Setting a High Bar: What Does
Incentive Plan Rigor Look Like?
The slide deck will be made available
following the webinar.
Chris McGoldrick
Research Manager
Equilar
Chad Norton
Vice President
Capital Group
Steve Pakela
Partner
Pay Governance
2
Panelists Chad Norton Vice President
Capital Group
Chad Norton co-manages the firm’s proxy
voting efforts for the American Funds group
of mutual funds. He works extensively with
investment analysts and portfolio managers
on corporate governance, executive
compensation, social and environmental
issues. Chad also participates in the
formation of Capital’s proxy voting policies,
as well as the firm’s engagement efforts
with portfolio companies. Chad joined
Capital in 1983 and previously held
positions with American Funds Service
Company, Capital’s in-house transfer agent,
and served as the corporate secretary for
three of the American Funds. Chad
received his MBA from Pepperdine
University’s Graziadio School of Business
and Management and a BA in political
science from the University of Redlands.
Chris McGoldrick Research Manager
Equilar Chris McGoldrick is Research Manager at
Equilar, where he supports the firm’s
research on executive compensation,
corporate governance, and disclosure
practices. Chris is responsible for the
company’s thought leadership and oversees
the production of Equilar’s industry leading
content. He has contributed analysis and
commentary on numerous topics that have
appeared in leading media outlets that
include the Associated Press, CNBC, The
Washington Post, and Bloomberg. He has
spent the majority of his career specializing
in executive compensation and corporate
governance, with experience at the
University of Delaware’s John L. Weinberg
Center for Corporate Governance and the
Council of Institutional Investors in
Washington, D.C. Prior to joining Equilar,
Chris served as a Teach For America corps
member and taught at a KIPP charter
school in Newark, New Jersey. Chris holds
a B.S. in finance and economics from the
University of Delaware.
Steve Pakela Partner
Pay Governance
Steve Pakela is a Partner at Pay
Governance. He advises clients in areas
such as compensation strategy
development, incentive plan design (both
short- and long-term), executive severance
and all forms of competitive compensation
review. He also advises on director
compensation and corporate governance
issues. Steve has extensive experience
functioning as an advisor to client
Compensation Committees. He works with
a broad range of companies that represent
such industries as manufacturing, mining,
financial services, consumer products,
technology, higher education and
healthcare. Steve was a former Principal
and leader of the executive compensation
practice at Towers Perrin's Pittsburgh office
where he practiced for 13 years. Steve is a
Certified Public Accountant and a member
of both the American and Pennsylvania
Institutes of Certified Public Accountants.
Steve is a graduate of Westminster College
with a B.A. in Business Administration,
concentrating in Accounting.
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Agenda
Prognostications
Evaluating
Selection & Goal Setting
Background
4
Background
5
Say on Pay Results
2.2% 2.1% 3.9%
6.0%
14%
72%
0.0%
20.0%
40.0%
60.0%
80.0%
<50% 50-59% 60-69% 70-79% 80-89% 90-100%
Distribution of Russell 3000 Say on Pay Approval Rates
2011 Year-End
2012 Year-End
2013 Year-End
2014 YTD (9/15/2014)
● Russell 3000 2014 YTD voting results are generally consistent with 2011-2013 full-year
trends.
● Currently 63 Russell 3000 companies have failed Say-on-Pay in 2014 YTD versus 56 in
2013, 58 in 2012, and 38 in 2011.
6
Annual Performance Metrics
41.6%
38.5% 36.9%
34.6%
23.3%
12.7% 10.9%
15.6%
10.9%
7.5%
44.6%
41.3%
35.8% 35.3%
25.4%
19.2%
16.1% 15.9% 14.1%
11.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
Revenue OperatingIncome
Other Non-Financial
EPS Cash Flow Cost Ratio IndustrySpecific
Net Income Safety DivisionPerformance
Prevalence S&P 500 CEO Short-Term Incentive Plan Performance Metrics
• Continuing differentiation between short- and long-term incentive plan metrics.
• Intent is to address institutional investor and proxy advisory firm criticism of duplication
between short- and long-term incentive plan performance measures, which could lead to
“paying twice for the same performance.”
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Long-Term Performance Metrics • Total shareholder return (TSR) has overtaken profit-based metrics (e.g., EBIT, EPS) to
become the most prevalent metric in long-term performance-based plans
• TSR is overwhelmingly measured on relative, rather than absolute, basis in LTI plans.
However, absolute TSR modifiers increasing in prevalence (e.g., maximum payout at 100%
of target for negative absolute TSR performance).
48.0%
29.4%
16.7% 19.0%
11.5% 9.5%
7.5% 9.1%
6.0%
57.7%
26.6%
18.1% 17.5%
11.2% 9.1% 9.1%
7.3% 5.7%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
Relative TSR EPS ROC/ROIC Revenue OperatingIncome / Margin
ROE Cash Flow Net Income Stock Price
Prevalence S&P 500 CEO Long-Term Incentive Plan Performance Metrics
2011
2012
2013
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Selection & Goal Setting
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Incentive Plans
Provide direct link between
corporate strategy and compensation
Drive sustainable company
performance over the long term
Rationalize compensation
costs to shareholders
Satisfy corporate governance concerns of
various constituents
Align employees with business unit
and corporate objectives
● Performance measurement is critical to any short- and long-term incentive design.
● When the appropriate performance metrics are selected and goals are properly
calibrated within executive incentive design they achieve the following:
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Selection Considerations
• The SEC requires companies to disclose executive incentive plan performance measures and either the specific performance goals (e.g., EPS of $1.25), or the degree of difficulty associated with achieving specific goals.
Disclosure Rules
• Companies are also expected to select appropriate metrics and not to deviate from pre-established goals when determining incentive payouts. Altering metrics, or even the definition of a metric, in order to increase payouts is a contentious issue with proxy advisory firms.
Governance Expectations
• In challenging and/or uncertain times marked by volatility within the market, maintaining line-of-sight is critical to ensuring that executives remain engaged and focused on the company’s long-term strategic priorities.
Market Conditions
• Incentive compensation is a material expense item for most companies and, as such, compensation committees want to communicate to shareholders that funds are being expended prudently.
Financial Expense
• Information asymmetry, where one party in a transaction (e.g., management) has more or better information than the other (e.g., board) exists with respect to corporate performance expectations.
Moral Hazard
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Metric Types
Market Measures Operating Measures Financial Measures
Idea ● Reward performance for a
company’s market
performance
● Reward performance for a
company’s operational
performance
● Reward performance for a
company’s financial performance
Performance
Metric
● Relative TSR
● Stock price appreciation or
absolute TSR
● Interest coverage ratio
● Inventory days on hand
● Debt to capital ratio
● Revenue
● ROIC or ROE
● EPS, EBITDA , Cash flow
Disclosure
Example
● Shares/units will vest upon
the relative achievement of
TSR versus peer group over
one 3-year performance
period
● Shares/units will vest upon the
achievement of a pre-established
debt to capital ratio for one 3-
year period
● Share/units will vest upon the
generation of 8%, 10%, or 12%
average ROIC for one 3-year
period
Reasoning ● Market-based measures are
highly prevalent in the market
and regarded to be a
“complete picture” of company
performance
● Operational achievements are
often leading indicators of
financial results
● A comprehensive view of
financial performance would take
into account revenue, profits and
the capital employed to generate
those profits
● Since companies typically “get what they measure,” it is important they measure the right
thing to optimally incentivize executives and achieve alignment between key stakeholders.
● Companies typically select incentive plan metrics from three distinct categories.
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Setting Challenging Goals
Difficulty Assessment
Probability of Attainment Assessment
0-19% Extremely Challenging
20-39% Very Challenging
40-59% Challenging
60-79% Moderately Challenging
80-100% Not Challenging
Goal Difficulty Analysis Inputs
● Ten Years of historical company performance
● Ten years of historical company peer group performance
● Upcoming-year analysts’ estimates for the company
● Upcoming-year analysts’ estimates for the peer group
Slide sourced from Executive Pay at a Turning Point, Chapter Twelve: Debunking Myths of Easy Goals and Tools for Assessing the
Difficulty of Goals, by Aubrey Bout and Brian Lane of Pay Governance.
Additional Questions for the Compensation Committee
● How often have historical annual bonus payouts been paid above target?
● How have payouts historically aligned with the business cycle?
● How was prior-year performance, and did they beat their goals?
● How are this year’s growth goals compared to last year’s?
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Evaluating
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Proxy Advisors “Shareholders would also expect such a company to fully disclose performance metrics and goals,
which should be reasonably challenging in the context of its past performance and goals, guidance the
company has provided to analysts, etc(…)
Results of financial/operational metrics: If a disconnect is driven by cash pay, ISS considers the rigor of
performance goals (if any) that generated the payouts. Recent (GAAP) results on metrics such as return
measures and growth in revenue, profit, cash flow, etc. -- both absolute and relative to peers – may also
be examined to assess the rigor of goals and whether the quantitative analysis may be anomalous (if
other metrics suggest sustained superior performance). As noted above, company disclosure about the
metrics, goals, and adjustments to results, should be clear and fulsome.”
- “Evaluating Pay for Performance Alignment: ISS’ Quantitative and Qualitative Approach (January 2013)
“Performance measures should be carefully selected and should relate to the specific business/industry
in which the company operates and, especially, the key value drivers of the company’s business.
While cognizant of the inherent complexity of certain performance metrics, Glass Lewis generally
believes that measuring a company’s performance with multiple metrics serves to provide a more
complete picture of the company’s performance than a single metric, which may focus too much
attention on a single target and is therefore more susceptible to manipulation. When utilized for relative
measurements, external benchmarks such as sector index or peer group should be disclosed and
transparent. The rationale behind the selection of a specific index or peer group should also be
disclosed. Internal benchmarks should also be disclosed and transparent, unless a cogent case for
confidentiality is made and fully explained.”
- 2014 U.S. Glass Lewis Policy Guidelines
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Shareholders “The compensation committee should establish performance measures for executive compensation that
are agreed to ahead of time and publicly disclosed. Multiple performance measures should be used in an
executive’s incentive program, and the measures should be sufficiently diverse that they do not simply
reward the executive multiple times for the same performance. The measures should be aligned with the
company’s short- and long-term strategic goals, and pay should incorporate company-wide performance
metrics, not just business unit performance criteria.
Performance measures applicable to all performance-based awards (including annual and long-term
incentive compensation) should reward superior performance—based predominantly on measures that
drive long-term value creation—at minimum reasonable cost. Such measures should also reflect
downside risk. The compensation committee should ensure that key performance metrics cannot be
manipulated easily.”
- Council of Institutional Investors Corporate Governance Policies (May 2014)
“Compensation should be objectively linked to appropriate company-specific metrics that drive long-term
sustainable value and reflect operational parameters that are affected by the decisions of the executives
being compensated(…)
Performance metrics, weights and targets should be disclosed, including why they are appropriate given
the company’s business objectives and how they drive long-term sustainable value(…)
TIAA-CREF believes that performance goals for equity grants should be disclosed meaningfully.
Performance hurdles should not be too easily attainable. Disclosure of these metrics should enable
shareholders to assess whether the equity plan will drive long-term value creation.”
- TIAA-CREF Policy Statement of Corporate Governance (6th Editiion)
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Prognostications
Thank You
Setting a High Bar: What Does Incentive Plan Rigor Look Like?
Chris McGoldrick
Research Manager
Equilar
Chad Norton
Vice President
Capital Group
Steve Pakela
Partner
Pay Governance
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