Understanding executive pay: Back 2 basics - Part II

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1 Executive Briefing Canada Issue 9 December, 2014 Your executive compensation resource > Executive Pay Compensation peer groups Long-term incentives shares Understanding executive pay: Back 2 basics - Part II As a follow up to our article in November, Understanding executive pay: back to basics, part I, we again aim to simplify the technical and acronym-laden landscape of executive compensation. We focus here on other important terms and key concepts, followed by a discussion of their use in practice. Back to Basics 2 > Contact Anand Parsan anand.parsan@haygroup.com t Christopher Chen christopher.chen@haygroup.com t Hay Group Limited Executive Compensation National Practice 121 King Street West Suite 700 Toronto, ON M5H 3X7 Canada Compensation peer groups A peer group (or comparator group) consists of other (typically 12-20) organizations that are in certain ways (described below) similar to the subject organization. In general, peer groups are a useful tool to help both compensation committees and management understand compensation at the executive level. Peer groups provide perspective on the design of compensation programs, including target and actual compensation, at similar organizations. In addition, peer groups can be used to validate the level and form of executive compensation. An effective peer group can provide compensation committees and management with a better understanding of relative pay and performance of their company versus the market. Development of an appropriate peer group involves a balance of both art and science. Several key considerations typically are involved in designing an optimal peer group, with the following six factors commonly used as guidelines: Size. An organization s size, generally defined as annual revenue, usually has the highest correlation to target executive compensation opportunity. However, for banks or other financial institutions, total assets typically are a stronger measure than annual revenues. Market capitalization may also be a useful reference, or a strong measure of size, in small-cap, high growth industries. A general rule of thumb is to include organizations with size ranging from one-half to two times the target organization s size, with the median of the peer group approximating the target organization s size.

2 Sector. Industry sectors provide a strong reference to an organization s competitors for executive talent, capital and customers. The process of sector selection should begin at the highest Global Industry Classification Standard (GICS) code reference for the target organization and refine down to the organization level by industry and sub-industry. Business model. It is important to understand how the target organization is structured and how it generates revenues. These factors will influence the size and design of compensation plans. In addition, business complexity, risk and global footprint are issues that may influence executive job scope and pay levels. Talent market. The market for talent to or from which executives may be recruited provides another facet of comparison for executive compensation levels. In appropriate cases, this may involve the inclusion of much larger organizations than otherwise would be considered based on the size factor alone. Degree of internationalization. Peer organizations that mirror the organization s national and/or global presence should be included in a well-designed peer group. Customer base/market share. Organizations that are focused on a similar magnitude and demographic of customers can provide strong compensation comparisons. Peer groups should be reviewed on an annual basis to account for any changes in business structure or environment (including acquisitions or dispositions) or changes to the peers themselves (e.g., privatization or bankruptcy). Publicly traded organizations are required to disclose any peer group used in determining executive pay levels in the Compensation Discussion and Analysis (CD&A) section of the annual proxy statement. Included in the disclosure is the rationale for peer group selection. Proxy advisory services such as Institutional Shareholder Services and Glass-Lewis use their own methodology for developing peer groups to evaluate a company in their voting recommendation analyses. Advisory services comment on the size and composition of organizations peer groups when evaluating compensation programs and practices for Say on Pay vote recommendations (most commonly the size of organizations in the peer group, in terms of revenues). Peer group development can be a particularly challenging process for organizations with unique business segments and/or organizational structures, organizations that have predominantly non-public or foreign competitors, as well as organizations whose size is significantly larger or smaller than its industry competitors. Long-term performance shares In our prior Understanding executive pay: back to basics article, we provided a general overview of long-term incentives. Here we provide a more in-depth discussion regarding long-term performance shares, which have become increasingly prevalent in executive pay programs over the last five years. Many long-term plans are designed as a grant of full value shares (or units) that vest based on actual performance against predetermined performance objectives over an extended period of time (typically three years).

3 Benefits. The benefits of this type of plan include a strong emphasis on performance orientation, as executives must reach specified performance levels to receive payouts. In addition, a performance share plan allows an organization to choose performance measures that drive long-term business success, whether they be financial, operational, or share price-related. When it comes to share usage and accounting, performance shares can use fewer shares than stock options. Performance plans can also be structured as cash plans, which eliminate the use of any shares. Drawbacks. There are drawbacks to performance share plans. Accurate long-term performance forecasts can be problematic, particularly in a cyclical business, which may make targets ineffective. As a result, performance shares might have a lower perceived value to employees as payouts are completely dependent upon performance. Performance measurement. Many organizations choose to use one absolute and one relative performance measure that reflect three-year cumulative business performance. A typical relative performance measure is total shareholder return ( TSR ), which represents the investor perspective, is easy for plan participants to understand, and for public organizations, is a continuing key long-term measure of strategic importance. relevant to the business. Common alternatives for measuring absolute performance include: net operating profit, revenue growth, operating cash flow, earnings before income taxes, depreciation and amortization (EBITDA), return on invested capital (ROIC) or a measurable strategic milestone. Performance measurement example: absolute performance. If a performance share vehicle is utilized, a common best practice design for the absolute portion of the plan includes setting three levels of performance and three commensurate levels of payout: Threshold: minimally acceptable performance, results in a payout of 50 percent of target Target: target performance, results in a payout of 100 percent of target Maximum: truly outstanding performance, results in a payout of up to 200 percent of target If performance threshold and maximum levels are set equidistant from the target level, then this plan design becomes leveraged, or provides more dollars for every incremental improvement above-target than it does for below target. This type of leverage in a long-term program can provide a valuable executive retention tool as long as performance is above target. Absolute performance measures are generally focused on a financial metric that is both an indicator of strong business performance and

4 Performance measurement example: relative TSR. If a relative performance measure such as TSR is utilized, payouts are generally commensurate with an organization s performance ranking versus a peer group. The peer group against which a company measures relative TSR should reflect the company s core business, business cycles and structure, but may be significantly broader or completely different from the organization s compensation benchmark peer group. For example, a relative TSR peer group may be an established, industry specific index (e.g., S&P/TSX 60 index) or a broad index (e.g., S&P/TSX Composite). Other alternatives for a TSR peer group typically include: GICS code comparators by group GICS code comparators by industry Peer group used for competitive pay benchmarking Expanded peer group (competitive pay benchmarking group plus additional companies) Payout of the relative TSR portion of the performance share plan is dependent upon performance versus the peer group (with the payout as a percent of target gauged to the performance ranking against the peer group). The design could be structured as follows: Performance ranking vs. peer group 90 percent - top percent percent percent percent percent percent <30 percent Payout as a percent of target 2x 1.75x 1.5x 1.25x 1x 0.5x 0.25x 0x Company Aʻ Company Bʻ A new concept for compensation committees to consider is a relative plan governor. It is possible for a company to have poor, or even negative performance, yet still outperform the relative group, indicating a maximum payout. If performance is negative a consideration should be to cap payouts at target levels regardless of performance versus the peer group. This article was originally published in the Executive Edition, Hay Group s resource on executive compensation matters. We would like to thank Sydney Hilzenrath for her contributions to this article.

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