The Role of Employee Stock Ownership Plans in Compensation Philosophy and. executive compensation arrangements

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1 The Role of Employee Stock Ownership Plans in Compensation Philosophy and Executive Compensation Arrangements James F. Reda * Employee stock ownership plans, or ESOPs, have existed for more than 60 years as a tool for spreading all or part of the ownership of corporations among its workers. ESOPs at publicly traded companies proliferated in the mid-1980s as an anti-takeover defense and have received new interest for the annual Say on Pay votes. What e ect, if any, does an ESOP have on a company's compensation philosophy and executive compensation plans and programs? An ESOP plan can be viewed in one of three ways: (1) to concentrate shareholder vote with management, which is particularly important for an anti-takeover defense, (2) to provide nancing the company, which is helpful to transfer ownership and (3) provide a pension for employees, which can also be integrated with a de ned contribution plan such as a 401(k) plan. ESOP plans were introduced in the mid-1950s as an e cient form of employee stock ownership. They came under the jurisdiction of ERISA in 1974 and have existed in their present form ever since. Although these plans do have some very real limitations, they can also provide employees with a substantial motivation to save for their retirements. Our rm recently conducted research in order to determine whether or not an ESOP materially alters compensation philosophy and executive compensation levels at public companies at the executive level. A well developed compensation philosophy is key for a successful company. It starts with a thesis as stated in a compensation program objective and is underpinned with internal characteristics, peer group comparisons, pay positioning strategy and alignment with the business plan. For public companies, the compensation philosophy is described in the Compensation Discussion and Analysis ( CD&A ) section in their proxy statements. The answer is that, at the executive level, ESOPs have virtually no e ect on either 1) compensation philosophy or 2) executive compensation arrangements at U.S. publicly traded companies. WHAT IS AN ESOP? * JAMES F. REDA works with both public and private organizations in planning, creating, and implementing incentive programs. He also advises companies on incentive strategy, including long- and short-term senior executive employment arrangements, change-in-control metrics, business combinations, shareholder rights, and corporate governance issues. Mr. Reda is a recognized expert in the area of integrating incentive and corporate strategies. He has more than 27 years of experience speci cally in the area of senior executive compensation. Prior to forming his own rm in 2004 (which was acquired by Arthur J. Gallagher & Co. in 2011), Mr. Reda worked at three major executive compensation consulting rms. 34

2 Role of Employee Stock Ownership Plans in Compensation Philosophy Figure 1. Overview of an ESOP ESOP plans are the only type of either retirement or employee stock purchase plans that holds either company stock or cash in a separate trust, where employees are the bene ciaries and stock is placed in their names in separate accounts. They are de ned contribution plans, but di er from other types of de ned contribution plans in that they can only be established by C or Subchapter S corporations (the latter are by far the most common type of ESOP owner). No other type of business entity may use them, such as partnerships, professional corporations, or sole proprietorships. To create an ESOP plan, the employer forms an ESOP committee, usually consisting of owners and key management members, and perhaps some key employees or a representative for rank-and- le employees. The committee makes decisions about how the plan will be funded and operated, and appoints a trustee to run the trust according to their speci cations. ESOP plans are also unique in that they are typically funded solely by employer contributions; although employee contributions are allowed, they are seldom required for this type of plan. The employer makes taxdeductible contributions into the employee accounts within the trust each year according to a preset formula, which is typically calculated according to some combination of employee tenure and compensation on an individual basis. ESOPs are the only retirement plans allowed by law to borrow money; thus they can be attractive to company owners and managers as instruments of corporate nance and succession. An ESOP formed using a loan, called a leveraged 35 ESOP, can provide a taxadvantaged means for the company to raise capital. According to a pro-esop organization, at least 75 percent of ESOPs are, or were at some time, leveraged. In addition, ESOPs can be attractive instruments of corporate succession, allowing a retiring shareholder to diversify his or her company of stock while deferring capital gains taxes inde nitely. Company insiders face additional con icts of interest in connection with an ESOP's purchase of company stock, which most often features company insiders as sellers, and in connection with decisions about how to vote the shares of stock held by the ESOP but not yet allocated to participants' accounts. In a leveraged ESOP, such unallocated shares often far outnumber allocated shares, for many years after the leveraged transaction. This can be very helpful in providing votes

3 Journal of Compensation and Bene ts for maintaining control in proxy ghts as well as Say of Pay votes. The total annual deductible contribution cannot exceed 25% of the total pay (salary and bonus) of all plan participants for a calendar year. For purposes of this allocation, total pay is limited by the IRS, as with 401(k) plans (the limit in 2015 is $265,000). Thus, the maximum amount allocated to the highest paid employee can only be $66,250 in 2015 (25% times $265,000). Employers typically fund the plan with shares of their own stock that have been valued by an independent appraiser, but may make cash contributions as well, which is typically used to fund the repurchase of shares from employees when they retire. Long-term Incentive awards (at grant date value) are not considered pay for purposes of determining the ESOP allocation. Therefore, the e ect on total pay, including LTI is less for senior executives. WHO USES ESOPS? There are approximately 11,500 ESOPs in place in the U.S., covering approximately13 million employees. According to the National Center for Employee Ownership, only 3% of all ESOPs are in public companies, and few are integral parts of corporate culture. In contrast, stock option, or other equity compensation, plans are used primarily in public rms as an employee bene t and in rapidly growing private companies. A previous study on broadbased compensation at public companies with ESOPs compared to comparable non-esop companies has concluded that large ESOPs with employee share ownership greater than 5% seem to have more or less neutral e ects on employee compensation. 1 However, since ESOP contributions must be allocated at the same percentage across the company, the e ect will be higher for lower-level employees. In this article, we are measuring the e ects of an ESOP on executive compensation at public companies, speci cally that of the Chief Executive O cer. However, both public companies and private companies have the same limitation on the amount allocated to each employee, which is in general the lesser of (i) 25% times total pay and (ii) $62,250 in 2015 (25% times IRS limit of $265,000). Thus, we expect the e ect of an ESOP to be similar at both public and private companies. ESOPS AND COMPENSATION PHILOSOPHY Simply put, a compensation philosophy consists of the following ve components: 1. Compensation program objectives. 2. Internal vs. external pay equity. 3. Peer group comparisons. 4. Pay positioning strategy. 5. Performance alignment with business plan. 36

4 Role of Employee Stock Ownership Plans in Compensation Philosophy Figure 2. Components of a Compensation Philosophy Most stated compensation philosophies are really compensation program objectives, or a starting point in stating the real compensation philosophy. The compensation program objectives are at the core of the compensation philosophy, and set the stage for the other four components, as follows: E Internal vs. External Pay Equity. At some companies, employees are more concerned with how their pay stacks up against others within the organization, while at other companies there is more concern with how pay stacks up against other organizations. In general, a company should not rely primarily on peer group comparisons in setting pay. At best, base salary levels should be compared against a broad-based peer group, but should only be used as a general guide for short- and longterm incentive opportunity amounts. E Peer Group Comparisons. Peer groups are used basically for two purposes. First, they are used to set the base salary, annual bonus, long-term incentive and other compensation and bene ts such as health and welfare plans and other compensation and bene t plans ( Compensation Peer Group ). Second, they may be used to measure the company's nancial success compared against the peer group ( Performance Peer Group ). E Developing a Pay Positioning Strategy. The purpose 37 of a pay positioning strategy is to increase the company's pro tability. You don't want to undercompensate employees as they will leave the company due to low pay, and you do not want to over compensate employees resulting in corporate waste. There is a relationship between turnover rate and competitive market positioning. E Alignment with the Business Plan. Because incentive compensation comprises the bulk of executive pay packages at publicly-traded companies, boards of directors and senior management are continually searching for the right performance measures to balance rewards with both nancial and operational perfor-

5 mance as well as non- nancial and individual performance. Once companies get beyond the dif- culties of designing executive programs that adequately balance pay versus performance, they now have the added pressure of clearly explaining their pay-for-performance formula to investors. Public companies are required to include a CD&A in their annual proxy statement, which is where these companies set forth a description of their compensation philosophy and articulate details about their policies and procedures, such as how the company has sought to align pay with performance. If ESOPs were an important component of the compensation philosophy at the public companies that have them, we would expect to nd them covered in su cient detail within the CD&A. We reviewed the CD&A of 32 public ESOP companies. Of these 32 companies, 20 made no mention of the ESOP at all. Eleven mentioned the ESOP only very brie y. Only one of these 32 companies described their ESOP in detail and emphasized its signi cance, stating that Our principal retirement savings vehicle is our Employee Stock Ownership Plan (the ESOP ). Since our Journal of Compensation and Bene ts initial public o ering in 1993, the ESOP has been a signi cant source of retirement savings for all our employees, including our named executive o cers. ESOPS AND EXECUTIVE COMPENSATION ARRANGEMENTS In order to compare compensation arrangements of ESOP vs. Non-ESOP public companies, we conducted an analysis using the methodology described below: E We reviewed a list obtained from the NCEO of 217 public companies with Employee Stock Ownership Plans and Employee Stock Ownership through 401-K plans, and sorted it according to their GICS classi cation. We then selected the ve most prevalent industries for a total population of 115 companies ( ESOP Companies ). E The ve most prevalent industries were: Banks (32 GICS: 4010), Capital Goods (23 companies- GICS: 2010), Utilities (28 companies-gics: 5510), Materials (17 companies- GICS: 1510), and 15 Health Care Equipment & Services (15 companies- GICS: 3510). E We develop peer groups for these ve industries 38 based primarily on their scal year 2013 revenue (total assets in the case of Banks), and full time employees. Peer group companies in the ve industries add up to 95 companies ( Non-ESOP Companies ). E We pulled compensation information for the CEO from the most recent proxy ling (corresponding to FY 2013 compensation), for the ESOP Companies groups and their corresponding Non-ESOP Companies peer groups and compared the di erent elements of compensation (Base Salary, Target Bonus and Long-term Incentive average of the last three years). We observed that compensation arrangements are very similar across the ve industries, and did not nd any material di erences between the ESOP and Non-ESOP groups. Some di erences in pay levels were observed in Banks and the Health Care Equipment and Services industries. Pay Levels Average di erential of the ve industries is immaterial, with Non-ESOP Companies levels only 2.06% below ESOP Companies. Pay levels for Banks is 27.41% higher for

6 Role of Employee Stock Ownership Plans in Compensation Philosophy ESOP Companies, and 27.35% lower in the case of Health Care Equipment and Services companies. Pay di erences for the other three industries range from -9.38% to 3.48%, as shown in Figure 3. Figure 3. Pay Di erentials: ESOP vs. Non-ESOP Pay Mix Very similar pay mix schemes were observed for the ve industries as shown Figure 4, which illustrates the weights assigned to the di erent components of compensation (i.e. Base Salary, Annual Bonus and Lon-term Incentive). 39

7 Journal of Compensation and Bene ts Figure 4. Pay Mix: ESOP vs. Non-ESOP EFFECT OF ESOPS ON COMPENSATION PHILOSOPHY AND COMPENSATION LEVELS Employee Level E ect Comments CEO No e ect, except that voting power represented by the ESOP may contribute to the continuation of the CEO tenure by avoiding proxy contests for controlling the board and Say of Pay votes Based on review of publicly traded companies, the compensation philosophy as noted in the CD&A and LTI mix and compensation levels are no di erent. The maximum 25% of compensation is for salary and bonus. LTI makes up a large percentage of compensation. Other Senior Executives Small to No E ect Same as CEO, but as normative compensation levels decrease, the potential e ect of the ESOP increases. Mid-level employees (managers and professional employees) Small to moderate e ect Typically, the LTI amount (as percentage of salary) decreases as salary decreases. Thus, ESOP can represent up to 25% of salary and bonus, which typically represents most of the total compensation. 40

8 Role of Employee Stock Ownership Plans in Compensation Philosophy Employee Level E ect Comments Other employees, typically Moderate to signi cant e ect ESOPs bene t the lower levels of non-exempt em- employees the most for reasons ployees listed above CONCLUSION The presence of an ESOP does not materially alter either compensation philosophy or compensation arrangements at the senior executive level. For those below the executive level, ESOPs can make up a substantial portion of compensation, particularly at the lower levels of the Company. ESOPs can also be a very large portion of retirement income. ESOPs are encouraged by favorable U.S. tax treatment at both the company and the employee level. Most publicly traded companies who use ESOPs use them as a way to concentrate management control. There are some examples of ESOPs that control a majority of the company, but most ESOPs provide a minority ownership interest. NOTES: 1 Employee Capitalism or Corporate Socialism? Broad-Based Employee Stock Ownership, E. Han Kim of the University of Michigan and Page Ouimet of the University of North Carolina, paper for American Finance Association 2010 Annual Conference. Available at l3/papers.cfm?abstractid=

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