Owe Me the Money! The State of Pension, LTIP and Severance Plans in Canada www.ggainc.com www.torys.com Agenda Part 1: Pension Plans....... 1 Defined Benefit vs. Defined Contribution.. 4 Immediate ing.... 5 Notice Entitlements... 6 Grow-in Rights on Termination..... 8 Developments IBM v. Waterman.. 10 New Disclosure Obligations.. 12 Target Benefit Pension Plans... 13 Part II: Long Term Incentive Plans ( LTIPs ).. 14 Types of LTIPs. 16 Selecting and Calculating LTIPs. 18 Treatment of LTIPs at the End of Employment.. 27 Clawbacks.... 29 2015 All Rights Reserved 1 PART I: Trends in Today s Pension Plans 2015 All Rights Reserved 2 1
Pension Plan Design Objectives Which Objective is Correct? Total compensation - part of a holistic total compensation program Attraction for mid-career executives forfeiting benefits from exiting company Retention features to ensure high pension-value is deferred after a certain tenure Competition prevalence among other companies Lock-up ensure adherence to non-disclosure and confidentiality agreement Taxation efficient tax deferral during active executive service Wealth accumulation effective way for executives to build up net worth Security maintaining executive living standard during retirement Diversification altering the risk profile of wealth/savings for executives Executive entitlement differentiation of benefits from regular employees Culture company philosophy towards executives 2015 All Rights Reserved 3 Defined Benefit vs. Defined Contribution Defined benefit employer bears funding risk Employer contributions vary based on plan performance, members receive set payments for life on retirement In the case of single employer plans, the employer is typically the sponsor and the administrator Administrator has fiduciary duties Defined contribution employee bears longevity and investment risk Employer contributions are set Member makes investment decisions On retirement, employee uses funds to buy an annuity or a life fund 2015 All Rights Reserved 4 Immediate ing Effective July 1, 2012, the Pension Benefits Act (Ontario) ( PBA ) was amended to provide for immediate vesting A plan member whose employment is terminated on or after July 1, 2012 is entitled to a deferred pension All pension plan members are entitled to pension benefits upon the termination of their employment Do employers have an obligations to continue making pension contributions during the notice period? 2015 All Rights Reserved 5 2
Notice Entitlements ESA Benefits must continue during the statutory notice period Therefore, employers must continue making pension contributions during the notice period If a plan requires employee contributions, employees must continue to make their contributions Even if the terms of the pension plan only apply to active employees and an employee is given pay in lieu of working notice, the employer must make contributions because the ESA deems that terminated employees are actively employed by their former employer during the statutory notice period (s. 62(1)) 2015 All Rights Reserved 6 Notice Entitlements Common Law Working notice Employer must continue pension plan contributions during working notice period Damages in lieu of notice Defined contribution plans: damages = the defined contribution the employer would have made during the reasonable notice period Defined benefit plans: damages = the difference between the value of the pension at the end of the reasonable notice period and the value of the pension at the beginning of the reasonable notice period 2015 All Rights Reserved 7 Grow-In Rights on Termination This only applies to defined benefit pension plans Certain pension plan members are entitled to retire without diminished pension benefits after a certain period of service Grow-in rights allow employees who are terminated before eligibility to enjoy enhanced retirement benefits Members who are terminated before completing the required level of service are entitled to enhanced retirement benefits if their age plus years of service equals or exceeds 55 2015 All Rights Reserved 8 3
Grow-In Rights on Termination All employees who are terminated after June 30, 2012 are entitled to grow in rights on termination Exceptions Employees who resign Employees who are terminated for cause Jointly sponsored and multi-employer plans can opt out of providing grow-in benefits 2015 All Rights Reserved 9 IBM Canada v Waterman Employee had 42 years service with the employer and was terminated without cause Court set reasonable notice period at 20 months Employer gave the employee 2 months working notice Employee was eligible for a full pension Employer took the position the employee s pension benefits should be deducted from the employee s 18 months notice pay Supreme Court of Canada ( SCC ) had to determine whether pension benefits were deductible against payments due during the reasonable notice period 2015 All Rights Reserved 10 IBM Canada v Waterman General rule: damages should only compensate a plaintiff for their actual loss Plaintiff should be put in the position he/she would have been in had the employer performed its contractual duty Private insurance exception: payments from private insurance are not typically deductible from damage awards Employee earned these benefits through his years of service Pension benefits are not intended to be an indemnity for lost wages SCC applied the private insurance exemption When terminating older, long service employees, employers must remember pension benefits are not deductible from reasonable notice pay 2015 All Rights Reserved 11 4
Enhanced Disclosure Requirements New disclosure requirements under s. 27(2) of the PBA Came into force on January 1, 2015 Administrators will be required to provide statements to former and retired members This includes terminated employees with a vested interest in the pension plan Contents of disclosure Similar to annual statements provided to active members Status of plan funding, employer payments, solvency assets, solvency liabilities, information with respect to asset holdings 2015 All Rights Reserved 12 Target Benefit Pension Plans What is a target benefit plan? Three main attributes: 1. Employer and employee contributions are fixed (or may vary within a narrow range) 2. Actuaries set a target benefit based on a number of assumptions 3. If plan performance differs from projections, both accrued benefits and future target benefits can be decreased First adopted in New Brunswick (Shared Risk Model) Ontario legislature has adopted a PBA amendment that allows for target benefit plans Amendment not yet in force 2015 All Rights Reserved 13 PART II: Long Term Incentive Plans 2015 All Rights Reserved 14 5
Purpose of Long-Term Incentive Plans Align executives with stakeholders. Equity based long-term incentives link pay to future equity value and therefore to shareholder return. Executives will be rewarded accordingly based on the business decisions they make today. Focus executives on multi-year objectives. Retention vehicle? 2015 All Rights Reserved 15 Types of LTIPs Stock Options Employee entitled to purchase shares at a set price once options vest Restricted Share Units ( RSUs ) Employee granted stock which vests according to a vesting plan based on passage of time Performance Share Unit Plan ( PSU ) Similar to an RSU, but vests on the achievement of performance criteria, not passage of time 2015 All Rights Reserved 16 Types of LTIPs cont d. Deferred Share Units ( DSU ) Employee granted a unit with a value equal to the current market price of an employer s stock; upon retirement, termination, or death, employee receives a payment equal to the price increase between date of grant and date of payment 2015 All Rights Reserved 17 6
LTIP Design Should Align with Business Strategy Stock Options Stock Options RSUs PSUs DSUs Capital Expenditure Revenue Lifecycle Image Source: http://www.cairnenergy.com/assets/images/charts/project_lifecycle_new.gif 2015 All Rights Reserved 18 How to calculate stock options ¼ ¼ ¼ ¼ Exercise HOLD Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5-10 No. of Stock Options Granted 100,000 Current Share Price $X Exercise Share Price Used in private and public companies $Y Final Payout at Exercise = No. Of Stock Options Granted X (Current Share Price - Exercise Share Price) Smaller cap companies typical Option Terms 5-10 years Mid to large cap companies typical Option Terms 7-10 years 2015 All Rights Reserved 19 Stock Options: Advantages & Disadvantages Advantages Leveraged pay potential Simple Can align with long-term success (i.e. 10yr term) Align with future shareholder gains Fixed accounting Employee tax advantage Disadvantages Excludes value of any dividends being paid May put disproportionate focus on increase in share price Creates dilution Seen as free ride by some Lack of downside risk Potential for windfall gains Continuous underwater options are de-motivating despite management doing a good job Accounting 2015 All Rights Reserved 20 7
How to calculate RSU/DSU payout 1 2 3 Sum Sum Sum Target No. of Restricted Share Units 50,000 Units Stock Price at ing Date $X Final Payout at ing = Target No. of Restricted Share Units X Stock Price at ing Date 2015 All Rights Reserved 21 RSU/DSU: Advantages & Disadvantages Advantages Full value of stock price Less dilutive than options Settle in cash net of withholding tax (typically) Accumulate dividends in additional units Easier to administer compared to real shares Disadvantages Perceived as a give away Potential for significant payouts for sub-par performance Less leverage compared to options Pre-revenue, financing arrangements required to settle in cash 2015 All Rights Reserved 22 How to calculate PSU payout Illustration assumes cliff vesting Yr. 1 Yr. 2 Yr. 3 Performance Period 1 2 3 Performance Period Yr. 4 Yr. 5 Yr. 6 Performance Period The Number of Units Changes based on Performance Period Results Target No. of Performance Share Units 50,000 Units Performance Performance Final Payout at ing Level Multiplier Maximum 150% = Target 100% Target No. of Performance Share Units Threshold 50% X Performance Multiplier X Stock Price at ing Date 2015 All Rights Reserved 23 8
PSU: Advantages & Disadvantages Advantages Link pay stronger to performance Full value of stock price Less dilutive than options Settle in cash net of withholding tax (typically) Accumulate dividends in additional units Easier to administer compared to real shares Less potential for payouts for subpar performance Disadvantages Potential for significant payouts for sub-par performance Pre-revenue, financing arrangements required to settle in cash Defining performance may be challenging 2015 All Rights Reserved 24 Phantom Equity in General Phantom Equity can be used to mimic Share Options, RSUs, DSUs or PSUs. The main differences between Phantom and Real Equity are: Employees do not become owners of the organization with Phantom Equity. Phantom Equity does not directly affect share dilution rates. Phantom Equity plans do not require shareholder approval. Phantom Equity can only be settled in cash, which impacts cash flow. Phantom Equity must vest and be settled within 3 years to remain aligned with Canadian tax rules as it is settled in cash. It can be tough to determine an appropriate company valuation under a Phantom Equity Plan at privately-held organizations and requires consideration of capital injections and dividend payments to shareholders to avoid windfall gains or losses to participants. 2015 All Rights Reserved 25 GGA s Approach to Reviewing LTIPs Step 1 Step 2 Step 3 Step 4 Interviews with stakeholders Desktop review Modeling & Stress Testing Discuss LTIP Alternatives 2015 All Rights Reserved 26 9
Treatment at End of Employment Termination for Cause All vested and unvested entitlements may be forfeited Termination Without Cause Employee might be able to exercise entitlements during the notice period or for a set time after termination Resignation Depends on employer Can be similar to termination for cause or termination without cause Death Estate can exercise vested entitlements within 30 days, unvested entitlements are forfeited Retirement ed entitlements can be exercised until expiry, unvested entitlements are forfeited 2015 All Rights Reserved 27 LTIPs and Termination without Cause Does an employee who was terminated without cause have any right to LTIP compensation which is vested but not yet exercisable? Starting Point: Yes. The employee is entitled to all forms of remuneration (including LTIPs) during the reasonable notice period The entitlement to LTIP during the notice period is merely presumptive Employee and employer can contract out of this Courts will only deny employee LTIP during the notice period if the intent is clear and unambiguous 2015 All Rights Reserved 28 New Developments: Clawbacks What is a clawback? Employee forfeits previously awarded compensation What can trigger a clawback? Misstatement of employer financial statements Misconduct by the employee In the US, clawbacks are mandated by legislation In Canada, clawbacks are voluntary But increasing in popularity 2015 All Rights Reserved 29 10
How to reach us Paul Gryglewicz Managing Partner Global Governance Advisors paul.gryglewicz@ggainc.com (647) 286-0626 @PaulGrygGGA Mitch Frazer Partner Torys LLP mfrazer@torys.com (416) 865-8220 2015 All Rights Reserved 30 11