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SOCIETY OF ACTUARIES

SOCIETY OF ACTUARIES. Executive Compensation Plans: United States and Canadian Perspectives Compensation Theory and U.S. Practice October 4, 2001. Daniel J. Ryterband Managing Director Frederic W. Cook & Co., Inc. COMPENSATION THEORY -- “SIMPLIFIED”.

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SOCIETY OF ACTUARIES

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  1. SOCIETY OF ACTUARIES Executive Compensation Plans: United States and Canadian Perspectives Compensation Theory and U.S. Practice October 4, 2001 Daniel J. Ryterband Managing Director Frederic W. Cook & Co., Inc.

  2. COMPENSATION THEORY -- “SIMPLIFIED” • Characteristics of large, industrialized companies • Owners are generally absentee • Board of directors represents owners interests • Management is hired by the Board • Compensation is used as a tool to incent specific behavior

  3. COMPENSATION THEORY -- “SIMPLIFIED” (cont’d.) • Role of compensation -- unite human capital with financial capital to create value • Owners provide financial capital, but not necessarily management skills • Employees provide management skill, but not necessarily financial capital

  4. COMPENSATION THEORY -- “SIMPLIFIED” (cont’d.) • Compensation objectives • Attract • Retain • Motivate All compensation elements support these objectives, although to different degrees

  5. COMPENSATION THEORY -- “SIMPLIFIED” (cont’d.)

  6. COMPENSATION THEORY -- DEVELOPMENT OF A STRATEGY 1. What is an appropriate level of compensation? - Market pressures - Experience and skillset - Size and scope of job - Criticality of position 2. How should total compensation be allocated among various elements? - Riskiness; pay/performance relationship - Dependence on stock price 3. What performance measures are most appropriate? - Financial (e.g., EPS, TSR, cash flow, revenue growth) - Strategic (e.g., market penetration, customer service, safety) 4. How should performance be measured? - Absolute vs. relative - Internal vs. external Bottom Line: Ensure compensation program supports fundamental objective of maximizing shareholder value

  7. BASE COMPENSATION

  8. BASE COMPENSATION (cont’d.) • Observations 1. Executive salary growth rates have trailed levels implied by media 2. Government interaction has not prevented growth in salaries 3. Growth rates generally reflect change in perceived importance of position

  9. ANNUAL INCENTIVE DESIGN • All successful bonus plans share common characteristics: 1. Performance metrics are tied to critical success factors 2. Metrics are controllable by participants 3. There is careful calibration between targets and payout levels • Reasonably achievable goals • Perceived as fair by participants

  10. ANNUAL INCENTIVE DESIGN (cont’d.) • Two basic design approaches: 1. Target goal setting -- awards determined based on achievement of predetermined goals • May or may not be budget-based • May include both financial and non-financial goals 2. Formulaic approach -- pool of awards determined based on a prescribed formula relating to financial results

  11. ANNUAL INCENTIVE DESIGN (cont’d.)

  12. ANNUAL INCENTIVE DESIGN (cont’d.) Factors to consider in selecting basic approach 1. Need to focus on specific, defined goals 2. Cyclicality of the business environment 3. Difficulty of setting specific targets at corporate and business unit levels 4. Integrity of the budget-setting process 5. Degree to which cost should be headcount driven 6. Degree to which company wants to “manage” size of payout

  13. ANNUAL INCENTIVE DESIGN(cont’d.)

  14. ANNUAL INCENTIVE DESIGN (cont’d.) • Most common performance metrics 1. Earnings per share 2. Net income 3. Return on equity 4. Revenue • Typical salary of lowest paid participant - $70,000 to $80,000

  15. PRIMARY LONG-TERM INCENTIVEAPPROACHES • Stock options - provides the right to purchase a prescribed number of shares at a fixed price for a specified period of time • Value is contingent on share price appreciation • Restricted stock - a grant of full-value stock in which receipt is generally contingent on meeting a service requirement

  16. PRIMARY LONG-TERM INCENTIVE APPROACHES (cont’d.) • Performance shares - restricted stock in which the number of shares that vest is contingent on meeting both a service requirement and achievement of prescribed performance goals • Earn-out based on both stock price change during cycle and shares earned • The performance cycle is typically 3 years • Cycles can be end-to-end or overlapping • Performance metrics are typically financial • Can be absolute or relative

  17. PRIMARY LONG-TERM INCENTIVE APPROACHES (cont’d.) • Performance units - cash bonus award structured similarly to performance shares

  18. PRIMARY LONG-TERM INCENTIVE APPROACHES (cont’d.)

  19. STOCK OPTIONS - TWO BASIC TYPES • Nonqualified stock options - used by most large, mature companies • Provides company with favorable tax/accounting treatment • Incentive stock options - used more commonly by less mature companies • Common among start-ups, pre-IPO companies and those that have not yet reached profitability • Provides favorable accounting treatment to Company and favorable tax treatment to employee • Favorable tax treatment to employee comes at expense of tax benefit to company

  20. STOCK OPTIONS - INNOVATIONS • Performance-contingent vesting - vesting is contingent on meeting prescribed performance goals • Performance-accelerated vesting - award vests at a specified date (e.g., 7 years from grant) but accelerates if prescribed performance goals met earlier • Premium options - exercise price is set at a premium to fair market value at grant date • No gain until price appreciates by a specified level • Indexed stock options - variable exercise price, with adjustment (up or down) tied to an index

  21. STOCK OPTIONS - INNOVATIONS(cont’d.) • Reload stock options - upon exercise of the original option by paying the exercise price in the form of already owned shares, a new grant is made automatically • Number of reload shares exactly equal to number of shares tendered to pay exercise price on original grant • Exercise price of reload grant equal to FMV on date original award exercised • Term of reload equal to remaining term on original grant

  22. STOCK OPTIONS - INNOVATIONS(cont’d.) • Reload example: 1. Employee holds 100 options • Exercise price - $10 per share ($1,000) • Term - 10 years 2. Option is exercised at 4th anniversary of grant • Fair market value - $20 • Payment of exercise price - 50 shares (50 x $20 = $1,000) 3. Reload shares granted - 50 • Exercise price - $20 • Term - 6 years

  23. STOCK OPTIONS - INNOVATIONS(cont’d.) • Reload Implications (Primary Benefits) • No EPS dilution, assuming share price remains stable or appreciates after reload award triggered

  24. STOCK OPTIONS - INNOVATIONS(cont’d.)

  25. ACCOUNTING FOR EQUITY-BASED INCENTIVES • Two primary accounting standards 1. APB Opinion 25 - intrinsic value accounting 2. FAS 123 - fair value accounting • Companies permitted to choose between the standards • Virtually all companies have elected to use Opinion 25 • FAS 123 requires footnote disclosure in annual financial statements

  26. ACCOUNTING FOR EQUITY-BASED INCENTIVES (cont’d.) • Fundamentals of Opinion 25 • Expense equals the intrinsic value of an award on the measurement date • A measurement date occurs when each of two factors are known: 1. Number of shares the grantee is entitled to receive 2. The price the grantee must pay for the shares

  27. ACCOUNTING FOR EQUITY-BASED INCENTIVES (cont’d.) • Factors that postpone the measurement date result in “variable” accounting • For example, variability in exercise price of an option, variability in number of performance shares to be earned • Exception for vesting based purely on continued service

  28. ACCOUNTING FOR EQUITY-BASED INCENTIVES (cont’d.) • General measure of expense under Opinion 25

  29. ACCOUNTING FOR EQUITY-BASED INCENTIVES (cont’d.) • FAS 123 compensation expense • Fair value of award at measurement date • Fair value determined using an option pricing model (e.g., Black-Scholes) • Expense generally recognized over vesting period for employee awards

  30. TAX TREATMENT - A BASIC OVERVIEW

  31. TAX TREATMENT - A BASIC OVERVIEW (cont’d.) • Section 162(m) • Limits the allowable deduction for proxy named executives to $1 million per year per executive • Exception for “performance-based” compensation: • Granted pursuant to a plan in which material terms are shareholder-approved • Size of the award must fall within an individual limit specified in the plan • Plan must be administered by a committee composed solely of 2 or more outside directors

  32. PROXY STATEMENT DISCLOSURE RULES • The SEC requires publicly-traded U.S. companies to disclose compensation paid for the prior fiscal year • CEO and each of the 2nd through 5th highest paid executives • Named executive officers, or NEOs • There are 3 inter-related components: 1. Narrative description of policies, philosophy, and issues that influence compensation decisions

  33. PROXY STATEMENT DISCLOSURE RULES (cont’d.) 2. Overview of pay amounts in the “Summary Compensation Table” for NEOs 3. All other tables and descriptions • Summary Compensation Table: • Salary and bonus paid, including deferred amounts • Other annual compensation, including perquisites (in excess of $50,000 or 10% of base and bonus), dividends on LTIP awards (excluding R.S.), “above-market” deferred interest, tax reimbursement or gross-up payments, and discounts on purchases of company stock

  34. PROXY STATEMENT DISCLOSURE RULES (cont’d.) • Grant value of restricted stock • Number of option shares or stock appreciation rights • Value of LTIP awards earned • Value of “All Other Compensation,” including split-dollar life insurance and allocations under DC retirement plans

  35. PROXY STATEMENT DISCLOSURE RULES (cont’d.) • Other tables/descriptions include: • Option/SAR grant table - lists options or SARs granted, exercise price, expiration date, hypothetical “value” • Value estimated based on either Black-Scholes Model or projection over term at 5% and 10% appreciation rates • Option exercise table - lists shares covered by exercises, gain at exercise date, number of exercisable and unexercisable outstanding options, intrinsic value of exercisable and unexercisable outstanding options

  36. PROXY STATEMENT DISCLOSURE RULES (cont’d.) • LTIP table - lists shares granted, performance period, and estimated future payouts at threshold, target, and maximum earn-out • Other - stock performance graph, pension table, summary of employment agreements, description of director pay, beneficial ownership table, repricing table

  37. COMPENSATION TRENDS • The Drivers • Revolution in communication and medical technology • Emergence of the “New Economy” • Increased productivity • High growth with low inflation • Abundant capital • Favorable stock market conditions • Economic slowdown and Nasdaq “correction”

  38. COMPENSATION TRENDS (cont’d.) • The Results • Leaner organizations with higher performance-based pay • Shareholder-value strategic focus • Explosion in equity-pay component • Many different forms • Bigger values and more participants • Higher share usage and dilution • Increased shareholder scrutiny

  39. HOT TOPICS 1. Stock Option Dilution 2. Underwater Options 3. Use of Non-Shareholder Approved Equity Plans 4. Pay for Performance Linkage 5. Stock Ownership 6. Continuing Accounting Debate

  40. STOCK OPTION DILUTION • Ways to measure dilution 1. Run rate • Annual options granted as a percent of outstanding 2. Overhang (diluted basis) • Potential share dilution attributable to outstanding options A , where A equals outstanding options and B A + B equals outstanding shares -- Example: 100 outstanding shares and 10 options equals 9.1% {10/(10 + 100)}

  41. STOCK OPTION DILUTION (cont’d.) 3. EPS dilution • Difference between diluted and basic EPS • Diluted shares outstanding include equivalent shares attributable to options • “Net shares added” calculated under Treasury stock method • Assumes all outstanding options are exercised and proceeds are used by company to repurchase portion of shares issued • Proceeds equal to exercise price plus tax benefit

  42. STOCK OPTION DILUTION (cont’d.) • Financial impact of dilution on shareholders • Reflected in diluted EPS, which translates into lower share price • Stock price = diluted EPS x P/E ratio • Additional options create incremental EPS dilution • Investor concerns • Focus is primarily on overhang, rather than EPS dilution

  43. STOCK OPTION DILUTION (cont’d.) • Short-sighted for several reasons 1. Treats underwater options similar to in-the-money awards 2. Doesn’t address EPS implications 3. Doesn’t address “cost” of options already exercised • General rules of Thumb • Typical run rate - 2% for old economy, 4% for new economy companies • Tolerable overhang - 10% for “old economy”, 20% or more for “new economy” companies

  44. STOCK OPTION DILUTION (cont’d) • Growth in run rate and overhang has been substantial Median Levels* 1999 1989 Run Rate 2.07% 1.05% Overhang** 13.07% 6.90% * Source: Pearl Meyer & Partners “1999 Equity Stake” ** Includes awards outstanding plus shares reserved for future grant

  45. STOCK OPTION DILUTION(cont’d.) • Investor reaction • Average negative votes by shareholders on share reserve requests in 2000 was 20.7% • Up from 17.4 in 1997 • The greater the size of the request, the greater the negative vote Proposal as % Negative Shares OutstandingVotes Less than 5% 19% 5% - 9.9% 22% 10% or more 31% * Source: Investor Responsibility Research Center

  46. UNDERWATER OPTIONS • 1990’s bull market ended in March 2000 HighCurrentPercent Change (10/19/01) Nasdaq 5,049 1,528 -70% S&P 500 1,527 1,015 -34% DJIA 11,723 8,727 -26% • Underwater options complications • Reduces retention/performance incentive • Encourages overly risky behavior • Fosters build-up of excessive overhang

  47. UNDERWATER OPTIONS (cont’d.) • Traditional Solution - “reprice” • Cancel and reissue, or reset exercise price • New accounting rules result in variable expense for “repriced” options • Alternatives for dealing with underwater options 1. Do nothing - stay the course; long-term focus

  48. UNDERWATER OPTIONS(cont’d.) 2. Accelerate next year’s grant • Takes advantage of depressed price • May backfire if share price falls further 3. Extra, on-top grant • Takes advantage of depressed price • Increases overhang (can use short term to minimize) and EPS dilution 4. Selective restrictive share grants • Restores retention/incentive value • Creates P&L charge

  49. UNDERWATER OPTIONS (cont’d.) 5. Collared options • New grants made, which vest and expire 6 months and a day after price target reached • Increases overhang and EPS dilution • Protects against “double dip” after price recovers 6. Buy-out underwater options for restricted stock • Reduces overhang substantially • Restores retention/incentive value • Creates P&L charge • Must be timed to avoid “repricing” • 6 months and 1 day rule

  50. UNDERWATER OPTIONS (cont’d) 7. Cancel now, regrant later • Employees surrender options now in exchange for promise to grant new awards later • Reduces overhang if exchange ratio based on economic equivalency • Creates perverse incentive during waiting period • Must be timed to avoid “repricing” • 6 months and 1 day rule

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