2.2 comprehensive guiding principles – powerful tools for ... · comprehensive guiding principles...
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Comprehensive Guiding Principles –Powerful Tools for Executive Pay
Decision MakingSven Slavenburg, Director, Towers Watson
Katharine Turner, Managing Director Executive Compensation EMEA, Towers Watson
Overview• This session sets the stage for a discussion of the current state of executive
compensation:– In short, while there have been recent enhancements to the state of executive compensation,
there is significant room for improvement
• To foster more effective approaches to pay design and decisions, Towers Watson developed its ‘EC Principles’ (or, more formally, Towers Watson’s Principles and Elements of Effective Executive Compensation Design*)
• In this session we will elaborate on the principles and related effectiveness of Executive Compensation policy and programmes
• In general, many themes and topic areas do align with the perspectives of (especially) investors and proxy advisors, but not all (principle-based vs. (narrow) rule-based, no room for exceptions)
• We look forward to discussing with you during this session* Principles were developed with publicly-listed companies in mature economies in mind
What we are going to cover
• The current state of play on executive pay • What is working and what is not• Adopting a principles-based approach• Key areas to focus on• Examples of how the principles• Applying the principles
The current state of play
• Principles addressing some of these issues exist in the market, but have limitations:
– Too narrow – reflect a partial ideology or perspective
– Too theoretical – hard to apply the specifics
– Too prescriptive – don’t account for different business priorities and circumstances
Overall Economy Say-on-Pay Pay Irritants
but
Slow to moderate growth
Strong markets for toptalent and executive
but
Generally high vote outcomes
Shareholders not satisfiedwith current state
but
On the decline
Widespread concerns over inequality and pay excess remain
Forces for Conformity areDriving Decisions
Proxy advisors, market norms and so-called ‘best practices’ have disproportionate influence on design
Forces for Tailored ApproachesShould be Driving Decisions
As company strategies, cultures, and talent differs, so should approaches to executive pay
but
The evolution of executive compensation
What’s working and what’s not
Pay PhilosophyMost executive pay is delivered via incentive programmes Pay components are often viewed independently and are not considered from a total rewards perspective (e.g. retirement, contract provisions)
Programme Design
Pay is reviewed annually Over-reliance on simplified benchmarking and ‘market-norms’ which may contribute to a ‘ratcheting up’ of pay
Performance-based Pay
Pay is generally sensitive to performance Incentive targets and ranges lack rigour and a holistic view of performance
Governance
Compensation committees devote significant attention to pay issues, especially for the CEO Compensation committees are reluctant to use discretion as a strategic tool
Shareholder Communication
High say-on-pay support for pay programmes and decisions Stakeholders, including investors, are still not convinced
Risk mitigationGreater adoption of clawbacks and bonus deferrals Share ownership guidelines are not robust, nor aligned with the prominence of equity incentive programmes
Generally working
Generally not working
Many gaps have persisted
over time
Boards and HR teams need a helpful ‘principles-based’ framework to support sound pay policies
A powerful, but flexible, framework for assessing – and improving the effectiveness of –executive pay programmes
Assessments are not focused on a specific or binding ‘score’ or a ‘number’. Assessments help foster a structured and comprehensive discussion about client compensation
programmes and potential enhancements
Holistic framework for the design, governance, management of programmesRoadmap to guide the discussion and assessment of programme effectiveness
Applicable to all executives (recognising that programmes can vary across groups) Reflects market experience and research
There are six key categories
Six Topic Areas Governing objectives and EC
philosophy Pay level reference group selection
and benchmarking Performance-based pay:
Mix, measures and funding Targets, ranges and discretion Pay-for-performance assessment
and incentive programme review Governance Other terms and conditions Special circumstances
Four Overarching Principles
Purpose: Supporting the mission, vision and values of the organisation
Alignment: Reflects the orientation of programmes around shareholder value creation
Accountability: Links pay to key areas of board, management and individual responsibility
Engagement: Represents the motivational/behavioural aspects of rewards
75 Principles & Elements of
Effective Executive Compensation
Design
Critical development inputs included: In-depth research, EC consultant working groups and workshops, input from hundreds of Board members, ‘pilot’ client discussions and presentations
Examples of Principles and Elements
Challenge Element & Principle to support
Compensation strategies often piecemeal
EC levels should be analysed and considered holistically, including all elements of direct and indirect compensationII. 7 Direct and indirect compensation [Accountability, Engagement]
Benchmarking may be misapplied or over-simplified
There must be a thoughtful and objective but non-formulaic process for determining the organisation’s market reference groupII. 4 Thoughtful peer selection [Accountability, Engagement]
Organisations should consider a defined range, as opposed to a single data point, when assessing direct compensation competitivenessII. 6 ‘Market’ is a range [Accountability, Engagement]
While individual adjustments to align with market levels are entirely appropriate, organisations should avoid effectively automatic adjustments solely to align with a single market data pointII. 8 Avoid automatic adjustments [Accountability, Engagement]
Incentive plan goal-setting lacks rigour and is formulaic
A rigorous process must be applied in setting performance targets and ranges that should consider: (i) the organisation’s long-term strategic plan; (ii) enduring standards reflecting historical norms of financial performance for the organisation, industry and relevant peer organisations; (iii) analyst/economic forecasts; and (iv) the organisation’s budgeIII. 11 Rigorous target setting [Purpose]
Discretion is a critical tool for ensuring a holistic assessment of sustainable performance and quality of outcomes, and should be applied to incentive funding and allocation decisions based on a predefined framework. Compensation committees should consider how best to disclose and explain their use of discretionIII. 14 Apply informed discretion: [Accountability]
Examples of Principles and Elements
Challenge Element & Principle to support
Incentive plan goal-setting lacks rigour and is formulaic
Discretion is a critical tool for ensuring a holistic assessment of sustainable performance and quality of outcomes, and should be applied to incentive funding and allocation decisions based on a predefined framework. Compensation committees should consider how best to disclose and explain their use of discretionIII. 14 Apply informed discretion: [Accountability]
Pay-for-performance assessment narrowly focused
For purposes of assessing pay-for-performance alignment and EC programme design changes, pay-for-performance analyses must: (i) include NEOs; (ii) be conducted over a multi-year basis; (iii) include both the direct market reference group for compensation benchmarking and a broader market perspective; (iv) consider both percentile ranking and sharing-rate analyses vs. peers; (v) consider TSR as well as the financial performance measures used in the organisation’s incentive plans; and (vi) use either earned or realisable pay frameworksIII. 17 Broad scope [Alignment]
Examples of Principles and Elements
Challenge Element & Principle to support
Despite stock ownership guidelines, many executives lack a true owner mentality
If organisations provide equity compensation, they must adopt share ownership guidelines and should scale them to reflect the value of the equity compensation levelsV. 2 Guidelines a must [Alignment]
For senior executives, a majority of total rewards should be in the form of incentive compensation, a majority of incentive compensation should be in the form of long-term incentives and a majority of long-term incentives should be focused on shareholder alignment and/or line of sight (i.e. retention-focused incentives should be the smallest LTI component)III. 1 Favour ‘line-of-sight’ and ‘alignment’ rewards [Engagement]
Insufficient tailoring of programmes
Each organisation’s business and people strategies should align with long-term value creation and should drive the design and management of the organisation’s compensation programmesI. 3 Long-term [Purpose, Alignment]
EC programmes should also be aligned with the organisation’s culture and individual employee characteristics and, when possible, consider stakeholder preferencesI. 4 organisationally-aligned [Purpose, Alignment]
Compensation strategies are often piecemeal and static
Organisations often lack a robust strategic framework for pay decision-making
The various components of executive compensation programmes are often set independently and in a vacuum, without enough consideration as to how they interact with each other or with pay for the rest of the organisation
Significant challenges/gaps in market practice
Compensation strategies must be constantly evolving to reflect changing business strategies and needs
Governing Objective and Executive Compensation Philosophy (examples)1
I. 2 Holistic: Organisations must undertake a holistic consideration of pay and performance [Purpose]
I. 5 Market-informed: Executive compensation should be informed by, but not driven by, market practices [Engagement]
I. 6 Transparent: Organisations should articulate and periodically review their rewards strategy [Purpose]
Relevant design elements
Benchmarking may be misapplied or oversimplified
Temptation to ‘cherry pick’ peer organisations or data points in setting market reference points
Organisations are forced to revert to the median
Automatic adjustment to the market
Primary focus on pay opportunity, and not on pay outcomes
Significant challenges/gaps in market practice
Deviating from market can trigger shareholder concerns but may be appropriate if a proper rationale is in place
II. 2 Multiple reference groups: Compensation levels should be benchmarked against multiple market perspectives including direct competitors, industry competitors and general industry [Accountability, Engagement]
II. 4 Thoughtful peer selection: There must a thoughtful and objective process for determining the organisation’s reference group, while avoiding a purely formulaic process [Accountability, Engagement]
II. 6 Market is a range: ‘Market’ is a range of practices, not a single data point [Accountability, Engagement]
II. 8 Avoid automatic adjustments: While individual adjustments to align with market levels are entirely appropriate, organisations should avoid effectively automatic adjustments solely to align with a single market data point [Accountability, Engagement]
Relevant design elements
Pay Level Reference Group Selection and Benchmarking (examples)2
Incentive plan goal setting remains problematic
Committees should feel comfortable challenging budget-driven internal goals and should be sufficiently informed to do so
Many organisations fail to take a sufficiently holistic approach to assessing performance
The goal-setting process is still based primarily on budget
Overall pay mix overly focused on retention, rather than on ‘line of sight’ and alignment
Overreliance on TSR as a performance measure
No holistic view of performance that reflects leading and lagging indicators
Significant challenges/gaps in market practice
III. 6 Measure holistically: Organisations should include multiple measures across all incentive plans to promote a holistic view of organisation performance [Alignment]
III. 11 Rigorous target setting: A rigorous process must be applied in setting performance targets and ranges, which should consider long-term strategies, historical performance and industry norms, analyst/economic forecasts and the organisation’s budget [Purpose]
Relevant design elements
Performance-Based Pay (examples)3
Targets are often arbitrary and subject to negotiation
Payout curves for different incentive metrics should be examined to avoid unintended consequences
Threshold and maximum payouts are too closely linked to budget and not typically set based on likelihood of attainment
Often an arbitrary process
Rigorous thinking around the payout curve is often lacking
Payout curves rarely tested
Sharing rate between threshold and target, or target and max often missed
Significant challenges/gaps in market practice
III. 12 Tailored incentive curves: The incentive payout curve should reflect:
Volatility/sensitivity of underlying measures (more volatility warrants wider performance ranges)
Probability of achievement
Affordability of outcomes
How corresponding payouts compare to market [Accountability]
III. 14 Apply informed discretion: Discretion is a necessary tool and should be applied based on a predefined framework [Accountability]
Relevant design elements
Performance-Based Pay (examples)3
Pay-for-performance measurements narrowly focused
Reviewing pay-for-performance analyses should involve a robust discussion, rather than a pass/fail exercise
Over-emphasis on voting guiding agencies’ and proxy advisors’ pay-for-performance tests can result in undue conformity and a race to the middle in pay programme design
Many organisations focus too narrowly on:
Short-term results
TSR alone
The CEO (sometimes NEOs), but not on the tier below
Significant challenges/gaps in market practice
III. 15 Annual and retrospective: Organisations must annually review retrospective pay-for-performance alignment [Alignment]
III. 16 Assess impact of changes: To inform compensation programme design changes, organisations must review the pay-for-performance alignment of proposed changes on a retrospective and prospective basis [Alignment]
Relevant design elements
Performance-Based Pay (examples)3
Committees sometimes play a narrow compliance role when a more strategic focus is needed
Committees must be prepared to make difficult (and, when necessary, unpopular) pay decisions
Compensation committees often have too narrow a perspective and focus too much attention on TSR
Committees must take ownership of a broader agenda that includes succession planning, talent and performance management, and goal setting
Committees should be more involved in shareholder engagement efforts
Significant challenges/gaps in market practice
IV. 1 Accountable: The committee must be directly accountable for making decisions about the compensation of the CEO and the senior executive team [Accountability]
IV. 13 Ongoing shareholder engagement: Public companies should ensure there is ongoing communication with shareholders and consider external feedback on compensation [Engagement]
Relevant design elements
Governance (examples)4
Despite share ownership guidelines, many executives still lack a true owner mentality
Holding requirements run counter to common financial planning advice and require changes in longstanding views
Although most organisations have share ownership guidelines, target ownership levels are too low given the proportion of executive pay delivered in the form of equity
Executives also need to hold equity beyond termination to maintain long-term focus approaching termination
Significant challenges/gaps in market practice
V. 2 Guidelines a must: If organisations provide equity compensation, they must adopt share ownership guidelines and should scale them to reflect the value of the equity compensation levels [Alignment]
V. 4 Retention requirements: In conjunction with share ownership guidelines, organisations should implement share retention requirements set as a percentage of equity awards until the required level of ownership is achieved [Alignment]
V. 5 Post-employment holding requirements: Holding requirements should be in place for at least 12 months post-termination for senior executives [Alignment]
Relevant design elements
Other Terms and Conditions (examples)5
Contractual provisions for ‘special circumstances’ require closer scrutiny and ongoing attention
Existing contractual benefits will take time to unwind, but new agreements require drawing a line at some point
Executive contracts often contain provisions that run counter to pay-for-performance considerations
Persistent one-off contracts and evergreen agreements are a problem
Significant challenges/gaps in market practice
V. 11 Limit individualised contracts: Individual employment contracts should be limited to instances of compelling business need or competitive rationale [Engagement]
V. 12 Sunset individual severance terms: Contractual severance may be appropriate if justified by business need but should sunset over no more than three years [Engagement]
V. 13 Avoid evergreen contracts: Evergreen (automatic rollover) contracts should be avoided [Engagement]
Relevant design elements
Other Terms and Conditions (examples)5
We can enhance the effectiveness of executive compensation
Practice: analysis and workshops• Recognising gaps and relevant areas for improvement as well as improving awareness, knowledge and oversight
• Both Supervisory Boards, named executive officers and Executive Committees
Spanish financial services company – training programme for Board members
THE PRESENTING
PROBLEM
According to the Spanish Corporate Governance Code companies must provide Board members with training programmes, when appropriate
There have been other new appointments in the Board during 2014
WHAT ARE WE DOING?
Designing three ‘training’ modules for the Committee
Briefing them on corporate governance, pay trends and running a ‘blue sky’ workshop
Thank you
Katharine TurnerTowers Watson
Sven SlavenburgTowers Watson