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Executive Compensation

The way ahead for equity within the package

Agenda
1. 2. 3. 4. 5. 6. 7. 8. Some theory and some history The rise of the mighty option Equity diversification The role of regulation and the law of unintended consequences How corporate equity fits within the wider pay practices elsewhere and what about pensions The impact of globalisation and IT Some predictions for the future Is incentive pay immoral?
2005 Towers Perrin

Agency theory
Executive pay goes up as company size gets bigger. If pay is not performance linked, the incentive is to acquire even if shareholder value is destroyed This is an agency problem addressed in part by performance pay Part of the performance pay concept is alignment of interest with shareholders So why not pay in equity? In particular options are good

In fact the more performance pay the more alignment surely But options dont align with shareholder interest and self interest reasserts itself for executives bringing back the agency problem!
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Alignment: Reward Strategies


Compensation

Why do we do equity pay?

Culture Compensation Culture


How much? How often? Remuneration in line with market practice? local market sector companies multinationals Recruitment Danger of averaging up Employee expectations Cost/affordability for company how do we define cost? recharge costs to Business Units? Local country tax breaks economic distortion

Communication

Communication

Demonstrating alignment of employee and company interests Justifying differences of approach Demonstrating fairness and consistency up, down and across

Employee ownership Profit sharing or incentive? i.e backward or forward thinking? Pay for performance? Defining performance measured where? (corporate/BU) measured how? (internal/external) Pay to play? Who gets what? all in this together? or winner takes all?

2005 Towers Perrin

Alignment: Business Performance


Shareholder Value

Performance

Ability

Motivation

Opportunity

Compensation

Culture

Communication

Share Plan Effects


2005 Towers Perrin

Executive Compensation - A UK Chronology


Base pay, plus directors shares, circa 1850 to 1940 Base, plus true bonus (for exceptional performance) circa 1920 to 1975 or so Base, plus bonus, plus options: 1980 to 1995 Base, plus bonus, plus options, plus PSP: 1990 to 2000 Base, plus bonus, plus options, plus PSP, plus DSP 1995 to 2002 Base plus bonus, plus LTI (managed as a mix): 2000 ongoing

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The rise of the mighty option: In praise of options Employees only gain if shareholders gain No P&L charge (then) Simple to communicate and understand Risk free for employees

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Companies around the world are increasing their use of long-term incentives (LTIs)
Estimated Percentage of Companies Offering Long-term Incentive Plans (1997, 2001, 2003)

By 2003, most large companies around the world had some type of LTI

programme
Local companies have increasingly used LTIs to attract talent Most LTI vehicles were option based

2005 Towers Perrin

The development and incidences of annual bonus, share option and other long-term incentive arrangements in UK companies
100 90

Percentage of Companies Surveyed

80 70 60 50 40 30 20 10 0

1988

2000

1991

1982

1992

1995

1996

1997

1998

1989

1999

2001

2002

1993

1981

1983

1987

1984

1980

1979

Annual Bonus

1985

1986

Share Options

1990

1994

Other Long-Term Incentives

Source: Towers Perrin Survey of Top Executive Remuneration 2004


2005 Towers Perrin

2003

2004

FASB
Council of Economic Advisers, we raised strong concerns about conflicts of interest and problems in accounting standards and practices, particularly as they related to derivatives and options. FASB called for a change of accounting practices. The Secretary of Treasury and the Secretary of Commerce, however, violated basic principles of good governance, which call for the independence of FASB, and intervened to squash the proposed revisions. They succeeded.
Capital Hill Hearing, Senate Banking Housing and Urban Affairs Review of US Economic Health by Dr Joseph Stiglitz Nobel Laureate Professor of Economics, Columbia University
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Alan Greenspan
Regrettably, the current accounting for options has created some perverse effect on the quality of corporate disclosures that, arguably, is further complicating the evaluation of earnings and hence diminishing the effectiveness of published income statements in supporting good corporate governance. The Federal Reserve staff estimates that the substitution of unexpensed option grants for cash compensation added about 2 1/2 percentage points to reported annual growth in earnings of our larger corporations between 1995 and 2000. Many argue that this distortion to reported earnings growth contributed to a misallocation of capital investment, especially in high-tech firms.
Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System New York University Stern School of Business, March 26, 2002
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So are options dead what is driving the discussion?


Accounting for share options Mid 90s: bull market Recent years: bear market Tougher performance conditions required by UK institutions and increasingly seen elsewhere Pressure to drop re-testing Willingness to assess the number of shares or options to be awarded to deliver the right gain for the target/maximum performance levels

2005 Towers Perrin

Incidence of long term incentives percentage of companies (UK listed only)


100%

0% 17%

0% 16%

0% 16%

3% 11% 6%

1% 10% 8%

5% 5% 9% 25%

90%

80%

9%

11%

11% 13% 19% 17% 8%

70%

12%

10%

10%

60%

29%
50%

18%

25%

29%

32%

32%

22% 3% 6% 3%
13% 17% 17% 15%

40%

30%

5%

5%
13%

5%
13%

20%

16%

10% 12% 0%
Chairman and Chief Executive All Other Main Board Directors Corporate Executive Committee Members

23% 13% 13% 17%

28% 17%

Other Reporting Level 2 (No Board)

All Reporting Level 3

All Reporting Level 4

All Reporting Level 5

Share Options Only (%) Deferred Bonus Only (%) Share Options and Deferred Bonus (%) Share Options, Performance Shares and Deferred Bonus (%)

Performance Shares Only (%) Share Options and Performance Shares (%) Performance Shares and Deferred Bonus (%) No LTI

Source: Towers Perrin Survey of Top Executive Remuneration 2004


2005 Towers Perrin

Long term equity?


Me to a financial advisor: Im thinking of investing in equity for 3 years. Response: Short term trading in equities is not to be advised its too risky. Me again: No not equities generally, just shares of one company. Financial Advisor: No, definitely not, the risk increases enormously, not only is the time period too short, but much too concentrated and lacking diversification.
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So..? Where did this three year rule come from? And even if managers can influence the performance of their unit/company profits, does that truly reflect in share price over the same period?

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Our survey valuations are based on ten-year historical data: performance condition evaluation
For example, the chart below shows the distribution of EPS growth among the FTSE 100 companies

0.500% 0.450% 0.400% 0.350% 0.300% 0.250% 0.200% 0.150% 0.100% 0.050%

Probability

-150.0%

-190.0%

-250.0%

-230.0%

-210.0%

-170.0%

-130.0%

-110.0%

210.0%

130.0%

110.0%

170.0%

190.0%

EPS

Growth

150.0%

230.0%

250.0%
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Area under the vesting curve probabilities based on past performance


Alternatively it is possible to use the past to give us guidance Use historical TSR to generate potential rankings The model uses correlation between TSR of stocks, median TSR and standard deviation for each stock
3%

2%

2% Probability

1%

1%

Expected Value: 41%


0%

28

64

34

10

40

52

16

22

37

58

70

43

49

79

13

19

76

55

61

25

31

46

67

82

85

Ranking

73

88

And .almost all of this leaves executives cold, even if they understand, which few do

270.0%
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-70.0%

-50.0%

-90.0%

-30.0%

-10.0%

10.0%

30.0%

50.0%

70.0%

90.0%

0.000%

Impact of regulation and unintended consequences


Company law governs ability to offer shares Tax sometimes penal, and sometimes favourable, but only for defined plan type Investor codes / governance codes Impact of disclosure

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Governance Codes
First issued in 1973 by the Investment Protection Committee of the ABI (funnily enough the same year as Black Scholes invent their formula) 1992: joint ABI and NAPF guidance requires exercise conditions for all new option plans Greenbury report in 1995 mandated listed company disclosure and performance conditions on all option grants 1998: Combined Code consolidated guidance and embed the comply or explain principal 2002: Directors Remuneration Report Regulations
annual vote performance graph reinforced disclosures

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Governance Codes
Similar but lagging patterns as seen in the Netherlands, Germany, France, Sweden, Spain, USA, Canada and Australia But none of the remedies seems to fully satisfy the need
Executive pay is abnormal And too high For too little performance And not properly regulated

So more regulation is predicted

With equally ineffectual results

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Disclosure
Disclosure causes pay inflation. This is because few companies can maintain a below average pay stance
mt 0
No No

m?
No

mt 1
Decompress

Pay moves towards average

t0

t1

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Corporate Equity Pay: Where does it fit?


Fixed Pay Focus Top End Government Judges Generals Regulators Central Bank Variable Pay Focus

High Pay Focus

Entrepreneurs Capital Markets Professions Top end Corporates

Open ended opportunity

Low pay focus

Everyone else

Piece Work Zero hours controls Commission only sales

Much is equity based

Work for what you get

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Pension: Important, complex and diverse


Pension values are huge and rarely understood Pension of 50% of final pay may be worth 10 times final pay Companies have different historical approaches External forces driving need to change / innovate: Government polices changing More competitive times Governance and shareholder activism Cross European (world?) consistency / transparency Increased disclosure requirements (e.g., UK, EU)
2005 Towers Perrin

Emerging pension issues Executives focus on pension level and differences Base, bonus and long-term incentives moving toward reasonable harmonisation, or rationalisation for executives Pension is increasingly important to executives pension differences can no longer be dismissed as allowed for in pay

2005 Towers Perrin

Defined Benefit vs. Defined Contribution


Current Situation
Belgium France Germany Italy Netherlands Spain Sweden Switzerland UK US 80% DB; 20% DC+ 90% DB 85% DB - Board Members 60% DB - 2nd level Executives PREVINDAI is DC 70% DB; 30% Hybrid / DC 75% DB; 25% DC 60% DB; 40% DC 80% DC; 20% DB 40% DB; 40% DC; 20% other 80% DB; 90% DC

Trend / Comment
New plans are mostly DC Historic tax reasons; new law to hybrid 2nd level Executive Plans moving from DB to DC type Few beyond PREVINDAI Limited trend to Hybrid & Career Average DB Moving to DC, especially for new entrants Trend to DC, especially for new entrants Continued movement to DC New plans mostly DC; tax reform influences Move toward DC (including Cash Balance)
2005 Towers Perrin

Pensionable Earnings
Definition
Belgium France Germany Italy Netherlands Spain Sweden Switzerland UK US 50% (Base only) ; 50% (Base + Bonus) Base + Bonus Senior Executives: 60% (Base + Bonus) Board Members: 100% (Base only) Base + Bonus DB plans use Base only Base only (a few exceptions) 60% are Base + Bonus Base + Bonus (via DC Plan) 90% are Base only 85% are Base + Bonus

Trend / Comment
Pressure to include Bonus A few ceilings (e.g.65 x SSC) Some DC / Hybrid include Bonus No trend to include Bonus
2005 Towers Perrin

Globalisation and IT Effects


Better disclosure combined with IT/Internet access allows cross border / global pay comparisons to be made much easier Western / US business values and lifestyles mean global cities are reasonable places to live, fostering international travel The rise of the global capital markets means that shareholders are demanding the same kind of corporate performance and governance in many jurisdictions Increasingly firms are willing to hire and executives are willing to travel, so the foot print of executive search is getting much bigger Expatriate employees are fast becoming history, to be replaced by the global executive and the more flexible and more junior equivalent, the international mobile employee (IME) For the lower paid, offshoring and economic migration are forces keeping normal pay lower than otherwise. The upshot is executive pay is rising at a faster rate than normal pay.
2005 Towers Perrin

Some predictions
Executive pay will continue to rise and rise at a faster rate than general pay Much of this growth will remain performance related and equity based Performance vesting will simplify and will start to focus on the absolute delivered result, not relative performance There will be a dilution battle: if corporates win, then dilution levels will rise and become more diverse if not, phantom plans and cash based LTI will rise rapidly
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Is incentive pay immoral : the 7 deadly sins? Greed Pride Sloth Gluttony Wrath Envy Lust

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Is incentive pay immoral : the 7 deadly sins?


Performance pay works because of GREED and PRIDE the desire for more money combined with the feeling of winning and self worth. The combination is the antidote to SLOTH GLUTTONS will always want more and more, no matter how much you give them However, incentive pay invokes WRATH and ENVY in others which disclosure has made much worse. So far only LUST has been kept out of the equation (but then again, diamonds are a girls best friend!)

2005 Towers Perrin

Questions?

Thank you for your participation

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