Mercer-webbriefing-121108

December 11, 2008Weathering the Storm:Executive Compensation Decisionsin Unprecedented TimesSpeakersBruce Greenblatt Principal,Executive Remuneration bruce.greenblatt@Will FergusonWorldwide Partnerwill.ferguson@Today’s AgendaThe Environment Current Issues2009 and Beyond Crystal BallQuestionsThe EnvironmentThese are unprecedented times in the US . . .Depressed Stock MarketThe S&P 500 and the Dow Jones Industrial Average have tumbled by 35-40% since the beginning of 2008Uncertain Labor MarketsEmployers slashed 533,000 jobs in November –the most in 34 years Unemployment rate at highest level in five yearsCompanies in TurmoilCollapse of large financial institutionsGovernment has intervened to protect hardest hit industries, including financial sector and Big Three automakersForecasts for 2009 performance have been revised downwards…and globallyInflation major concern in Europe, China, India, and emerging markets India and China GDP growth expected to slow relative to rapid growth over recent years–GDP growth in Europe projected to stagnate in 2009Consumer spending is being hurt worldwide–Rising dollar–InflationWeakened, unstable equity marketsLayoffs are occurring everywhereThe current environment has dramatic implications for rewards and talent programsEconomic conditions are wreaking havoc on 2008 performance versus established goals for annual and long-term incentive programsThe uncertain economy is creating issues with 2009 incentive program goal-settingDepressed stock prices are forcing a choice between dramatic increases in annual share usage and reductions in long-term incentive opportunity levels for 2009Current equity value for executives has significantly declined, loosening retention hooks and diminishing alignment to future performanceCurrent IssuesCurrent IssuesAs a result of the economic downturn, companies will need to address several issuesAnnual Incentives2008 payoutsProgram design, including measures and goal settingLong-term Incentives2008 payoutsCalibration of 2009 equity and long-term incentive awardsProgram design, including vehicle mix, measures and goal settingUnderwater options and reduced equity valuesExecutive TalentIdentify key talent and evaluate talent needs based on new business imperativesDifferentiate talent in rewards programsAnnual IncentivesA majority of companies expect below target 2008 incentivepayouts and are not expecting to adjust awardsMost companies are not expecting annual incentive programs to pay out above target for 2008–23%will be below threshold for 2008–40% expect to be between threshold and targetCompanies are not expecting to adjust awards–49%do not plan to adjust calculated payouts for any participants–7%are considering discretionary awards for all participants–21%are considering discretionary awards to select participants Despite the challenging economy, approximately one-third ofcompanies are anticipating performance above target for 2008,indicating that the environment varies by sector, and even by company Source: Mercer’s Annual and Long-term Incentive Survey: Decision 2009Mercer recommends the following framework when consideringannual incentive payouts for 2008;Step 1: Compare performance against goals in plan supplemented witha multi-perspective approach to provide more performance context:–Absolute–Relative–Shareholder;Step 2:Validate whether those payout levels are appropriate;Step 3:Based on payout that may be warranted under Step 1, determine where to allocate funds–Company-wide–Business unit–Individual;Step 4: Determine alternatives for appropriate rewards for key contributors if neededIn this environment, we recommend caution when considering senior executive discretionary awards.Many companies are considering changes to their annual incentive programs to account for uncertainty in 2009Source: Mercer’s Annual and Long-term Incentive Survey: Decision 2009n = 194-196Anticipated changes Planning to Implement/ConsideringNot ConsideringHave Not Addressed YetChange in the range of performance 44%44%12%Change in performance measures 42%47%11%Allow for increased discretion related to payouts31%57%13%Use of more absolute performance measures29%57%14%Use of more relative performance measures28%60%12%Mercer recommends reviewing annual incentive programdesign to assess the need for changes in 2009Consider performance measures–Companies may go “back to basics”and return the focus toprofitability–Portfolio approach based on performance within the company (e.g., fund based on business unit)–For 2009, others may focus executives on navigating successfullythrough the downturnConsider the range of performance targets–Companies may revisit their payout curves and create wider ranges from threshold to maximumReview of more relative performance measures–Use of relative measures allow companies to mitigate for some ofthe economic uncertaintyLong-term IncentivesNearly half of participants are considering adjustments to theirlong-term incentive grant guidelines for 2009Approximately one-half of companies plan either to reduce their 2009 equity guidelines or are still in the process of developing a definitive plan–Of those companies expecting to decrease their guidelines, themajority (62%) expect to decrease the levels by 10% -30%Early approaches to recalibration of guidelines include:–Manage to target 2009 run-rate (38%)–Based on historical stock price (27%)–Arbitrary fixed percentage reduction (19%)49%plan to maintain the level of opportunity provided under theirequity guidelines for 2009Actions are very situational and are in response to each company’s particular circumstancesSource: Mercer’s Annual and Long-term Incentive Survey: Decision 2009About two-thirds of companies are considering at least one change to their LTI programs for 2009Source: Mercer’s Annual and Long-term Incentive Survey: Decision 2009Anticipated Changes Planning to Implement/ConsideringNot ConsideringHave Not Addressed YetUse special retention awards45%42%12%More emphasis on service-vested full-value shares for participants below senior executives33%55%11%More emphasis on service-vested full-value shares for senior executives30%56%14%Reduce LTI participation29%62%9%Discontinue/decrease emphasis on stock options 26%62%12%Use more cash for LTI26%59%15%Discontinue/decrease emphasis on performance shares/units 19%66%15%Shift value from LTI to annual incentive12%76%13%n = 145 -190Companies also are considering changes to their performance equity/cash LTI programs for 2009n = 106Anticipated ChangesPlanning to Implement/ConsideringNot ConsideringHave Not Addressed YetChange in the range of performance 36%46%18%Change in performance measures30%55%15%Use of more absolute performance measures 23%62%15%Use of more relative performance measures 21%64%16%Allow for increased discretion related to payouts 13%71%16%Move to shorter performance periods9%73%18%Source: Mercer’s Annual and Long-term Incentive Survey: Decision 2009•Economic run-rate •Total share usage and plan capacity •Shareholder and advisory guidelinesWe recommend that companies evaluate a range of factors to determine the best course of action related 2009 grant magnitude and vehicle mix –there is no “one-size fits all”approach•Retention value of outstanding awards •Differentiation of critical talent•Employee engagement•Impact of theeconomic environment on company and industry•Financial expense •Relative impact on peer share prices and their potential actionsEmployee PerspectiveCompany PerspectiveShareholder PerspectiveUnderwater Stock OptionsUnderwater stock options are a prevalent issue90%of companies have at least one tranche of underwater stock optionsOf those companies with underwater stock options, on average, 85% of the stock options granted to the named executive officers over the last 3 years are underwaterFor approximately 60%of companies, 100%of their stock options granted over the past three years are underwaterOn average, the stock option awards are 40% underwater –Approximately 15%of the companies have stock options that are on average 70%underwaterSource: Mercer’s 350 Core Research Companies. Data extracted from proxy disclosures and Standard and Poor’s Research Insight Database. Share prices as of October 31, 2008.Underwater Stock Options Approximately 45% of companies surveyed are taking a “wait and see” approach related to underwater stock optionsDo you plan to take any action related to underwater stock options, such as repricing, option exchange or special retention awards?Yes we plan to take action. 3% Uncertain 20% No, we do not plan to take action at this time but will consider later. 26%Long-term Incentivesn = 152No, we have decided not to take action and will not consider in the future. 51%Source: Mercer’s Annual and Long-term Incentive Survey: Decision 2009Mercer 20Underwater Stock Options While underwater options impact employee motivation and retention, taking action has risks so companies should carefully assess their situation From a company’s perspective, outstanding options may no longer provide meaningful incentive or retention value, while the company incurs significant expense However, there are a number of hurdles, including potentially difficult optics, shareholder approval and disclosure for a repricing/exchange We expect repricing and exchange activity will be very limited. Companies should consider the following when examining their situation: – Degree to which stock options are underwater – Duration of options being underwater – Remaining term of option and potential for recovery – Shareholder and employee optics – Employees impacted and potential alternatives (LTI program mix, selective retention strategies)MercerLong-term Incentives21Executive TalentExecutive Talent No incentive payouts, equity with little or no value…what can companies do to keep their top talent? Recognize that top talent has choices whatever the market conditions – and has expectations for career progression and differentiated rewardsTalentKnow your talent – evaluate talent needs and retention risks based on new business imperatives and focus on differentiation Communicate with and engage employees – Be clear and direct about the company’s situation and impact on rewards – Emphasize the total value proposition that the firm offers to employees – Convey key messages about performance differentiation and alignment with pay – Have a transparent process for performance evaluation and reward determinationMercer 232009 and Beyond2009 and Beyond Companies may want to consider conducting a comprehensive review of incentive programs in 2009 Account for the impact of the new business environment Ensure the plans are aligned with changes in strategy and future talent needs Look across all plans, not just individually but in the aggregate Ensure that there is balance among metrics, time horizons, and vehicles Evaluate the outcomes of the plans: is there alignment between pay and future performance? Are the plans encouraging appropriate levels of risk taking?The following pages illustrate five steps for reviewing incentive programs The following pages illustrate five steps for reviewing incentive programsMercer252009 and Beyond Step 1: Measures Consider balance of profitability, growth, efficiency and shareholder return measures – Drive value creation & support business strategy Consider balance of absolute and relative measures – Is your peer group still valid for relative comparison? Consider balance of time horizons: short, mid- and long-termAnnual Incentive Plan Growth Profitability Efficiency Shareholder experience Absolute Measure Relative Measure Time Horizon ShortFo r il lus tra tioOption PlanPerformance Share Plannp urp ose son lyMidLongMercer262009 and Beyond Step 2: Target Setting Assess difficulty in attaining goals Uncertain economic conditions will make goal setting difficult Consider a multi-perspective approach to goal setting that incorporates internal (e.g., budget) and external (e.g., analyst expectations) considerations Typical inputs into the goal-setting process such as historical company and peer performance may not be as relevant over the next several yearsMercer272009 and Beyond Step 3: Calibration of pay to performance Test probable & extreme performance outcomes Is the amount you will pay reasonable in light of the performance? How much is being shared? Compared to the return shareholders would receive? As a percentage of profits? Compared to peer norms? What is the probability of payout at different performance points?Sharing Ratio of STI Payouts and % of Net Income 100% 90% 80% Net Income (%) 70% 60% 50% 40% 30% 20% 10% 0% 0% 25% 50% 75% 100% 125% 150% 175% 200% STI Payout (% of Target)Forillus trati on p urpo s esonlyMercer282009 and Beyond Step 4: Vehicle Mix Is there an appropriate balance between cash and equity in your incentive plans? Is your equity program appropriately balanced among types of vehicles to best achieve your strategy? – Look at: performance focus, employee perception of value, shareholder concerns, retention impact, number of shares needed, accounting costImmediate objectives VehicleShare Options An option with an exercise price per share not less than the market price at grant, or a right to the increase in value of a shareFo r il lus tra tio• • • • • • •AdvantagesDisadvantagesProvides reward based on performance improvement after grant Direct link to shareholder value Vesting can be dependent on performance measures• • • •Performance Shares The right to receive shares subject to performance conditions being achievedGood alignment with shareholder value Balances internal and external goals Retains some reward value in falling market Sliding performance / vesting scale encourages continued efforts to improve performancenp urp ose s• • •A nil-cost one-way bet for participants Dilutive if new shares are issued May not act to incentivise or retain staff if share price is volatile or depressed Past Company experience may lead individuals to discount the value of optionsSetting long-term performance targets is challengingon lyRestricted Shares A conditional award of a share or unit with vesting based on time only Mandatory Bonus Deferral Portion of bonus deferred with vesting based on service and possibly performance, which may have a premium/matching award; may be delivered in restricted shares, RSUs or cash• • • • • • • •Simplest approach Assists retention Encourages share ownership Retains some reward value in falling market Increases retention effect through deferral of bonus Expands timeframe over which quality of performance results can be judged Strengthens alignment with shareholders Performance/vesting scale can encourage longer-term thinking in current performanceNo link to future performance Less alignment with shareholder value• • •May cause confusion between short-term and long-term incentive Relies on bonus deferral threshold being attained every year May be seen as a ‘take away’ from bonusAddresses objectives less wellAddresses objectives betterMercerOngoing objectives292009 and BeyondStep 5: Impact on excessive risk takingMeasures and payout ranges should not encourage excessive risk taking –steep payout curves should be moderated and uncapped plans should be evaluatedFactors to be considered:–Economic value created–Sustainability of results–Relative performance–Rolling timeframes rather than only annual–Balance of annual, intermediate and long-term–Appropriate evaluation by employee level and role–Alignment with internal controlsConsider design features that could help mitigate short-term risk taking over long-term decisions:–Balance structure with discretion in evaluating performance–Add sustained performance feature–Require holding of acquired shares for a specified timeCrystal BallCrystal BallFinancial institution constraints (for companies taking advantage of EESA relief programs) may influence future regulatory initiatives and governance–Golden parachute payments–Tax deductibility of top senior executive officer pay–Compensation clawbacks–Incentive programs that encourage excessive risk takingGreater differentiation of key talentRebalancing of fixed versus variable pay may occurLong-term incentive grant values will decline; use of cash may increaseIncrease in shareholder presence –pressing for transparency of how decisions support aligning pay with performanceTo Submit QuestionsTo submit a question while infull screen mode, use the Q&Abutton on the bottom right-handside of your screen.To submit a question while in halfscreen mode, use the Q&A panelon the bottom right-hand side ofyour screen. For further information, please visit our on-line library of Executive Remuneration Perspective articles at/perspectiveWill Ferguson will.ferguson@ Bruce Greenblattbruce.greenblatt@Principal,Executive Remunerationbruce.greenblatt@Worldwide Partner will.ferguson@。