Guidelines For Designing Executive Compensation
This white paper is intended to guide boards of directors,
compensation committees, and executive management teams
in designing executive compensation programs that avoid
red flags of capital providers. Lending institutions and
institutional investors that scrutinize executive compensation
follow some of the common practices of employers that
have designed successful executive compensation programs.
Background
Objectives. One of the preliminary steps
in designing executive compensation is to identify its
primary objectives. The three objectives that are most
important to providers of executives as well as most employers
are:
-
Attracting executives for hiring by the organization;
-
Retaining executives after they are hired; and
-
Motivating executives by providing incentives while
they are employed.
Those involved in designing executive compensation need
to be aware that most capital providers have secondary
objectives of:
-
Minimizing the after-tax cost to the employer organization
(i.e., is the compensation deductible); and
-
Minimizing any accounting charge to earnings.
Components. Another initial step in designing
executive compensation is determining its common components.
An executive compensation program's most common components
are:
Defining the Roles of the Board and Management
A preliminary step in designing a successful executive
compensation program is defining the roles of the board
or its compensation committee and management. Most providers
of capital believe that the role of a board or its compensation
committee is to determine:
-
The terms of employment, including compensation,
of the chief executive officer (CEO);
-
The overall direction and objectives of the compensation
system for management; and
-
A maximum limit on the aggregate compensation of
all executives, other than the CEO, as a group.
In most cases, providers of capital prefer that the CEO,
rather than the board, have the authority to hire, fire,
and compensate the rest of the executives, other than
the chairman of the board, subject to any direction and
limits set by the board. However, many providers of capital
favor the board’s assuming some oversight by setting the
maximum limit on the aggregate compensation of all executives
as a group. Often this determination is assumed as part
of approval of the organization’s operating budget for
the ensuing year, but most providers of capital prefer
that at least the aggregate compensation of executives
be considered separately from the rest of the budget.
Typically, when a board determines the terms of the CEO’s
employment, it indirectly sets the limits on the terms
of the rest of the executives’ employment. Most CEOs are
not inclined to give a term of employment to a subordinate
that they did not receive from the board themselves.
Today, most providers of capital favor an annual evaluation
of the CEO’s performance by either the board or its compensation
committee as part of the compensation process. To many,
the most important part of the compensation process is
the feedback and mentoring that the board or its compensation
committee can give to the CEO regarding his or her future
performance.
Finally, management’s role is to perform due diligence
for the board or its compensation committee by researching
executive compensation of industry peers, surveying its
executives as to what incentives they would like, and
reporting any comments from shareholders, investors, and
other providers of capital. Management can also suggest
compensation packages that it believes are appropriate
for consideration by the board or its committee.
Determining the Components and their
Objectives
Another preliminary step is determining the objective
of each of the executive compensation program's components.
Establishing these objectives allows a board of directors
to formulate the program's philosophy, which must be disclosed
in proxy materials of public reporting companies. Although
the components of different classes of executives will
likely vary, the objectives of those components are often
consistent from one class of executive to another. Typical
components and their objectives include:
-
Salary: To provide the base or minimum compensation
for attracting and retaining executives.
-
Annual bonus: To provide short-term incentive
based upon annual performance of the individual or
of a business unit or segment of which the individual
is a part within the organization.
-
Long-term incentives: To provide incentive
based upon the performance of the organization over
a period of time typically ranging up to three to
five years.
-
Retirement and severance benefits: To provide
post-employment compensation for retaining executives
until retirement or through a change in control.
-
Other benefits and perquisites: To relieve
executives of matters such as expenses for health
care that may divert their attention from focusing
on their responsibilities for the organization and
to provide executives with perks that will allow them
to compete with executives of comparable positions.
Below are the results of a recent survey where executives
ranked each component on a scale of one to five, with
one being of little importance and five being of great
importance.
Component |
Attraction |
Retention |
Incentive |
Salary |
4 |
3 |
1 |
Annual bonus |
3 |
4 |
5 |
Long-term incentives |
4 |
5 |
5 |
Retirement &
severance benefits |
2 |
3 |
1 |
Other benefits
& perks |
1 |
1 |
1 |
Survey by Counsel for Boards and Executives of CEOs and
NEOs of randomly selected new and traditional economy companies
in August 2000.
Based upon these
and other surveys, salary is a major factor in attraction,
except for new economy companies where it may only be
a secondary factor. Salary is less of a factor in retention
if there is incentive compensation, and does little for
incentive. An annual bonus is slightly less of
a factor than salary in attraction and is a major factor
for both retention and incentive. Long-term incentives
are becoming major factors in attraction, especially with
new economy organizations. Traditionally major factors
in retention, long-term incentives are becoming the major
factors for incentive. Retirement and severance benefits
are, at best, only secondary factors in retention. Other
benefits and perks do not hold much influence, except
in the non-profit world where they remain secondary factors
for retention.
Integrating
the Components among Various Classes of Executives
Typically, compensation
components are integrated in a consistent pattern among
the various classes of executives. The three most common
classes of executives for this purpose are:
-
CEOs;
-
NEOs,
or the five highest-paid executive officers as a group.
This is typically information that publicly traded
companies are required to report in proxy and public
offering materials; and
-
Top hat
group, which is a select group of management and
highest-paid employees for which the organizations
provide compensation and benefits not subject to the
participation, vesting and funding provisions of ERISA.
Compensation components
usually vary in amount and proportion among the different
classes with some consistent pattern. For example, the
table below details the components, expressed as a percentage
of total compensation, of each of these three classes
for our client, a traditional economy organization in
which there is significant institutional investment.
Component |
CEO |
NEOs |
Top
Hat Group |
Salary |
28% |
35% |
45% |
Annual
bonus |
28% |
25% |
20% |
Long-term
incentives |
30% |
25% |
15% |
Retirement
& severance benefits |
12% |
12% |
12% |
Other
benefits & perks |
2% |
3% |
5% |
Total |
100% |
100% |
100% |
Comparing
Industry Peers
In designing executive
compensation, the components and total compensation of
each class of executive should be compared with those
of industry peers. Generally, these comparisons are made
by measuring the total compensation of executives as a
percentage of the organization’s revenues and total
compensation of all employees, which are easily available
from annual reports as well as from sources such as the
Almanac of Business and Industrial Financial Ratios,
by Leo Troy and RMA Annual Statement Studies, by
Robert Morris Associates.
Both of these
percentages vary greatly by industry. The table below
sets forth the percentage of executive compensation that
consists of an organization’s revenues and its total compensation
of all employees for organizations in various industry
peer groups.
Industry
Peer Group |
As
% of revenues |
As
a % of total compensation of all employees |
General
constructions |
2.4% |
40% |
Rubber |
1.1% |
10.4% |
Motor
vehicle manufacturing |
0.4% |
4.2% |
Telecommunications |
0.3% |
2.4% |
Electric
utilities |
0.3% |
4.8% |
Retail
apparel |
1.5% |
9.9% |
Retail
food |
2.8% |
12.7% |
Banks |
2.5% |
23.4% |
Life
insurance |
0.2% |
5.7% |
Hospitals |
0.4% |
0.8% |
Nursing
facilities |
1.2% |
2.7% |
Announcing
Bonus Criteria and Standards in Advance
Because of the
importance executives’ attach to annual bonus programs
for both retention and incentive, boards or their compensation
committees should announce in advance the criteria and
standards that will be used to determine bonuses for the
ensuing year. A recent survey ( Survey by Counsel for
Boards and Executives of proxy statements and annual reports
of randomly selected new economy companies and traditional
economy companies publicly available during the 12-month
period ending June 30, 2000) showed that about 80 percent
of new economy companies and 75 percent of traditional
economy companies announce their annual bonus criteria
and standards in advance. As a percentage of total compensation,
the annual bonuses of these programs range from 30 percent
for a non-profit CEO to 50 percent for a traditional economy
CEO to 70 percent for a new economy CEO.
Unless there is
behavior that the organization needs to encourage or discourage,
the more successful programs base the annual bonus on
the performance of a business segment or unit. The segment
or unit must be something that is affected by the executives’
efforts, and it must be empirically measurable. Examples
of these segments include:
-
For CEOs,
the segment is usually the entire enterprise, and
the most common measure is growth in earnings per
shares or in return on equity;
-
For the rest
of the NEOs, the segment is often the entire enterprise
or, for operating officers of a division or subsidiary,
it is the division or subsidiary. The most common
measure is growth in earnings before taxes or, to
the extent that these executives do not control depreciable
or amortizable assets, earnings before taxes, depreciation
and amortization; and
-
For the rest
of the top hat group, it is frequently the financial
factors of the business segment or unit they affect,
such as sales growth, especially for new economy companies
stressing growth, or growth in operating income or
profit for more established companies.
Surveys of customer
or employee satisfaction can also serve as measures of
performance. Non-financial measures could include the
completion of a project, such as closing a stock offering,
listing on NASDAQ, reorganization of segments or units,
or identifying a successor CEO.
The more successful
annual bonus programs have standards for three levels
of payout, more or less on a bell curve, based upon the
expected likelihood that the financial measure can be
achieved:
-
Minimum
or Threshold Payout Level. At this level of payment,
there is at least a 75 percent, but less than 50 percent,
likelihood of achieving this measure (nothing is paid
for performance falling below the 75 percent level).
-
Target
Payout Level. At this level of payment, there
is a 50 percent, but less than 75 percent, likelihood
of achieving this measure.
-
Maximum
Payout Level. At this level of payment, there
is a 25 percent or less likelihood of achieving this
measure.
For example, a
CEO may receive a multiple of 0.5 times his or her target
bonus if the organization has at least a 10 percent, but
less than 15 percent increase, in earnings per share.
A CEO may collect a multiple of 1.0 times his or her target
bonus if the organization has at least a 15 percent, but
less than 20 percent, increase in earnings per share.
Finally, a CEO may receive a multiple of 1.5 time his
or her target bonus if the organization has a 20 percent
or more increase in earnings per share for the performance
period.
Considering
Options and Other Forms of Equity for Long-Term Incentives
A recent survey
(Survey by Counsel for Boards and Executives of proxy
statements and annual reports of randomly selected new
economy companies and traditional economy companies publicly
available during the 12-month period ending June 30, 2000)
revealed that the forms of long-term incentive most frequently
used by for-profit companies are:
-
Non-qualified
stock options, used by over 75 percent of the
surveyed companies;
-
Restricted
stock options, employed by about 35 percent of
the surveyed companies;
-
Incentive
stock options, used by about 30 percent of the
surveyed companies;
-
Phantom
stock options, used by about 15 percent of the
surveyed companies;
-
Stock appreciation
rights, employed by about 5 percent of the surveyed
companies; and
-
Cash plans
(other than phantom stock and stock appreciation rights),
used by about 20 percent of the surveyed companies.
Stock options
are a popular form of long-term incentive because they:
-
Do not involve
a cash expenditure or an accounting charge to earnings
for the employer and, with respect to a non-qualified
stock options, entitle the employer to a tax deduction
upon the exercise of the option; and
-
Allow each
executive to determine when he or she is taxed by
exercising the option, if non-qualified, or selling
the underlying stock, if incentive; and allow the
executive to share in capital equity growth, which
has been growing at a faster rate than other forms
of wages and salaries since the 1990s.
Staying
within Some Dilution, Burn and Overhang Limits
Share Dilution.
Although options are a cash-free form of compensation
to the employer, excessive use of options can create so
much potential dilution in voting rights or earnings per
share that they diminish the market value of the employer’s
stock. Although options represented 8 to 10 percent of
an organization’s outstanding shares on a fully diluted
bases prior to the 1990s, a recent survey shows that options
today represent, on a fully diluted basis, about:
Increase
in Share Dilution. Based upon a recent survey,
options are increasing as a percentage of companies’ total
outstanding shares at a rate of 2.0 percent annually.
This is often referred to as the “burn rate.”
Price Discount.
Most capital providers disapprove of price discounts greater
than 25 percent. That is, they believe the exercise price
of options should be at least 75 percent of the market
price. However, the price discount taken by itself is
rather meaningless. A better measure is an overhang factor
or value transfer.
Value Transfer.
Teachers Insurance and Annuity Association - College Retirement
Equities Fund (TIAA-CREF) (March 2000 Policy Statement
on Corporate Governance). suggests an overhang limit on
value transfer of 2.25 percent for most organizations.
TIAA-CREF calculates the value transfer by multiplying
the average share dilution (expressed as a percentage
of outstanding shares on a fully diluted basis) by the
average price discount of all stock options, restricted
stock, and other equity-based compensation programs of
the organization. The 2.25 percent limit is determined
by multiplying a 15 percent share dilution, which is the
maximum share dilution tolerated by TIAA-CREF without
a red flag, by a 15 percent price discount, which is the
maximum price discount tolerated by TIAA-CREF without
a red flag. The limit on value transfer for small capitalization
companies is 3.00 percent, which is a 20 percent share
dilution maximum tolerated for high technology companies
multiplied by the 15 percent price discount maximum. The
limit on value transfer for high technology companies
is 3.75 percent, which is a 25 percent share dilution
maximum tolerated for high technology companies multiplied
by the 15 percent price discount maximum.
Considering
Floating Price and Use-Them-or-Lose-Them Options
Capital providers
argue against traditional fixed-price options for two
reasons:
-
They are “riskless”
to the executive because there is no incentive to
exercise until the option is about to expire; and
-
In times of
rising market prices, they contribute to dilution
in per share earning and eventually market value.
As a result, it
is becoming more common for non-qualified options to have
an exercise price that “floats” with the market price
of the underlying security. Typically, these are discount
options having an exercise price that is a percentage
of the market price of the underlying security at the
time. The typical discount is 15 to 25 percent, so that
the exercise price is 75 to 85 percent of the market price.
Capital providers
argue against traditional fixed-term options because there
is little incentive to exercise the option until they
are about to expire. Some organizations have tried “reload”
options to encourage their exercise. A reload option automatically
renews itself if it is exercised during a certain window,
typically tied to a vesting schedule where the option
would renew itself for the number of shares purchased
within, for example, a three-month period of the option’s
vesting with respect to those shares. However, providers
of capital are objecting to these “reload” options because
they believe they contribute to greater dilution than
traditional options. As a result, it is becoming more
common for both non-qualified and incentive stock options
to include a tiered “use-them-or-lose-them” feature. In
lieu of a vesting schedule on the exercise of the option,
the option provides that if less than a percentage of
the total shares subject to the option are purchased during
any period, the shares that are not purchased are forfeited.
For example:
-
If less than
20 percent of the total number of shares subject to
the option are purchased prior to the second anniversary
of the date of grant, the optionee forfeits a number
of shares up to 20 percent of the total;
-
If less than
40 percent of the total number of shares subject to
the option are purchased prior to the fourth anniversary
of the date of grant, the optionee forfeits a number
of shares up to 40 percent of the total;
-
If less than
60 percent of the total number of shares subject to
the option are purchased prior to the sixth anniversary
of the date of grant, the optionee forfeits a number
of shares up to 60 percent of the total; and
-
If less than
80 percent of the total number of shares subject to
the option are purchased prior to the eighth anniversary
of the date of grant, the optionee forfeits a number
of shares up to 80 percent of the total.
All remaining
shares that have not been purchased will be forfeited
upon the 10th anniversary of the date of grant.
Conclusion
The two areas
of governance for which independent shareholders and other
providers of capital demand the most oversight are accuracy
of the organization’s financial statements and compensation
of the organization’s executives. One is accomplished
by requiring internal accounting controls and an audit
of the resulting financial statements. The other is accomplished
by some oversight of the compensation process. By following
these guidelines, your organization can avoid the red
flags that shareholders and other providers of capital
may raise regarding executive compensation.
Source/Author: Bricker
& Eckler LLP, John P. Beavers