Rationalizing GlobalReward Programs

April 27, 2006 10:15am

Sean TrotmanDeloitte Tax LLP

Greg KoppDeloitte Consulting LLP

Introduction/Objectives

• Discuss current trends and issues in executive andequity compensation

• Provide an overview of the tax and regulatorychanges affecting compensation and equity plandesign

• Provide a framework to assist companies optimizetheir equity program from a design, riskmanagement and ongoing maintenancestandpoint

Agenda

• Overview of Changing Market Greg

• Emerging Trends Globally Sean

• Performance Plans Greg

• Rationalizing Methodology Sean

• Questions & Answers All

Overview of Changing Market

Dramatic Climatic Changes

• Unprecedentedlegislative andregulatory changes

• Shareholder concernand activism

• Complex interactions• Accounting is no longerthe major factor inincentive plan design

• The world ofcompensation ischanging

FinancialFinancialReportingReporting

Investor &GovernmentActivism

TaxTaxChangesChanges

IndependenceIndependence

DisclosureDisclosureRequirementsRequirements

CompensationCompensationObjectives andObjectives and

StrategyStrategy

Regulatory Changes

• Significant impact on financial statement, design,disclosure and controls• Sarbanes-Oxley – Governance, controls,

certification, disclosure• 409A – Deferred compensation legislation

• Far reaching

• FAS 123R – Fair value accounting• Mandatory expensing, January 1, 2006 for calendar year

companies

• SEC Proxy Disclosure - Transparency• Proposed regulations issued in January 2006• Expected to be adopted in 2007• Most significant impact on executive rewards disclosure

Shareholder Involvement and Activism

• Shareholders and their representatives arebecoming increasingly more active in executivecompensation and Board governance

• Shareholder proposals

• Increase in litigation

• Disney, NYSE, Hewlett Packard….

• Continued media attention

• Focus on overindulgence

• Influence of shareholder representatives andindustry thought leaders

• ISS, Glass Lewis, IRRC, NASD, Corporate Library

Board Expectations

• Boards are expected to be more active andresponsible for executive compensation policies,programs and reward levels

• Responsible for philosophy

• Independent

• Make informed decisions

• Hire advisors

• Be proactive

Strategies

• What to do?

• Construct a supportable and defensiblephilosophy and strategy• Balance business and human capital requirements, company

values and culture and stakeholder expectations

• Build programs that meet these objectives

• Consistency in decision making andadministration

• Communicate

• Consistent evaluation of the entire rewardsprogram

New Era In Compensation Planning

Other Long-Term IncentivesBeing Used More Frequently

Other Long-Term IncentivesBeing Used More Frequently

Stock Options are Being De-Emphasized

• Other forms of long-term incentives more efficient• Dilution concerns• Reflects the requirement for option expensing• Prior years award levels cannot be sustained• Employee push back

• Increase in restricted stock and unit programs• Reflects the fact that it is not possible to design

compensation plans without P&L expense• Dilution concerns• Competitive practice changes

More Balanced and Holistic Programs

More Balanced and Holistic Programs

• More diversified LTI programs• Balancing Cash vs Equity• Balancing Incentive and Retention• Increased focus on Performance-Based awards• Balancing local country requirements with overall global

objectives

Increased TransparencyIncreased Transparency• Greatly enhanced transparency for proxy officers• Outcomes to be determined – “Shock and Awe” or “Ho

Hum”• Use of one number creates “Total Rewards” evaluation

and approach

Deloitte Stock Compensation Survey

• Focused on companies’ attitudes and expectationsto equity compensation

• 343 participants, across industry

• Reaction to FAS 123(R)

• Projects company expectations around equitycompensation

• Evaluates strategic drivers for equitycompensation programs

Companies Reducing Stock Option Grants

75%

53%

83%

0%

20%

40%

60%

80%

100%

n= 276 n= 206 n= 70

Percentage of Companies

AllCompanies

PublicCompanies

PrivateCompanies

Different Forms Of Long-Term Equity-BasedCompensation

Concerns Regarding CompensationPractices

Emerging Trends Globally

End To “One-Size-Fits-All” Practice

• More imagination with respect to plan design

• Utilization of portfolio of awards

• Increasing use of performance conditions

• Tax considerations more important:

• More locally qualified plans e.g. France, UK

• Financial modeling takes on greater importance

• Administration systems become more responsiveto greater global complexity

Focus On Cost Control

• Plan designers consider effective cost control

• Better tax efficiency• Use of chargebacks

• More local tax-qualified plans (e.g., SAYE, SIP)

• Modification of plan design to lessen expense• Options - shorter terms, performance conditions

• ESPP - 5% discounts, no look back, monthly purchases

• Adjustment of award sizes to deliver sameproportion of option value to salary

Improving Tax Efficiencies

• US, UK and Netherlands have helpful corporatetax regimes

• US and UK regimes most beneficial

• Statutory deduction equal to taxable benefitdelivered to employees

• Deduction available regardless of source ofshares (form or jurisdiction)

• For all other countries a cash outlay must occur

Money Movements

U.S. Parent

Foreign Sub Employee

Employee paysstrike price of $25to U.S. Parent

U.S. Parentdelivers $100of stock toemployee

Foreign Subreimburses U.S.Parent for“spread” of $75pursuant toReimbursementAgreement

Employee providesservices to ForeignSub

Potential Benefits

• Obtaining tax deductions in jurisdictions whereotherwise not available

• Repatriating cash to the U.S. tax-free

• Increasing EPS by reducing the income statementcharge where company expenses awards underFAS 123(R)

• Reducing global effective tax rates

• Addressing global compliance issues

Easing The Income Statement Impact

Example – Reduces income statement impact by

approximately US$6,650,000

In addition, this strategypermits repatriation of cashto headquarters withoutincurring dividendwithholding taxes, whichimproves cash flow.

$62,350,000 Net Impact on Earnings

<6,650,000>Income Statement Tax Benefit Offset

35%Average Non -U.S. Corporate Tax Rate

20%Portion of Expense Incurred for Non-U.S. Employees

$69,000,000 Net Impact On Earnings

<26,600,000>Income Statement Tax Benefit Offset

35%U.S. Corporate Tax Rate

80%Portion of Expense Incurred For U.S. Employees

$95,000,000 Assumed FAS 123 Expense

$62,350,000 Net Impact on Earnings

<6,650,000>Income Statement Tax Benefit Offset

35%Average Non -U.S. Corporate Tax Rate

20%Portion of Expense Incurred for Non-U.S. Employees

$69,000,000 Net Impact On Earnings

<26,600,000>Income Statement Tax Benefit Offset

35%U.S. Corporate Tax Rate

80%Portion of Expense Incurred For U.S. Employees

$95,000,000 Assumed FAS 123 Expense

Some Country-Specific Issues

• Deduction can be limited or restricted (i.e., not always foroption “spread”)

• France: limited to “capital loss”

• Ireland: FY05 Finance Act limitations

• Japan: unclear, but certainly restricted to non directorlevel employees

• Deduction can and should be claimed on accrual basis inmany locations

• Many jurisdictions are “form” over “substance” driven

• Treasury versus newly issued shares

• Correct documentation is key

Performance Plans

A U.S. Retrospective

• In the U.S., the use of performance plans for long-term incentives was driven by the accounting rules

• For most companies, the benefits of performanceplans didn’t outweigh the favorable accountingtreatment resulting in the increased reliance anduse of standard options

• Performance-based plans often resulted in“bad” accounting

FAS 123R Creates a Significant Opportunity To UsePerformance-Based Equity Compensation

A Global Retrospective

• Internationally, the use of performance based plans havebeen commonplace for years

• Germany:

• Performance measures were always used by Germancompanies

• Performance measures are required by law if newlyissued shares are used

• A majority of the DAX 30 Companies used “absolute”hurdles (e.g., premium price up 2002)

• Since 2002, more focus on “relative” performanceconditions to meet compensation objectives

• Netherlands: Performance plans on the rise due tochanges in accounting and taxation

A Global Retrospective

• United Kingdom

• Long history of use of performance criteria – at least 15 years

• Typical performance hurdles

• Total shareholder return

• EPS growth

• 50% of FTSE 100 have minimum threshold level of performance (e.g., EPSgrowth)

• Australia

• The majority of executive plans include performance hurdles

• Most common performance hurdles

• Total shareholder return

• EPS growth

• Share price

An Unprecedented Opportunity

• New culture of pay for performance• Options have been the primary source of long-

term incentives• Often resulting in a lack of alignment and line of sight between

individual, company performance and ultimate rewards

• How you pay is as important as how much you pay• Battle for competitive advantage has shifted

• From financial statement management and costminimization

• To rewards for accomplishment of goals thatdrive organization performance and shareholdervalue

The Case For Performance Plans

• Drive behaviors to support company’s strategicgoals and value drivers

• Force understanding and agreement as tocorporate, unit, and individual goals and objectives

• Support a performance orientation culture:

• Differentiation among employees

• No awards/payout for poor/mediocre performers

• High performance provides upside opportunities

• Positive shareholder optics

• Manage share usage and dilution

Evaluating Plan Designs

• Should pay be tied to performance factors?

• To what extent can/should market volatility bemitigated?

• How to balance company performance v. line ofsight?

• How do corporate and business units function?Autonomous or dependent?

• How much compensation cost can be tolerated?

• How much dilution is tolerable?

Goal Setting Challenges

• Goal setting will be a difficult process forcompanies that have historically relied only onstandard stock option as the sole source of long-term incentives

• What measures?

• At what level in the organization?

• Over what period of time?

• Internal or externally focused?

Choice Of Financial MeasuresA

mo

un

t o

f In

form

ati

on

Complexity

Revenue

Earnings

ROI

Economic Profit

Cash Flow

Selecting Metrics – Best Practices

• Goals should be aligned with ultimate shareholdervalue creation

• Balance of internal and external measures• Look beyond the short-term• Metrics should be quantifiable• Limit number of performance objectives• Set relevant, attainable yet challenging goals• Consider degree of shareholder transparency• Communicate with participants• Goals should be reviewed frequently to ensureconsistency with business and market

Rationalizing Methodology –Putting It All Together

Steps To Rationalize A Plan

1. Objectives 2. “31” Flavors 3. Scorecard 4. Modeling 5. Execute

ν Identify the objectivesν What is most important?

ν Businessν Talent

managementν Financial

reportingν Technology

ν Shortlist incentivesν Analyze in a Scorecardν How does each incentive vehicle stack up relative to each objective?

ν Select the most appropriate award(s)ν Design the planν Implement & administerν Update as market/ business dynamics changeν Do you need to clarify the objectives?

ν Choose 2-4 typesν Perform “what if” financial/economic modelingν What happens when you mix or replace stock options with restricted stock or SARs?ν What is the cost for tax, accounting, cash flow, dilution?

ν Understand the various incentive vehiclesν There are stock- based awards and cash-based awardsν There are awards that provide for full value and others just incremental valueν Some awards require a cash investment, others don’t

1. Identify The Objectives

• Business and Talent Management Requirements• Retention• Incentive / Reward• Competitiveness• Employee Ownership Objectives• Share Usage• Align Pay with Performance• Cost Minimization

• Accounting• Tax• Qualified Plans

1. Objectives 2. “31” Flavors 3. Scorecard 4. Modeling 5. Execute

2. Understand The Different Vehicles

1. Objectives 2. “31” Flavors 3. Scorecard 4. Modeling

InvestmentPurchase required

AppreciationNo purchase required

Receive value only

Full ValueNo purchase required

Receive base plusappreciation

Stock Purchase Plan

Stock Option

Stock Appreciation Right

Phantom Stock

Restricted Stock/Unit

Performance Stock/Unit

Cash-Based Incentive

3. Scorecard

Use Scorecard Approach to Evaluate Each Vehicle

1. Objectives 2. “31” Flavors 3. Scorecard 4. Modeling 5. Execute

PerformanceUnits

Exportability

Provides HighIncentive

Capital GainOpportunity

Easy toImplement/Administer

Low Dilution/Burn Rate

Net CashInflow

Low Expense

Linked to SharePriceAppreciation

LT Cash

StockSettled

SARsPerformance

SharesRestricted

Stock UnitsRestricted

StockStock

OptionsObjective

�_ � ⊗ _ _ ⊗

4. Economic “What If” Modeling

• Modeling of financial impact on company and employee isnecessary to structure the design decision

• What is earnings impact?

• What should the mix be?

• What should conversion ratio of options to stock be?

• What is impact on share reserve?

• Iterative process is necessary

• There is an optimal strategy for every organization

1. Objectives 2. “31” Flavors 3. Scorecard 4. Modeling 5. Execute

5. Execute

• Select the award vehicle or mix of award vehicles thatmake the most sense

• Design the plan with the appropriate provisions• Grant Levels• Participation• Performance Measures/Vesting• Termination/Change in control

• Implement globally• Communication/Administration

• Review and revise periodically

1. Objectives 2. “31” Flavors 3. Scorecard 4. Modeling 5. Execute

Where Should Design Go From Here?

• Be Creative• Don’t try to force a square peg in a round hole• Consider trends and benchmarking but choose

what fits your organization• Fit to culture, business strategy and needs

• Be Bold• Unique opportunity to change in conjunction

with total rewards program• Communicate, Communicate

• Before any changes occur• And, once new strategy is formulated

Questions?

Contact Details

Sean TrotmanNew York

((212) 436-2211∗ strotman@deloitte.com

Greg KoppNew York

( (212) 618-4463∗ gkopp@deloitte.com