Exotic Performance Features in Executive Compensation: How to Use Them Successfully

Transcription

1 Exotic Performance Features in Executive Compensation: How to Use Them Successfully Linda Steffen, Farient Advisors Jack Zwingli, Institutional Shareholder Services Background on Speakers Linda Steffen, Vice President, Farient Advisors 20 years of compensation consulting to a wide variety of industries, including businesses with unique operating and financial situations Developed new approaches concerning business volatility and overall pay volatility Jack Zwingli, Head of ISS Incentive Lab Background in governance, executive compensation Incentive Lab was founded to address the growth in performance pay with richer data and advanced analytics Extensive work went into developing the Award Simulator, used to value and model performance awards 1

2 Agenda What do we mean by "Exotic"? Recent trends in the use of exotic compensation design Types of performance measures Payout structure The impact of exotic design features on award payouts Case studies Top 5 tips to consider when designing a performancebased award using exotic design features Types of Exotic Design Features Exotic performance features take a variety of forms and generally are added to the plan, to: Create additional incentives for executives Manage risk Link performance measures to company strategy, or Address concerns from shareholders and others Metric Types: two growing types of exotic metric types Conditional Metrics trigger metrics where achievement leads to changes in the payout structure Modifier Metrics modify the payout structure of the underlying award based on performance Other complexity is introduced by payout structures, such as: Multiple step functions e.g., nine different levels, with Target achieved between 90% - 110% Matrix payouts e.g., achievement of various payout levels through two relative accounting metrics Relative metrics and Adjusted metrics are further examples of the increased complexity in performance award design Other metrics have been increasing in use as well 2

3 Exotic Metric Types Why and When? Relative metrics Especially TSR Adjusted metrics Especially EPS/Earnings Conditional Metrics pass/fail; adjusted payout levels Modifier Metrics multiplier, based on additional metric Other financial and non-financial metrics e.g., Environmental and Social metrics Recent Trends in Performance Metrics Total Shareholder Return (TSR) is the #1 L-T Metric EPS: 50% of L-T Earnings; Free Cash Flow: S-T doubled 25% of companies in FY 2013 disclosed using a conditional metric, compared to 16% in

4 Performance Metrics Can Be Volatile Metric volatility should be considered in selecting the appropriate performance measures Volatility varies by industry Exotic Payout Structures Multiple Step Functions Matrix Payouts Disconnect between measurement periods and vesting Extended Vesting Periods Holding Requirements 4

5 Recent Trends in Payout Structures Many awards use more than the three standard levels (Threshold, Target, Maximum) Performance measurement periods often do not match vesting periods (e.g., long-term awards) Various Methods to Find the Right Leverage There is a great deal of variation in setting Threshold and Maximum payouts Threshold payouts are generally in the 25% - 50% range, but in a number of industries 0% is the norm Conversely, there are companies with 75% payouts at Threshold Maximum payouts are generally in the 150% - 200% range, with downward pressure in some industries Other industries have more than 10% of companies with maximum payouts of > 200% 5

6 The Impact of Exotic Features on Payouts Every design choice has an impact on the expected value of performance awards, and the probability of achieving goals Awards are set with certain expectations of achieving each payout level The expected value of the awards are greatly influenced by design decisions Case Study: Adding a Conditional Metric The Compensation Committee wants to add a conditional performance metric - no award payouts unless Relative TSR is at least the 55th percentile vs. peers Award simulation allows companies to test the impact of alternative designs and conduct What if analysis Modeling provides clear comparisons between alternatives during the design process, avoiding the unintended consequences of flawed design choices Expected Value and Payout Probabilities Drop With R-TSR 6

7 Case Study: How Many Pay Levels? Payout Probabilities and Expected Value were modeled for seven payout levels As noted below, there is little difference between some of the levels Conclusion: added payout levels add complexity without providing any significant benefit Payout Level Goal Probability Payout Threshold 2.0% 94% 25% Below Target 4.0% 87% 75% Target 7.0% 65% 100% Above Target 10.0% 23% 150% Maximum 12.0% 20% 200% Expected Payout % 124% Little advantage in having these in-between levels Top 5 tips When Using Exotic Features 1. Understand the basic direction a change will have e.g., increasing a payout level will raise the expected value (unless the goals aren t achievable) 2. Don t add complexity where it isn t necessary Like unachievable goals or unnecessary payout levels 3. Avoid volatile or unstable metrics unless they reflect the nature of the business 4. A long-term award should have a long-term measure 5. Make sure perceived value is in the ballpark with accounting cost 6. [BONUS] Run the numbers, then use your judgement 7

8 An Action Plan For Adding Exotic Features 1. Review what your peers are doing Metric choice (types, weights, relationships) Payout structure Leverage 2. Model the award to understand the impact of design choices on probabilities and expected value Create a Base Case to compare against Test alternative scenarios to determine the likely impact 3. Develop a communications strategy to explain the plan design choices and manage expectations Thank You!! Linda Steffen, Farient Advisors [email protected] Jack Zwingli, Institutional Shareholder Services [email protected] 8