies continue to fine-tune their programs to try to get it right


The distribution of CEO bonuses is back to pre-crisis levels…


Percent of CEOs Receiving an Actual Bonus That is…

0% 5% 10% 15% 20% 25% 30% 35% 40%

>200% of target

>150% – 200% of target

>100% – 150% of target

>50% – 100% of target

<50% of target

0%

20072008

20092010


…and the alignment with performance continues to be strong

Tota

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ct C

ompe

nsat

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Total Shareholder Returns

Belo

w M

arke

tAb

ove

Mar

ket

Above IndustryBelow Industry

15%

17%

68%

2008

Tota

l Dire

ct C

ompe

nsat

ion


Belo

w M

arke

tAb

ove

Mar

ket


12%

12%

76%

2009

Tota

l Dire

ct C

ompe

nsat

ion


Belo

w M

arke

tAb

ove

Mar

ket


18%

16%

66%

2010



We also saw a close correlation between investor returns and the value of LTI granted that the CEO realizes

Three-year TSR (2008 to 2010)

LTI Realized/ LTI Granted*

Top-third TSR performance 33% 118%Middle-third TSR performance -1% 89%Bottom-third TSR performance -34% 49%

*Values include equity awarded to CEOs in fiscal years 2008, 2009 and 2010.Source: Towers Watson Executive Compensation Resources; Standard and Poor’s Compustat® database.


Companies made more one-time grants in 2010

Almost a third (29%) of companies made one-time and/or retention grants in 2010, compared to 16% in 2009

In both years, the great majority of these grants were time-based


2009

Companies Making One-Time and/or Retention Grants

16%

84%

One-time or retention grants madeNo grants made

2010

29%

71%


Finally, our review found many changes in CD&As

They are longerAverage length increased by 7%

Executive summaries are now the rageHalf (50%) of companies added an executive summary during 2011, so that a majority (64%) of companies now include one

Disclosures of annual plan goals improvedFully 85% of companies disclosed the specific performance goals for the 2010 plan yearMore than three-quarters (78%) of companies showed actual performance attained for 2010 to support the bonus paid


What We Know About Say-on-Pay Votes, So Far



Key observations to date

Overall, we’re seeing strong support for most companies’ proposals, similar to last proxy season

Proxy advisors and some shareholders acknowledge that “outliers” will come in for added scrutiny

The circumstances behind negative votes and company responses are highly situational

No one approach will work for all companies


Early say-on-pay votes show most companies are receiving strong shareholder support…

2.7% 1.4% 2.0%5.5%

13.7%

74.7%

0%

20%

40%

60%

80%

Below 50% 50% – 59.9% 60% – 69.9% 70% – 79.9% 80% – 89.9% 90%+

Distribution of Support for Say-on-Pay Proposals: 2011*Percentage of Companies in

Support Range

*Source: Towers Watson Executive Compensation Resources analysis as of April 4, 2011.

Support for Say-on-Pay Proposal


…but a negative ISS vote recommendation has an impact

The 14% of companies receiving negative Institutional Shareholder Services (ISS) vote recommendations have received above-average opposition from shareholders

Four companies have failed to get majority support for their say-on-pay proposals

On average, only about 46% of shareholders at each of these companies voted in favor of the say-on-pay proposalISS recommended votes against these proposals, citing such concerns as a pay-for-performance “disconnect” or change-in-control provisions containing tax gross-ups

ISS Vote Recommendation

Number of Companies

Votes in Favor

For 126 94%

Against 20 71%

Source: Towers Watson Executive Compensation Resources analysis as of April 4, 2011.


Subpar TSR performance doesn’t necessarily result in a negative ISS vote recommendation

Almost a third (29%) of companies failed both the one- and three-year TSR test

Yet ISS recommended votes in favor of say-on-pay at more than two-thirds (68%) of these companies

18%9%

23%

50%

ISS Say-on-Pay Vote Recommendations for Companies With Below-Median TSR

ISS support despite pay-for-performance concernISS support, other factors (e.g., pay decrease, new CEO)ISS negative, pay-for-performance concernISS negative, other concern

Positive recommendations (68%)

Negative recommendations

(32%)



Say when on pay: After an early push for triennial, annual votes gain steam

Three quarters (76%) of companies have seen annual vote frequency receive majority support

Only one-third (33%) of companies recommending triennial votes received majority support

Original Frequency Recommendation

Companies Recommending

Frequency

Frequency Implemented Frequency Decision PendingAnnual Biennial Triennial

Annual 49 20 None None 29

Biennial 9 3 1 None 5

Triennial 80 20 None 14 46

None 8 3 None None 5

Total 146 46 1 14 85

Implementation of Say-on-Pay Vote Frequency



After say-on-pay, now what? Some next steps to consider

Define the vote outcome you want to see

Review proxy advisor reports for accuracy

Determine what additional information will help you gain greatershareholder support

Assess the influence of proxy advisor vote recommendations

Determine who will represent the company in the shareholder engagement process and the timing of outreach efforts

What’s on the Regulatory Horizon?



One set of Dodd-Frank enabling regulations was released in late March…

Exchange Listing Requirements — “Independence”

Disclosure of “Conflicts of Interest”

Who Compensation consultants, lawyers and other advisors to the compensation committee

Compensation consultants

What Factors in evaluating independence:

1. Other services provided by the advisor’s firm

2. Fees as a percentage of firm revenue3. Policies and procedures to prevent

conflicts of interest4. Other business or personal

relationships with compensation committee members

5. Company stock owned

Proxy disclosure expanded to address:

Whether the work of the compensation consultant raised any conflict of interestand, if so, the nature of the conflict and how it was addressed

How the five factors influenced the committee’s conclusion

A second set of proposed regulations addresses the independence of compensation committee members


…while we await others later in 2011

How will pay be measured? What is the time period required?How will performance be measured — only TSR?Will this be in place for the 2012 proxy?

Disclosure of pay for performance 1

Disclosure of CEO pay versus median employee pay2Repeal legislation has been introduced in the HouseSEC officials have testified to Congress that there is little leeway because the statute requires median rather than average compensation

Clawbacks of compensation paid based on misstated financial results3Can discretion be exercised in enforcing the clawback?Would existing contracts be grandfathered? How is incentive compensation defined? Would the SEC regulate indemnity clauses?


Wrap-up and Q&A



Where do we go from here?

Get behind the say-on-pay vote totalsEven if your 2011 vote was highly favorable, things can change year to year depending on performance and payUnderstand the input from shareholders and proxy advisors

Stay committed to your principles and practices — you don’t need to conform to have a successful program or shareholder vote

Understand the value and implications of outstanding incentivesSignificant value created the past few years, given market volatilityInfluences expectations, with big vesting cliff likely on the horizon

Fine-tune your thinking in advance of the next round of SEC rule making

Consider potential pay-for-performance rationalization and disclosure


Questions?

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Watch for our soon-to-be-launched blog, Executive Pay Matters, for ongoing updates and information

on the latest trends and emerging issues in executive pay

Executive Compensation in the Say-On-Pay Era: Winning the Shareholder Value

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Transcript of Executive Compensation in the Say-On-Pay Era: Winning the Shareholder Value