STUDY OF 2012 SHORT- AND LONG-TERM INCENTIVE DESIGN CRITERION AMONG TOP 200 S&P 500 COMPANIES

Transcription

1 STUDY OF 2012 SHORT- AND LONG-TERM INCENTIVE DESIGN CRITERION AMONG TOP 200 S&P 500 COMPANIES December 13, 2013 James F. Reda & Associates A Division of Gallagher Benefit Services 1500 Broadway, 9th Floor New York, New York Main: (646) Fax: (212)

2 CONTENTS Introduction... 4 Executive Compensation Overview... 6 Overview of Study... 7 Objectives... 7 Data... 7 Procedures... 7 Incentive Design Overview... 8 Performance Measures Overview... 8 Pay-for-Performance Formula Overview... 8 Study Highlights... 9 Umbrella (Inside/Outside) Plans... 9 Individual Objectives in STIPs and Use of Discretion in Non-Umbrella Plans... 9 Setting STIP Targets Pay-for-Performance Stock Option Grants Receding Detailed Observations Performance Measures Used in Incentive Plans Short-Term Incentive Plans (Bonus Plans) Long-Term Incentive Plans Summary of Reported Measures Types of Measures Number of Measures Weights on Measures Absolute vs. Relative Measures Short-Term Incentive Plans Performance Levels Payout Levels Performance-Payout Relationships Long-Term Incentive Programs Long-Term Incentive Mix (Prevalence and Value) Vesting

3 Details on Performance-Based Programs ( LTIPs ) Performance Levels Payout Levels Performance-Payout Relationships Detailed Observations Of Disclosures Introduction Prevalence of Disclosure of Performance Measures and Targets Lack of Information on Pay-for-Performance Relationship Threshold, Target, Maximum The Importance of Disclosure (m) Disclosures Short-Term Incentives Long-Term Incentives Conclusions Appendix 1: S&P 500 Large Cap Companies Top Appendix 2: Summary of Top 200 Companies by Industry Code Appendix 3: Short-Term Incentive Measure Shares Appendix 4: Long-Term Incentive Measure Shares Appendix 5: Short-Term Incentive Details Appendix 6: Executive Grant Type Usage by Company Appendix 7: Long-Term Incentive Details Appendix 8: Industry Long-Term Incentive Mix About James F. Reda & Associates

4 INTRODUCTION It has been over three years since the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd- Frank ) was signed into law, and still, only two provisions related to executive compensation have been implemented (say-on-pay (SOP) and say when on pay). However, with the installation of a new SEC Chairman, Mary Jo White, there have been signs and messages that the backlog of new SEC guidelines, particularly those related to Dodd-Frank, will soon be released. Indeed, the proposed CEO pay ratio disclosure rule was released on September 18, 2003 with comments due December 2, We expect that proposed rules for the remaining executive compensation provisions (pay-for-performance analysis and clawback regulations) will occur sometime in In 2011, the inaugural year for SOP and say-when on-pay, just 44 companies (approximately 1.4% of companies with SOP proposals) failed to receive majority shareholder support. On average, companies received 91% favorable votes for SOP proposals. An analysis by Institutional Shareholder Services ( ISS ) indicated nearly three-quarters of the failed votes were due to pay-for-performance issues. All these companies received AGAINST recommendations from ISS. It has been estimated that an ISS AGAINST recommendation results in an approximate additional 25% in the AGAINST vote. In 2012, 61 companies failed the SOP vote, which represented 2.9% of companies, a significant increase from As of November 8, companies have failed in 2013 or 2% of companies with shareholder votes. Most of these companies had sub-par one year total shareholder return (TSR) performance when compared to their GICS peer group suggesting a likely disconnect between awarded pay and performance as measured by TSR also marked the inclusion of smaller reporting companies (market capitalization of $75 million and less) as they are now required to include a management SOP proposal on their ballots for the first time for shareholder meetings held on or after January 21, With SOP now entrenched in the psyche of compensation committees and ISS s evolving standards, improving disclosure of measures used, the values associated with those measures, and how they can be expected to drive performance should continue to be a priority for all public companies. The SEC requires that in their annual proxy statements, companies disclose the specifics of their executive compensation policies in clear language for investors. This requirement has developed from the assertion by the SEC that if executive compensation performance targets are central to a company s decision-making process, these targets must be disclosed to investors. ISS is also explicit in the need for robustness of disclosure, as this is a component of their qualitative assessment of SOP proposals. ISS SOP vote recommendation for 2013 was based on the same three quantitative analyses as 2012, and were as follows: 1. Relative Alignment (compared to group of companies in similar industries and of similar size): a. TSR rank compared to CEO pay rank for one year (weighted 40%) and three years (weighted 60%). Note that beginning in 2014, ISS will drop the one-year comparison. b. Multiple of CEO s total pay for the most recent fiscal year relative to the median pay of the peer group. 2. Absolute Alignment: Trend (slope) of annual CEO pay and the company s annual TSR over the prior five fiscal years (performance slope minus pay slope). 4

5 In 2013, ISS slightly modified their qualitative review, adding a realized pay review and changing from robustness of disclosure to completeness of disclosure. Qualitative review factors included the following: The ratio of performance-based to time-based equity awards; The overall ratio of performance-based compensation to total compensation; The completeness of disclosure and rigor of performance goals; The company's peer group benchmarking practices; Actual results of financial/operational metrics (e.g., growth in revenue, profit, cash flow, etc.) on both an absolute basis and relative to peers; Special circumstances related to such things as a new CEO in the prior fiscal year or equity grant practices (e.g., biennial awards); Realizable pay compared to grant pay (applied to S&P 500 companies only); and Any other factors deemed relevant. All of this indicates that companies should include in their proxy statements complete pay-for-performance disclosures such as minimum, target, and maximum performance goals and corresponding payout levels. The SEC rules and ISS voting guidelines require that all performance measures and goals be released and compared with actual results for both short- and long-term incentive plans. This study provides a behind-the-scenes look at how incentives are being structured to connect pay and performance. Because incentive compensation comprises the bulk of executive pay packages at publiclytraded companies, boards of directors and senior management are continually searching for the right performance measures to balance rewards with financial, stock price and operational performance as well as non-financial and individual performance. Once companies get beyond the difficulties of designing executive programs that adequately balance pay versus performance, they then have the added pressure of clearly explaining their pay-for-performance formula to investors. There are four broad issues for publicly-traded companies relating to performance-based compensation, which are as follows: Selection of short- and long-term performance measures that have been approved by shareholders (i.e., contained in incentive and equity plans); Adequate disclosure of performance goals (measures and levels) in the proxy filing; Review of the risk associated with performance plans and appropriate proxy disclosure; and Clawback of incentive payouts if financial statements have been restated, causing the performance goals to not be met (included in Dodd-Frank, but regulations have yet to be issued). Outside advisors, lawyers and consultants play a substantial role in the process of setting and describing performance measures and goals because designing the appropriate compensation package for senior executives is a difficult process. The unique environment of the company and the individual needs of executives must be considered as compensation programs are designed. In addition to these considerations, public scrutiny of executive pay decisions and practices complicates the overall process of setting executive pay. Many public companies are redesigning or have redesigned their incentive programs to ensure there is a link between performance achievement for the company and executive, and performance achievement for shareholders. A disconnect stemming from faulty incentive design could expose an executive and the board of directors to unwelcome scrutiny from shareholders and the public, in addition to the risk of a negative SOP recommendation and vote. 5

6 In order to investigate what (and how much) is being shared in annual proxy statements about executive pay packages and how incentive pay is designed, James F. Reda & Associates, a Division of Gallagher Benefit Services, Inc., has conducted a study of the 2013 annual proxy statement disclosures for 200 of the top U.S. companies (based on revenue). This is the fifth year we have conducted this in-depth analysis for the top 200 public companies. A list of the companies studied is included in Appendix 1. The sector mix was led by capital goods companies, details of which are shown in Appendix 2. EXECUTIVE COMPENSATION OVERVIEW There are five elements to executive compensation: Base salary, including cost of living, merit and promotional increases; Short-term incentives, which measure performance over a period of one year or less and are almost always paid in cash; Long-term incentives, which are typically denominated in shares of stock and reward performance for a period of time greater than one year; Benefits and perquisites, including basic benefits, SERPs, retirement, personal use of aircraft, financial counseling and other excess benefit plans; and Severance, including severance with or without a change-in-control, death, disability, or other. There are multiple factors that impact the alignment of pay and performance and are crucial to the overall executive program design: Performance measures; Pay-for-performance formula (minimum, target, and maximum levels for performance goals and payout levels); Long-term incentive pay mix; and Severance pay 1. 1 Please refer to our 2012 Study of Executive Termination Provisions Among Top 200 Public Companies for more information. 6

7 OVERVIEW OF STUDY OBJECTIVES The objectives of this research study were: DATA To identify the primary characteristics of short- and long-term incentive plan designs; To identify trends in long-term incentive programs, including stock options, time-based restricted stock, and performance-based programs; To analyze the trends in plan design disclosure over time; and To review target setting as compared with actual results. The data used for this study was collected from SEC filings (in most cases from proxy statements) based on information provided in the CD&A and related tables. The data was disclosed by companies in a variety of ways, including tables, descriptive text, and footnotes. PROCEDURES The pay-for-performance formula characteristics examined in this study include: Performance measures (types of measures and weightings); Performance levels (at threshold, target and maximum); and Payout levels (at threshold, target and maximum). For the purposes of providing comparable analysis given the variability of reporting and data, judgments were made as to the best ways to combine data. The data was carefully reviewed for completeness and accuracy. We reviewed proxies filed through August 2013 with fiscal years ending in 2012 or early 2013 (May, 2013). 7

8 INCENTIVE DESIGN OVERVIEW PERFORMANCE MEASURES OVERVIEW Performance can be measured against a fixed goal (such as an earnings target) or a relative goal (as compared against a peer group of companies). Long-term incentive plans (LTIPs) often use relative measures that can be disclosed without revealing strategically important information. Companies using measures expressed as levels or percent changes might not always disclose the goal values, claiming disclosure could cause competitive harm. An analysis of disclosures is provided below. Performance measures can be segregated into two main categories: market-based (stock price or total shareholder return) and financial-based (earnings per share, return on assets, etc.) Some refer to these performance classes as external and internal. Ideally, a balanced incentive program (including short- and long-term incentives) should include financial goals and stock-appreciation goals as well as absolute goals and relative goals. Thus, if the company does well against its business plan but underperforms in its industry, the incentive payout will fairly reflect overall performance. On the flip side, if a company does not hit its internal goals but outperforms its peers and/or the broader stock market, then some level of payout may be warranted. PAY-FOR-PERFORMANCE FORMULA OVERVIEW Investors are increasingly aware of executive compensation issues and are interested to see if pay corresponds with performance. Indeed, with SOP voting an annual event for most companies, pay-forperformance has become a core issue for investors and a priority measurement item for proxy advisory firms such as ISS. As a result, companies are more focused than ever on ensuring that shareholders are comfortable with their strategies by more clearly communicating their goals. Performance-based compensation is used by almost all companies to balance executive pay with corporate and individual performance. A fair balance can be struck between the goals of the shareholders and senior management under the oversight of the board of directors, but it is not a simple task. The selection of performance measures and corresponding performance levels can be one of the most difficult aspects of designing an incentive compensation program. Goals need to be reasonable and aligned with the business plan and investor communications. In addition, the minimum threshold payout for an incentive plan should be adjusted to be fair to both executives and shareholders. Because the relationship between pay and performance is often complex, communicating the purpose and design details of the executive performance program is challenging. However, despite changing disclosure expectations and interpretations, the interest in pay-for-performance continues to grow and will continue to be a focus of the SEC, proxy advisors, and shareholders. 8

9 STUDY HIGHLIGHTS UMBRELLA PLANS Of the 200 companies reviewed, 2012 disclosures for 57% of companies with STIPs indicated the use of umbrella STIP plans (also referred to as inside/outside plans), up from 50% in 2011 and 42% in Companies with these types of plans usually disclose fewer performance metrics than companies without these plans, especially threshold and maximum values. Similar to other performance-based programs, umbrella plans must follow specific guidelines in order to qualify as performance-based compensation that is in compliance with Internal Revenue Code162(m) and thus tax deductible. Two somewhat different plan designs are evident. The plan design found most often involves creating a bonus pool usually based on a percentage of an income measure ( outside plan ). Nearly two-thirds (65%) of umbrella plans use this approach. Each executive covered under this plan is allocated a percentage of the pool, which represents the maximum allowable payout to each person. Actual payouts are based on an inside plan which often includes a combination of financial/formulaic performance measures with corresponding threshold, target and maximum levels, and individual or discretionary goals. Because the outside plan is based on a financial measure that is approved by shareholders and meets the other 162(m) requirements, these individual/discretionary amounts are considered performance-based and therefore are tax deductible. To qualify for 162(m) deductibility, an executive s payment must be below the disclosed maximum amount and the sum of payments to all executives must be less than or equal to the pool amount. Additionally, a reduction in one executive s amount cannot result in an increase to another executive s payment. Once the pool and individual amounts have been established, only negative discretion can be used to adjust the amounts. The second plan type involves establishing a financial hurdle or hurdles which must be achieved before bonus payments can be made. These hurdles are designed to cover the amounts necessary to pay bonuses to the top executives. The actual bonus pool is usually a multiple of salaries of those executives participating in the plan. As described above, performance and individual goals can be created for determining the actual payment amounts. About one-third of companies with an umbrella plans use this approach. Because there is an overarching financial hurdle and payment limits established for the executives, this type of plan would qualify for 162(m) tax deductibility. INDIVIDUAL OBJECTIVES IN STIPS AND USE OF DISCRETION IN NON- UMBRELLA PLANS Many companies use individual performance measures in their STIPs. Of the 197 companies with STIPs, thirty-nine percent (39%) of companies included individual, specific objectives for one or more named executive officers (NEOs). Thirty-six (36%) of CEOs had individual objectives. Thirty-eight percent (39%) of the other NEOs had individual objectives. Individual objectives can be based on a combination of financial and non-financial measures. Of the executives that had individual objectives in 2012, 36% had a separate weighting for individual objectives ranging from 10% to 50%. In other cases the final award was an adjustment to a calculated, formulaic amount using discretion or a predetermined plus and minus range. 9

10 Discretion, excluding negative discretion related to umbrella plans, was used at 58% of companies with STIPs in 2012 to determine at least a portion of the bonuses paid to executives. Discretion can reflect individual performance, overall company performance relative to the industry, in recognition of special contributions, and other factors that the CEO or compensation committee deem valuable to the company. The use of discretion is not related to use of individual objectives, although these practices can overlap. SETTING STIP TARGETS The median year-over-year increase in target goals for 2012 was 6%, down from 9% in Target goals were set at 4% (at the median) over prior year actual results as compared with 6% in 2011 and 5% in The most notable change in 2012 was the much smaller increase in targets at the 75 th percentile as compared to 2011 as shown in Figure 1. Figure 1: Strength of Targets Target Over Target Over Prior Year Prior Year Results (%) Results (%) Target Over Prior Year Results (%) Target Target Target Percentile Change (%) Change (%) Change (%) 25 th -2% -4% -1% -1% -8% -1% Median 6% 4% 9% 6% 5% 5% 75 th 18% 9% 34% 15% 17% 16% Given the sluggishness of the economic recovery, these smaller increases, most of which relate to profitability, appear to be realistic and proper. Nevertheless, 34% of target performance goals were set at levels that were lower than the prior year actual results and 30% of goals were below the prior year target value. PAY-FOR-PERFORMANCE An examination of short-term incentive payouts relative to target indicates that fewer CEOs exceeded targets in 2012 than in 2010 and 2011, although the number exceeding was still significantly higher than in Among companies that reported short-term incentive payouts in 2012, 62% of CEOs were paid at or above target levels as compared with 72% in 2011, 76% in 2010 and 55% in On the other hand, more companies exceeded targets in LTIPs in 2012 than in prior years. Of the companies that disclosed long-term incentive performance and payout information, the percentage that met or exceeded goals was 60% in 2012 as compared to 53% in both 2011 and 2010 and 44% in We also reviewed how STIP target levels are set relative to the prior year target to see if decreasing the target value resulted in companies more able to exceed target. Said another way, if the bar is lowered, does that result in a higher likelihood of exceeding target as compared with companies that increased targets? For 2012 the answer was no as companies with lower targets achieved above target half the time, (50%) somewhat lower than for companies that increased their target over the prior year target, as 60% of these companies exceeded target. Consequently, companies that set targets below the prior year target were slightly less likely to achieve or exceed target performance as compared with companies that had increased their target. However, this raises other questions surrounding STIP payments near target levels to top executives pay when the company s financial performance appears to be slipping. 10

11 STOCK OPTION GRANTS RECEDING The shift away from Appreciation Awards (stock options/stock appreciation rights ( SARs )) and towards performance awards that are earned based on achieving performance goals continued in 2012 in dramatic fashion. For the third consecutive year, the prevalence of grants of performance-based awards exceeded the combined prevalence of time-based appreciation awards and the gap has been growing. Since 2009 when the prevalence was about even, performance-based awards are now 20 percentage points higher than stock options/sars (88% vs. 68%). Nonetheless, appreciation awards are still more prevalent than time-based restricted stock but the gap is closing. For example, in 2008, the difference in prevalence was 34 percentage points (82% vs. 48%), but in 2012 the difference was just 13 points (68% vs. 55%). The collective use of performance-based awards (which includes performance shares, performance share units, performance-based restricted stock, performance stock options, premium stock options, and long-term cash plans) totaled 88% in 2012, up from 82% in 2011 and 77% in On the flip side, the prevalence of stock option/sar grants, in total, has declined from 82% in 2008 to 68% in These figures exclude companies that did not make any LTI grants (four in 2012, two in 2011 and 2010, three in 2009, and five in 2008). We attribute the sudden shift from appreciation awards to performance awards in 2012 (6% decrease in stock options/sars and 6% increase in performance awards) to the impact of SOP and the influence of ISS, particularly their classification of stock options as non performance-based grants. Not surprisingly, the prevalence of time-based restricted stock/units also dropped in See Figure 2 below for further details. Figure 2: Prevalence of Use 100% 80% 60% 40% 20% 0% Appreciation Awards Restricted Stock/Units Any Type of Performance-Based Award In addition to the decrease in prevalence of appreciation awards, the value provided in the form of stock options/sars is also declining. In 2008, approximately 40% of the total LTI value was provided in the form of appreciation awards and in performance-based awards (with 20% in time-based restricted stock/units). 11

12 But by 2012, performance based awards increased to 50% of the total LTI value with a corresponding decrease in stock options/sars (with time-based restricted stock/units remaining flat). See Figure 3 below: Figure 3: Average LTI Mix Average Value Share of LTI Grants 100% 80% 60% 40% 20% 0% Appreciation Awards Restricted Stock/Units Performance-Based Stock/Cash DETAILED OBSERVATIONS PERFORMANCE MEASURES USED IN INCENTIVE PLANS S HORT-TERM INCENTIVE PLANS (BONUS PLANS) Findings include the following: Earnings per share (EPS) was the most common single measure used by the companies in the study that disclosed their performance measures. Forty percent (40%) of companies with nondiscretionary STIPs used EPS in 2012 as compared with 37% in 2011 and 40% 2009 and Ninety percent (90%) of companies using financial measures used at least one type of income-based measure in 2012 and 2011, up slightly from 89% in This category includes EPS, net income, operating income, EBITDA, etc. Other common measures used in 2012 included revenue (35%), cash flow (29%), and capital efficiency ratios (25%). Total shareholder return (TSR), the most commonly used measure in an LTIP, is not often used in a STIP. We found only 3% of companies with STIPs used TSR in 2012 as one of the performance measures. For companies with STIPS, use of non-financial measures (such as customer satisfaction, production goals, and new business market share) were disclosed at 47% of companies, down from 53% in 2011 and 56% in Thirty-seven percent (37%) of companies with STIPs and LTIPs used one or more of the same measures in both incentive programs. This is less than the 42% in 2011 and 40% in

13 LONG-TERM INCENTIVE PLANS Findings include the following: The number of long-term incentive plans (LTIPs) increased from 162 in 2011 to 173 in % of the top 200 companies now have LTIPs in place. TSR is the most commonly used performance measures in LTIPs, with 52% prevalence for those companies with LTIPs. This is much higher than 46% in 2011 and 45% in TSR is usually used as a relative measure that compares company performance to a peer group (58%) or composite index (44%). Thirty-five percent (35%) used the S&P 500 index as a benchmark. Ten percent (9 companies) use a TSR-based modifier to adjust the final performance result, with five of the companies using the S&P 500 index as the relative measure. Similar to STIPs, some type of income measure is commonly used in LTIPs. Fifty-two percent (52%) of companies with LTIPs used at least one measure of income in 2012, which was higher than the 50% in 2011 but down from 55% in 2010 and 54% in Of the income measures, EPS is still used most often but has been receding, with 59% usage in 2012, 61% and 62% usage in 2011 and 2010, respectively. Forty percent (40%) of the companies used a capital efficiency measure in 2012 as compared with 36% in 2011, 41% in 2010, and 31% in This category includes return on invested capital, return on equity, return on capital, return on net assets, economic profit, and economic value added. The use of revenue measures in 2012 decreased slightly to 20% from 21% in 2011, but remained above the 18% in 2010, and just 14% in Sixty-eight percent (68%) of performance periods reported were three years in length. as compared to 69% in 2011 and 70% in An additional 12% of companies used 3-year performance periods but set goals annually; this was up from 11% in 2011 and 10% in However, several companies indicated they would be returning to a 3-year cumulative design for fiscal year This performance measure data is summarized in Figure 4 on the following page. 13

14 SUMMARY OF REPORTED MEASURES T YPES OF MEASURES Figure 4: By Company (% of STI/LTI plans, Non-Discretionary)* Performance Measure STI LTI STI LTI STI LTI Income: EPS, net income, EBIT/EBITDA, operating income, pretax income 90% 52% 90% 50% 89% 55% Total Shareholder Return: Stock price appreciation plus dividends (relative and 3% 51% 2% 46% 3% 45% absolute), stock price Capital Efficiency: Return on equity, return on assets, return on investment, return on capital, 25% 40% 26% 36% 28% 41% return on sales, economic value added Revenue: Revenue, revenue growth 35% 20% 31% 21% 33% 18% Cash Flow: Cash flow, cash flow growth 29% 12% 28% 14% 28% 13% Sample size (number of companies): 200 STIPs**: 171 (2012) 172 (2011), 177 (2010) LTIPs: 173 (2012) 162 (2011) 154 (2010), *The sum of percentages is greater than 100% since most companies use more than one measure. **Important Point to Note: In the case of STI, this chart does not include individual discretionary performance plans (26 companies in 2012). Also, three companies did not disclose a STIP in The use of STI measures by industry is displayed in Figure 5 on the following page. With the exception of Materials, Telecommunications Services, and Pharmaceuticals, Biotechnology & Life Sciences, income measures were the most prevalent measures. Sample sizes are very low for several industries so drawing conclusions is limited by that fact. See Appendix 3 for the number of representative companies by industry as well as the prevalence of performance measures. 14

15 Figure 5: STI Measures by Industry STI Measures 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% Other Cash Flow Revenue Cap Eff TSR Profits 0% 15

16 The use of LTI measures by industry is displayed in Figure 6. As with STIPs, samples sizes are low for a number of industries. Profit measures, total shareholder return, and capital efficiency ratios are used to varying degrees by most industries. See Appendix 4 for the number of LTIPs by industry and the prevalence of measures. Figure 6: LTI Measures by Industry LTI Measures 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Automobiles & Components Banks Capital Goods Commercial Services & Supplies Consumer Durables & Apparel Consumer Services Diversified Financials Energy Food & Staples Retailing Food Beverage & Tobacco Health Care Equipment & Services Household & Personal Products Insurance Materials Media Pharmaceuticals, Biotechnology & Life Sciences Retailing Semiconductors & Semiconductor Equipment Software & Services Technology Hardware & Equipment Telecommunication Services Transportation Utilities Other Cash Flow Revenue Cap Eff TSR Profits 16

17 N UMBER OF MEASURES Most companies include multiple measures in their STIPs (Figure 7). In 2012, 76% of companies with STIPs used two or more financial measures in their plan design, which is up from 73% in 2011, 72% in 2010 and 70% in Figure 7: Short-Term Incentive Plans Number of Measures % 27% 28% 30% 2 32% 32% 32% 30% 3 25% 21% 24% 20% 4 9% 8% 11% 14% 5 3% 6% 2% 4% 6 or more 6% 6% 3% 2% With regard to LTIPs, the most common number of performance measures to include in a plan is one or two; however, the trend over the last four years has shown an increase in the number of measures used. As shown in Figure 8 below, the number of companies using one measure has declined from 46% in 2009 to 37% in 2012, and there has been a similar if less steep decline in the use of two measures (from 38% in 2009 to 35% in 2012.) On the flip side, companies using three measures have increased from 14% in 2009 to 21% in 2012, with a corresponding increase in the use of four or more measures from 2% in 2009 to 8% in Figure 8: Long-Term Incentive Plans Number of Measures % 39% 41% 46% 2 35% 35% 39% 38% 3 21% 22% 15% 14% 4 or more 8% 5% 5% 2% W EIGHTS ON MEASURES Not only are income goals common for both STIPs and LTIPs, but the weighting assigned to them tends to be relatively high. For example, the weight on EPS in STIPs tends to be higher than the weights on revenue or return measures, two other commonly used performance measures. In 2011 and 2012, 60% of companies using EPS assigned a weight of 50% or higher to this goal compared with only 27% for return measures and 2% for revenues. (Appendix 5, Table 1) EPS in LTIPs also have a weight of 50% or higher two-thirds of the time. Thirty percent of companies using EPS had a 100% weight (only measure). However, unlike STIP weights, LTIP return/efficiency measures generally have high weights with 76% having a weight of 50% or higher. TSR also is usually weighted highly with 81% having a weight of 50% or higher. Of course the use of measures and how they are weighted depends on the industry, as presented above (Appendix 7, Table 4). 17

18 ABSOLUTE VS. RELATIVE MEASURES All but one company with a STIP used at least one absolute measure to evaluate performance. Conversely, just 7% of STIPs included a relative measure in 2012, which is about the same as the last two years. Of the 86% of companies with LTIPs, 59% used at least one relative measure in their 2012 LTIP design. This is the highest percentage we have seen in the past five years, and we attribute it to the attempt by companies to more directly link long-term pay with performance. Seventy-nine percent (79%) of these companies used TSR as the relative measure in 2012 as compared with 75% in 2011, 73% in 2010 and 77% in both 2009 and Regarding absolute measures, seventy-five percent (75%) of companies included at least one absolute measure in their plan. In addition, thirty-four percent (34%) used a combination of absolute and relative measures. One such combination is applying a TSR modifier to the results generated by an absolute performance goal, which was used by nine of sixty companies using relative TSR. When all performance measures are aggregated, we found that 64% of all LTIP measures were based on absolute goals and 36% were based on relative performance. SHORT-TERM INCENTIVE PLANS PERFORMANCE LEVELS For short-term incentives, we had seen a flattening of the performance/payout curve in the years 2008 and 2009 with some lingering effects in This meant that threshold performance levels had been lowered along with payouts for these award levels, while maximum performance levels had been increased with no additional upside payout potential. We believe this was in response to the weak economy and the uncertainty that companies felt in setting goals. With the economy now on a more certain, albeit slow, growth pace, threshold performance levels as a percent of target increased in 2011 and 2012 over the lower levels seen in 2010 and At the low end, 6% of thresholds were less than 50% of target in 2012, up from 3% in 2011 and 4% in 2010, but lower than the 12% prevalence in 2009 when curves were most flat. At the higher end of the range, which includes threshold goals that were set at 80% of target or higher, the prevalence of this grouping increased from 61% in 2009 to 74% in 2012.which we attribute to an improving economy and more certainty that allowed companies to raise the payout floor. Maximum performance limits in 2012, expressed as a percent of target performance, were most commonly set between 105% and 109% (22%) or between 111% and 115% (21%). Overall, for maximum limits set at 120% or higher, the prevalence decreased from 41% in 2009 to 30% in As a result of the general lifting of the thresholds and lowering of the maximums, the performance bands for 2011 and 2012 were narrower than for both 2010 and This could be a reflection of greater certainty in the expected performance of companies while also limiting risk in the incentive structure. (Appendix 5, Tables 2 3). It is important to note that the threshold and maximum spread is usually related to the financial measure being used, and whether it is expressed as a level or a percent change. For example, earnings per share (EPS) when measured as a level is most often set in a very narrow band as compared to a return measure like return on invested capital (ROIC) or income measures like net income or operating income. Specifically, 55% of EPS measures have a threshold value of 90% of target or higher and 55% of maximum EPS values are 110% of target or lower. Ninety-four percent (94%) of threshold performance goals are within 80% of target, and 92% of maximum goals are within 120% of target. 18

19 On the other hand, return or efficiency measures like ROIC often have a wider spread around target. In our study we found that only 53% had a threshold performance value within 80% of target. Income measures were somewhat higher with 70% having a threshold performance value within 80% of target, but still significantly lower than the 94% usage for EPS. Performance ranges are also broader when the target is expressed as a percent change. Thirty-five percent (35%) of companies use a revenue measure which is sometimes expressed in growth terms. For example, in this study we found seven companies using revenue growth targets of which five (71%) had a threshold value less than 70% of target. Six of these companies reported maximum values, with four of the six (67%) setting the maximum more than 130% of target or higher. On the other hand, revenue goals expressed in dollar value terms had a very narrow range with 86% of measures having thresholds 90% or higher and 81% with maximum values at 110% of target or less. See Figures 9 and 10 below. Figure 9: Performance Thresholds by Type of Measure Threshold Relative to Target Measure Type 90% or higher 80% or higher 70% or higher EPS Level (n=33) 55% 94% 97% Income Level (n=53) 36% 70% 87% Return Ratio (n=17) 35% 53% 82% Revenue Growth (n=7) 14% 29% 29% Revenue Level (n=23) 86% 100% 100% Figure 10: Performance Maximums by Type of Measure Maximum Relative to Target Measure Type 110% or lower 120% or lower 130% or lower EPS Level (n=38) 55% 92% 95% Income Level (n=51) 37% 76% 88% Return Ratio (n=16) 25% 63% 88% Revenue Growth (n=6) 17% 33% 33% Revenue Level (n=21) 81% 90% 95% PAYOUT LEVELS Twenty-six percent (26%) of companies used a payout range (threshold to maximum) of 0% to 200% for their STIPs, which is relatively consistent with previous years. The next most common payout ranges were 50% to 200% and 50% to 150%, with prevalence of 9% and 5%, respectively. 19

20 STIP threshold payout percentages have drifted downward with 46% of companies eliminating cut-offs (e.g. 50% of target) and extending payouts to begin at just over 0%. Seventy-seven percent (78%) of threshold payout levels were below 50% of target. The most prevalent maximum was 200%, which was used in over half the companies (54%). (Appendix 5, Tables 4 6) PERFORMANCE-PAYOUT RELATIONSHIPS We reviewed the most typical performance-payout curves or relationships. This is defined as the performance threshold and performance maximum as a percent of target as compared to the payout percentages of target at threshold and maximum performance. Generally, there are no typical performance-payout combinations. In 2012, the most common combination for STIPS was 85% to 115% performance range with 0% to 200% payout range which had a prevalence of 6.8%. We have included the four most prevalent combinations of performance ranges for measures in 2012 in Appendix 5, Table 7. Threshold performance levels as a percent of target have remained relatively stable over the last few years. The median threshold percentage was 86% in 2012, relatively unchanged since 2009 when it was 85%. The average shows a little more variability, increasing from 75% in 2009 to 82% in On the other hand, payout thresholds as a percent of target declined significantly over the last few years, from a median of 50% in 2009, to 25% in 2010 and 2011, to 8% in 2012 (Appendix 5, Table 8). Also, as umbrella plans have gained ground and discretionary elements have become more prevalent, the concept of a threshold payout is disappearing. STIP maximum performance goals as a percent of target performance were slightly lower in The median had been 115% for the past three years, dropping slightly to 113% in The average performance maximum also declined from 130% in 2009 to 118% in Maximum payouts as a percentage of target payouts are similar to prior years with the median holding steady at 200%. (Appendix 5, Table 9) Long-Term Incentive Programs LONG-TERM INCENTIVE MIX (PREVALENCE AND V ALUE) One of the primary topics when designing a long-term incentive program is what types of vehicles should be used. To answer this question, proxy statements were reviewed to determine the most prevalent LTI mixes. Eighty-three percent (83%) of companies granting equity in 2012 and 2011 used more than one type of longterm incentive vehicle in their program, slightly higher than 80% in For purposes of this study, longterm incentive grants were categorized into one of five groups: Appreciation Awards (plain vanilla stock options and stock appreciation rights) AA Restricted stock and restricted stock units (time based) RS Performance-based awards PB (includes the following three categories below) Performance restricted stock and restricted stock units PRS Performance shares, performance share units, premium/performance stock options PS Long-term cash plans LTI CASH 20

21 Figure 11 shows the continued trend away from stock options in favor of performance-based long-term incentives. Indeed, there was a relatively significant shift in prevalence in Figure 11: Prevalence of Long-Term Incentives Grant Type Percent of Companies Making Grants* Appreciation Awards 68% 74% 75% 76% 82% Stock Options 64% 71% 71% 71% 76% SARs 4% 4% 4% 5% 6% Restricted Stock/Units 55% 60% 57% 55% 48% Any Type of Performance-Based Award 88% 82% 77% 75% 76% Performance Shares/ Units 72% 65% 60% 54% 55% Performance Restricted Stock/Units (performance hurdles) Performance/Premium Stock Options 13% 15% 11% 13% 11% 3% 2% 2% 3% 3% Long-Term Cash 16% 17% 18% 20% 20% * Company-by-company prevalence detail is provided in Appendix companies made equity and/or long-term cash grants during Figure 12 shows the continued trend away from stock options/sars in favor of performance-based longterm incentives. For the first time ever, performance-based incentives averaged 50% of LTI grant value. A high percentage of companies continue to decrease the weight of stock options in the LTI mix. A review of companies with stock options in 2012 shows that 11% increased option weights, 27% lowered the weight (on top of 31% that lowered the option/sar weight in 2011), and 63% had no change in weights. This includes companies who might have added or dropped stock options in Figure 12: Average Long-Term Incentive Mix Average Mix Grant Type Appreciation Awards 29% 32% 34% 37% 40% Restricted Stock/Units 21% 22% 23% 22% 19% Performance-Based Awards 50% 46% 43% 41% 41% The prevalence of performance-based plans, which had leveled off between 2008 and 2010, surged to new highs in 2011 and Eighty-eight percent (88%) of the Top 200 companies making LTI grants now include performance-based grants, up from 82% in 2011 and 77% in

22 Moreover, while the prevalence of stock options and SARs held steady at 74% for the last few years, for the first time we witnessed a significant drop in prevalence to 68% in So while the majority of companies still grant stock options to named executive officers, sixteen companies dropped stock options completely in 2012 while only two companies added stock option grants. Figure 13 shows the prevalence of various combinations of equity vehicles. The most common combinations are a mix of stock options and performance-based awards (31%) and a blend of stock options, time-vested stock, and performance-based awards (31%). The next highest combination is time-vested restricted stock and performance-based awards. Figure 13: LTI Mix Prevalence (all NEOs) LTI Mix Appreciation Award Only 3% 3% Appreciation Awards/Restricted Stock 5% 11% Appreciation Awards/Performance-Based (PB)* 31% 28% Appreciation Awards/Restricted Stock/Performance-Based (PB)* 31% 32% Restricted Stock Only 5% 5% Restricted Stock/Performance-Based (PB)* 14% 11% Performance-Based Only 11% 10% * Performance- based includes performance shares, performance stock units, performance restricted stock units, and long- term incentive cash. The declining presence of stock options can be seen as well in Figure 14 which shows the most prevalent LTI value mix combinations since The increase in performance-based awards is also evident. Figure 14: Most Prevalent LTI Value Mix-Trend (CEO) Percent of Companies* LTI Mix % PB 10.9% 10.8% 8.3% 6.9% 50% AA / 50% PB 8.8% 8.2% 9.3% 6.3% 40% AA / 60% PB 4.2% 3.1% 2.1% 1.6% 100% RS 3.6% 4.1% 4.7% 5.3% 100% AA 3.1% 4.6% 5.2% 7.4% 33% AA / 33% RS / 33% PB 2.6% 2.1% 1.5% 2.6% 50% AA / 50% RS 2.1% 2.1% 4.7% 4.2% *See Appendix 6 for details by company. The most common blends using three equity vehicles were: 33% AA, 33% RS, 33% PB (2.6% prevalence) 50% AA, 25% RS, 25% PB (2.6% prevalence) 25% AA, 25% RS, 50% PB (1.6% prevalence) 22

23 The decline in appreciation awards can be seen in the declining prevalence of stock options as well as the decline in the weight assigned to stock options. High-weight stock options (weight of 50% or more) have declined from 40% in 2008 to just 35% in 2010, 31% in 2011 and 28% in On the other hand, we continue to see increases in high-weight performance shares (weight of 50% or more), now up to 60% in 2012 from just 44% in Weights on time-based restricted stock have remained consistently low, with just 7% of companies with weights 50% or higher. (Appendix 7, Tables 1 3) LTI mix varies significantly by industry as shown in Figure 15 below. For example, Banks, Pharmaceuticals, and Utilities grant primarily performance-based stock, whereas Automobile & Components, Consumer Services and Semiconductors/Equipment rely more heavily on time-vested awards such as stock options/sars and restricted stock/units. Figure 15: LTI Mix LTI Mix 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Automobiles & Components Banks Capital Goods Commercial Services & Supplies Consumer Durables & Apparel Consumer Services Diversified Financials Energy Food & Staples Retailing Food Beverage & Tobacco Health Care Equipment & Services Household & Personal Products Insurance Materials Media Pharmaceuticals, Biotechnology & Life Retailing Semiconductors & Semiconductor Software & Services Technology Hardware & Equipment Telecommunication Services Transportation Utilities LTI Cash PS/PSUs PRSUs RS/RSUs Stock Options/ SARs 23

24 V ESTING Stock options, time-vested restricted stock/units, and performance-based awards generally have different vesting conditions as follows: Appreciation Awards: Annual vesting (85%) over three years (54%) or four years (36%) with a tenyear term (87%) or seven-year term (10%). Restricted stock/units: o Annual vesting (56%) over three years (58%) or four years (28%) o Cliff vesting (33%) over three years (80%) or four years (15%) Performance-based awards: o Cliff vesting over a three year performance period (68%) is most common o Twenty-three percent (23%) use a one-year performance period with vesting o Ten percent (10%) of performance plans have additional time vesting following the performance period, usually in cases where there is just a one-year performance period DETAILS ON PERFORMANCE-BASED PROGRAMS ( LTIPS ) PERFORMANCE LEVELS As mentioned previously, there are basically two types of performance-based awards: performance restricted stock/units (PRSs which we define as restricted stock/units with a performance hurdle and where maximum payout equals target) and performance shares/units or long-term cash plans (where the typical structure is threshold/target/maximum performance and payouts levels). In 2012, PRSs decreased in prevalence from 15% in 2011 to 13% in However, performance share/unit plans increased from 65% to 72% (see Figure 11), a reflection of the need to have a more traditional, and in some cases, a more challenging performance design. Performance share unit plans increased from 38% to 43% in 2011 and again to 52% in Performance share designs, on the other hand, decreased slightly from 23% to 22% as companies have shifted from sharebased grants to share unit grants which enable deferral of shares and, thus, taxation. Threshold levels for absolute performance goals have been on a roller coaster from 2009 through 2012, meaning that there has not been a clear trend from one year to the next during this time period. For instance, 7% of companies set the threshold at 7% in 2009, but in 2012, no companies used a threshold of zero. However, the usage of thresholds set between 1% and 69% of target has increased from 20% in 2009 to 33% in Part of this increase has been offset by a corresponding decrease in thresholds set at 90% of target or higher, which has moved downward from 34% in 2009 to 26% in 2011 and 27% in As with STIPS, it is important to note that targets can be expressed in terms of percent change or as levels. We noticed that threshold performance levels for goals based on a percent change were generally lower in relation to target than those goals based on a level which is comparable to what we observed with STIPs. As we saw with threshold levels, maximum performance levels for absolute measures, or caps, shifted downward from 2009 to Maximums at 120% of target or below comprised 46% of maximum s observed in 2009, before increasing to between 54% and 60% of all companies since then. In fact, for the past two years, the 101% to 109% category has been the leading category with 25% prevalence in 2012 and 28% in 2011 (Appendix 7, Table 5). With declines in both thresholds and maximums for 2010 and 2011, it suggested some companies lowered the floor and the caps to improve payout potentials in a weak economy. This began to reverse in 2012 with higher maximums in the 125% to 199% categories. 24

25 For relative measures, threshold performance continues to be concentrated at the 25 th percentile of performance (51% prevalence). Target performance is most often set at the 50 th percentile (80% prevalence in 2012, up from 67% in 2010). This continued increase has been offset with fewer companies setting target above the 50 th percentile (15% in 2012, down from 26% in 2010). Maximum performance resulting in maximum payout levels were most often set at either the 75 th percentile (39%) or the 100 th percentile (28%). Two companies reported 50th percentile hurdles for a vesting condition (no threshold or target), and another company set a 75 th percentile hurdle for an LTI kicker. (Appendix 7, Tables 5 10) PAYOUT LEVELS For LTIPs, there was a more even distribution between the payout ranges than we saw with STIPs. However, as is the case with STIPs, the range of 0% to 200% is the most prevalent of payout ranges followed by 50% to 200%. As we have seen with STIP payout thresholds, LTIP thresholds extending down to 0% of target is most prevalent (30% in 2012.) This is followed closely by the use of a 50% payout threshold (28% in 2012), which saw an increase after two years of declines. The maximum payout of 200% for LTIPs continues to be the most prevalent at 62%, far surpassing the next most prevalent maximum of 150% of target used by 20% of companies We excluded PRSs from this analysis because these types of plans simply use a hurdle value and either the target goal is achieved or not. (Appendix 7, Tables 11 13) PERFORMANCE-PAYOUT RELATIONSHIPS We reviewed the most typical performance-payout relationships in LTIPs, similar to the analysis described earlier for STIPs. For absolute measures, there is considerable variability in performance and payout relationships and very limited disclosure of this information. Consequently we are not reporting on this information for this report. The performance-payout curve for relative measures has more complete and consistent data. We found three performance-payout designs that stood out, with the only difference being the payout structure. The relative performance range for all three is 25 th percentile for threshold performance, 50 th percentile for target performance and 75 th percentile for maximum performance. Maximum payouts for all three were 200%; however, threshold payouts were 0%, 25% and 50%. A review of all thresholds, targets and maximums used by the top 200 indicates the market median is the 25 th percentile for threshold performance, 50 th percentile for target performance and the 81 st percentile for maximum performance. (Appendix 7, Table 16 as well as Tables 14-19) 25