INCENTIVE PLAN SERIES - Decusoft · • Majority of companies use one or two performance metrics in LTI plans (74%) –Differs from annual incentive plans where the use of three performance

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INCENTIVE PLAN SERIES

Long-Term Incentive Plans

Michael Sherry, Managing Director

Sandra Pace, Managing Director

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• Long-term incentives are awards earned and paid based upon achievement of goals over a period exceeding one year– Goals may be based on stock price or

business performance

– Typically equity-based, but a small number of firms use cash

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Purpose / ObjectivesPurpose / Objectives

Align executive / shareholder

interests

Align executive / shareholder

interests

Attract, retain and motivateAttract, retain and motivate

Focus participants on

critical performance

criteria

Focus participants on

critical performance

criteria

Provide competitive

pay opportunities

based on performance

Provide competitive

pay opportunities

based on performance

Create wealthCreate wealth

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Base Salary16%

Annual Incentives

22%

Long Term Incentives

62%

Average Pay Mix - Top 200 CEOs

Source: Based on a recent study by SH&P of the top 200 U.S. public companies.

Appreciation vehicles

• Stock options• Stock-settled

appreciation rights (SARs)

• Stock options• Stock-settled

appreciation rights (SARs)

Time-vested full value vehicles

• Restricted stock or restricted stock units (RSUs)

• Restricted stock or restricted stock units (RSUs)

Performance-vested vehicles

• Typically full-value awards – performance shares or performance share units (PSUs)

• Can also be performance-vested options or performance cash plans (LTIPs)

• Typically full-value awards – performance shares or performance share units (PSUs)

• Can also be performance-vested options or performance cash plans (LTIPs)

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• Performance-based awards are nearly universal amongst Top 200 Companies

• About one-half of companies use stock options and restricted stock

54% 48%

93%

Stock Options Service-BasedRestricted Stock

Performance-Based LTI

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20%

55%

22%

4%

1 Vehicle 2 Vehicles 3+ Vehicles 0 Vehicles

• Most companies use a portfolio approach to granting LTI, with the use of two or more vehicles being the most common approach

• Performance-based represents the largest award type in terms of LTI value mix

21% 17% 62%

Options Restricted Stock Performance Vested

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• The majority of companies utilize options and performance-based awards as part of their LTI program– Restricted stock and performance-based awards is the second most common approach to granting

LTI

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1%2%

18%

2%

30%

23% 22%

Options R/S LTIP Opts. & R/S Opts. & LTIP R/S & LTIP R/S, Opts. &LTIP

1 Vehicle 2 Vehicles 3+ Vehicles

The right to purchase shares of company stock at a specified price (exercise price) during a specified period of time (term)

Pros• Alignment w/ shareholders• Easy to communicate• Leverage• Fixed expense

Cons• Not viewed as performance-based by

some• Not tied explicitly to company financial

performance• Dilution; stock-settled SARs are less

dilutive than options• Expense recognized even if option

expires worthless

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10% 90%

Options Vesting Type

Cliff Step

1%

10%

34%

55%

0%

0%

6+

5

4

3

2

1

Years

Options Vesting Schedule

2% 1%

5%1%

92%

Options Term Schedule

5 Years

6 Years

7 Years

8 Years

10 Years

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Pros

• Strong retention value and popular with employees

• Alignment with shareholders• Less dilutive• Easy to communicate• Fixed expense

Cons

• Viewed negatively as “pay for pulse”• Not tied explicitly to company financial

performance• No leverage

The grant of shares (or the promise to grant shares in the case of RSUs) contingent on meeting the requisite service period

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0%

8%

22%

68%

1%

1%

6+

5

4

3

2

1

Years

Restricted Stock Vesting Schedule

Cliff27%

Step73%

Restricted Stock Vesting Type

Pros

• Strong focus on performance• Alignment with shareholders; popular

with advisory firms• Fixed expense may be subject to

reversal if performance goals are not met• May be less dilutive

Cons

• Challenges in setting performance criteria

• Poor goal setting may lead to perception that they are less valuable

• Reversal of expense is not possible for awards earned based on market conditions (stock price/TSR)

Shares (or the promise to receive shares in the case of PSUs) contingent upon achieving associated performance goals and meeting the requisite service period

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2%

4%

87%

3%

3%

5+

4

3

2

1

Performance Period

2%

5%

2% 2%

1  Year 2  Years 3  Years 4  Years

Additional Vesting

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Stock83%

Cash10%

Options1%

Cash + Stock6%

Stock + Options1%

Payout Type

39%

179%

50%

200%

Threshold Maximum

Threshold & Maximum Payout  %s Average Median

Performance Metrics

• Performance measures should be aligned with business strategy

• Reflect the key drivers of corporate and shareholder value

• Create clear line of sight for key employees that focuses their efforts and maps their accountability

Absolute metrics

• Dependent upon ability to predict future performance

• May not be viewed positively by shareholders

Relative metrics

• Can serve as “plugs” when absolute performance is difficult to predict

• Possibility of payouts for negative/poor performance that is merely “less poor” than that of some comparators

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• Majority of companies use one or two performance metrics in LTI plans (74%)– Differs from annual incentive plans where the use of three performance

metrics is most common

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36%

38%

16%

10%

1 Metric

2 Metrics

3 Metrics

4+ Metrics

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59%55%

46%

20%17% 16%

10%

Profit/Earnings TSR/Stock Price Returns Other Financial Revenues Cash Flow Other Non‐Financial

Metric Prevalence

50% 50% 50%

32% 33%

40%

23%

Profit/Earnings TSR/Stock Price Returns Other Financial Revenues Cash Flow Other Non‐Financial

Median Metric Weightings

Pros

• Relative performance useful when absolute performance is difficult to predict

• Viewed favorably by shareholders and shareholder advisory firms

Cons

• Not directly within management’s control• “Phoenix effect” can penalize steady

performers• Selecting the “right” comparator group is

critical• Expense recognized even if award is not

earned

Relative TSROne of the most prevalent performance metrics used among LTI programs

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• Majority of companies using TSR use it on a relative basis

• Small percentage of companies use Absolute TSR or both Absolute and Relative TSR

• 22 companies use Relative TSR as a modifier

Relative91%

Absolute7%

Both2%

TSR Usage

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• Relative TSR comparison

– 55% use a custom peer group¨ Median number of peers in

group – 14

– 40% use an Index¨ Of which 61% use the S&P 500

– 5% use both an Index and peer group

Index40%

Peer Group55%

Both5%

Relative TSR - Group Compared Against

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• ISS Guidelines

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ISS Pay for Performance Tests

Relative Degree of Alignment (RDA)

Compares the percentile ranks of a company’s CEO pay and TSR performance, relative to an ISS-developed peer group, over the prior three-year period

Multiple of Median (MOM) Expresses the prior year’s CEO pay as a multiple of the median CEO pay of its comparison group for the most recently available annual period

Pay-TSR Alignment (PTA) Compares the trends of the CEO’s annual pay and the change in TSR over the prior five-year period

2018 Update Financial Performance Assessment (FPA)

Used as a secondary screen; when the traditional 3 screens above result in a “low” concern, may change the result to “medium” concern if financial performance is weak. Conversely, a “medium” concern may change to “low” if financial performance is strong

Analysis compares relative ranking (versus ISS selected peers) of three-year CEO pay to three-year financial performance; metrics and weightings will be industry specific

• Glass Lewis Guidelines

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Glass Lewis Pay for Performance Tests

3-Year Weighted Average of Total Compensation for CEO and Top 5 Executives

Performance Metrics (3-Year Weighted Average)

Total Shareholder Return EPS Growth

Change in Operating Cash Flow

Return on Equity; Return on Assets

Rank Company vs Peers

Performance Compensation

Assign Grade Based on Relative Positions of Rankings

P>C by 60 to 100% =A C>P by 30 to 59% = D

P>C by 30 to 59% =B C>P by 60 to 100% =F

P>C or C>P by 0 to 29%=C

• Tax Cuts and Jobs Act of 2017– Early versions of this bill had drastic changes to the treatment of equity and deferred

compensation¨ These have been removed from both the House and Senate versions

– House and Senate versions both make major changes to Section 162(m)¨ Performance-based exception for compensation paid over $1M would be eliminated¨ CFO returned to group of covered employees

– Potential effects¨ Return of subjective metrics / discretion

− Potential pushback from shareholders / other groups

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• Pitfalls to avoid

Pay for performance misalignment

• Majority of equity awards not performance-based

• Increasing target LTI award in year of poor corporate or stock price performance

• Payouts of awards in years where TSR has declined

• Payment of dividends on unearned or unvested shares

Size/concentration of awards

• Large sign-on/retention awards or other one-off awards outside of the annual program

• CEO and other proxy officers receive out-sized portion of grants – measured as a percentage of NEO awards to all employee awards

Performance Metrics• Discretion usually viewed

negatively. • “Double-dipping” by using

same performance metric for both short term and long term

• Single, non-relative metric likely problematic

Design parameters• 1-year performance periods in

a “long term” incentive plan• Large/uncapped upside

potential• No ownership guidelines or

holding requirements• No clawback policy• Change in Control – Avoid

single trigger vesting of equity awards. Significant concern for shareholders and advisory firms.

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Key considerations in Long-Term Incentive Plan Design

• Align with strategy

• Balance is crucial

• Reevaluate on a regular basis

• Understand the ramifications of change

• Assess risk

• Communicate, communicate, communicate

• Don’t simply follow the herd

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Michael SherryManaging [email protected]

Sandra PaceManaging [email protected] www.shallpartners.com