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Join us on February 21, 2019, for an informative session on the emerging trends and key concepts in executive compensation that all directors should know. Learn from industry experts Laura Wanlass and Joe McNeal.
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Exec Comp 101: Emerging Trends and Key Concepts All Directors Should Know Laura Wanlass & Joe McNeal, Radford Silicon Slopes February 21, 2019 Agenda 11:30 a.m. Registration | Networking 11:50 p.m. Buffet Opens 12:05 p.m. Welcome | Presentation 1:30 p.m. Adjourn
Announcing the Newest Additions to the Utah Chapter Jill Anderson Kirk Aubry Willie Bogan James Clarke Peter Cohen Tracee Comstock David Crane Jeffrey Dyer Rainer Erdtmann J. Kimo Esplin Elisabeth Fisher Tammy Georgelas Steven Gorlin James Harrison Cameron Hoyler Mark Lehman Denver Lough Crystal Maggelet Jon Mogford Raul Parra Jeff Roberts Nathan Savage Todd Savage David Seaburg Zachary Tudor Jeremy Wright Joseph Wright
17 Full Board Members – Utah ChapterCommitted to Excellence in Board Leadership Extra Space Storage Inc. Larry H. Miller Management Corporation Med One Group Ltd. Merit Medical Systems, Inc. Nature's Sunshine Products Nu Skin Enterprises Inc. Overstock.com, Inc. People’s Utah Bancorp PolarityTE, Inc. Savage Services Corporation SkyWest, Inc. USANA Health Sciences Inc. Utah Higher Education Assistance Authority (UHEAA) Vista Outdoor Inc. WCF Insurance (Workers Compensation Fund) ZAGG Inc. Zions Bancorporation
Executive Compensation 101: Emerging Trends and Key Concepts All Directors Should Know NACD Utah February 21, 2019 Laura Wanlass, Partner Joe McNeal, Associate Partner
Our Agenda Today • Introductions • Level Setting – Overview of Compensation Committee responsibilities and typical annual calendar • Benchmarking Practices • Governance Trends • Hot Topics • Q&A
Level Setting – The Players: Roles and Responsibilities Board of Directors Compensation Committee CEO Compensation Committee Advisor Head of HR CFO / General Counsel
Establishing a Compensation Philosophy • Companies typically establish a pay philosophy to set pay ranges, bonus targets and/or equity awards against the competitive landscape • A pay philosophy provides a framework and reference point for making compensation decisions, while at the same time being flexible enough to accommodate the business’ needs and performance outcome • As a company grows, the mix of pay between salary, cash incentives, and equity changes over time typically placing more emphasis on salary and incentives as the company looks to hire more experienced employees and manage overall dilution levels • The actual compensation paid may be above or below the stated targets percentile based on a number of factors (e.g., tenure, individual contribution, scope of responsibilities, level of experience and affordability) Market definition and data availability differ by employee group • Executive: • Industry • National Pool • Size & Complexity • Data gathered from public filings (i.e., proxy) • Non-Executive: • Industry • Top recruiting targets • Generally geographic focus (local to regional) • Data gathered from published survey data
Start by Identifying Your Stage of Development & Prioritize Accordingly Go-Forward Public Company Compensation Maintenance IPO Compensation Roadmap Go Forward Equity Strategy (Share Reserves and ESPP) IPO Event Ongoing Cash/Equity Program Review and Incorporation of New Roles/Incumbents Salary Administration System Development Public Disclosure and Regulatory Preparation • Executive compensation SEC disclosure drafting • Equity plan terms audit and funding needs projections • Tax & regulatory compliance • Executive severance/change-in-control policies and contracts Equity Grant Guideline Development and Total Dilution Planning Consider Creating Systems to Level/ Job Match Employees Equity Holdings Retention and Refresh Assessment Acquisition Ready Startup Board of Directors Compensation Program Annual Bonus Assessment/ Design First Time Salary and Bonus Benchmarking Equity Award Valuation Assessment for ASC Topic 718 Accounting Comprehensive Executive Compensation Review • Peer group selection • Compensation Philosophy • Total pay Competitiveness
Equity Compensation is Where We See the Biggest Shift Most Common Practice Least Common Practice Emerging Practice
Pay Comparisons Determine competitive pay and identify differences from general industry market data Potential attractiveness/ability to retain key talent Performance Comparisons Determine performance relative to companies facing similar economic challenges Benchmark performance Input to setting incentive plan goals Compensation Structure Provide benchmarks for compensation structure (pay mix, leverage, vehicles, etc.) Why Have a Public Peer Group — Three Typical Functions Pay Comparisons Performance Comparisons Compensation Structure
Peer Group Development Process and Best Practices • Compensation benchmarking peer groups should represent labor market organizations that a company attracts talent from and looses talent to. Additional characteristics that should be evaluated in addition to labor market are: • Industry – Organization structure • Size (0.5–2.5) of sponsor company – Growth trajectory • Business life cycle – Complexity • Maintaining consistency among peers is critical for developing a valid trend line; don’t want significant overhaul of peer group on an annual basis • Availability of data for peer companies should be considered in selection process. Proxy data only available for publicly traded companies, and will only provide market data for a handful of executive jobs • A robust defensible screening process in selecting peer companies should be conducted focusing on company characteristics • Peer group will be disclosed in proxy CD&A and subject to investor scrutiny • While an organization’s peer group will provide useful market data, other factors should be considered in setting target pay opportunities including: • Internal equity – Company philosophy • Time in position – Individual performance • Future potential/succession planning
Value of Select Peers vs. Broader Industry Group Number of Peers Select Peers General Industry • A select peer group works best when: • Comparable companies can be identified or when the peer group as a whole is comparable to the target company on the selected evaluation criteria • Peers are demonstrated to pay differently (more/less or different mix) than a broad index (e.g., consumer products pay more than general industry companies) • Performance of the peers react similarly to economic conditions • Peers perform at comparable levels (only if seeking a high-performance or high-growth group) • The total number of companies provides a reliable dataset over time (minimum 12 companies but 18 to 25 is better) • They participate in published surveys • When these criteria cannot be substantially met, it may be more valuable to default to a more general category.
ISS Peer Group Methodology1 • In the table below, we have summarized the current methodology for developing ISS CEO pay-for-performance peer groups 1 ISS has not significantly altered it’s pay-for-performance testing methodology, which includes the RDA, MOM and PTA tests introduced several years ago; however, large cap companies are now subject to a review of realized pay 2 Assets are used for companies in GICS codes 40101010, 40101015, 40102010, 40202010 and 40201020 3 ISS generally selects peers from the Russell 3000 index; however, publicly disclosed non-Russell 3000 peers of Russell 3000 companies are considered
How to Think About Total Compensation • Mix of Pay • Variable Mix—variable to fixed compensation • Time Frame Mix—short- to mid-term variable to long-term compensation • LTI Design Mix—mix of vehicles (options, RSUs, performance plans, etc.) • Performance Measures/Goal Setting • Performance Metrics—linked to creating value and earnings quality/sustainability • Goal Setting—process for setting goals, degree of difficulty, and spread between threshold, target, and maximum goals • Performance Slope—incremental pay to incremental performance ratio (leverage) • Payout Opportunity—upside maximum payout level • Additional Compensation Elements • General Severance—amounts • Change-in-Control (CIC) Arrangements—triggers, severance amounts, equity treatment • Equity ownership and shareholding requirements • Retirement approach • Other Policies • Existence of policies that impact risk such as clawback policies and employment agreement severance terms • Use of discretion used by compensation committee
Equity Compensation – Primary Driver of Total Pay Levels • LTIs are the largest, most highly leveraged and most scrutinized portion of executive compensation • Executives are charged with creating long-term unit holder value as their primary duty; this alignment to unit holder interests is reinforced through LTI • Pay mix levels shown below reflect standard levels seen among Fortune 500 companies
LTI Vehicles Stock options Restricted stock/units Performance plans/units LTI Valuation What are these worth? How are they expensed? What are the key variables? Topics for Discussion LTI design presents an opportunity for companies to create a specific message to employees and shareholders • Consistent with recruitment and talent management • Consistent with investment thesis • Consistent with longer-term operating strategy • “This is how we intend to add value over time”
Evolving Mix of LTI Vehicles • Relative weight of various vehicles has changed over time • A decade ago stock options were clearly the dominant form of LTI for a variety of reasons, including “P&L” cost • Over the ensuing 4–6 years, the “balanced portfolio” approach is much more common among many companies and sectors • This may or may not be “optimal”—that should be evaluated by each company individually—but it is important to understand the history and how market practices have evolved
Purpose of CIC Protection To keep executive decision making neutral to job loss when considering possible corporate transactions To provide retention of key executive talent after announcement and through close of transaction To provide severance protection as a bridge for transition to new employment post-termination To provide a competitive executive compensation package when attracting and retaining key executive talent Key Design Elements Eligibility—Which executives should be eligible for this special protection? Triggers—What terminations or actions should trigger benefits? Benefits—What level of severance and other benefits should be provided? Other Provisions—How should excise taxes be treated? Should certain restrictive covenants be included? Overview of Typical Arrangements
The “Spot Market” • Prevalence and trends in CIC agreements remain largely unchanged during the last few years; however, there is movement in some areas. • Many new CIC agreements are moving cash multiples to 2 and away from 3 for the CEO and direct reports • Overall, the market continues to be dominated by 3 cash multiples for CEOs (through existing agreements), and we expect this to change over time as older agreements are replaced or modified • Gross-up payments are becoming more scarce in new plans and some companies are eliminating excise tax gross-up clauses in existing agreements • We expect these trends to continue as driven by institutional shareholders and shareholder advisory groups
Key Provisions and Marketplace Practices • Prevalence • Over 70% of large public companies provide CIC-related cash severance to some executives • Participation • Participation should be limited to: 1) executives actively involved in decisions that could lead to corporate transactions, or 2) critical executive talent that must be retained through the close of a transaction • Typical eligibility can be broken into 3 tiers: • Tier I: CEO and his/her direct reports (n = 5–7) • Tier II: The next level of senior management positions that are critical to the success or failure of the transaction; typically based on reporting level, pay, or eligibility for other incentive programs (n = 10–20) • Tier III (if used): Senior-level positions that are important to ensure a smooth transition; typically, these positions include corporate staff roles that are both critical to the success of the transaction and most vulnerable to a job loss on a CIC (n = 10–30) • May exclude executives eligible for retirement • Protection Period • Defined as the time period during which the executive must incur a qualifying termination following a qualifying CIC • Strong majority of companies provide 24-month period
Director Compensation Basics • Board pay similar to NEO pay is publicly disclosed and must be competitive • Most companies benchmark director pay annually or every other year • Director compensation responsibilities typically fall under the Governance Committee • Most often, the same peer companies that are used in executive pay comparisons are also used in director pay comparisons • Most director compensation programs contain a board retainer, committee fees, and equity component • Director pay does not have the same correlation to revenues as executive pay
Director Compensation Basics—Typical Components of Pay • Cash Retainer • Cash paid for board services…directors’ version of base salary • Typically paid quarterly • Annual Equity Award • Equity paid for board services, typically with little or no vesting requirements due to annual elections • Full value shares most common • Meeting Fees • Cash payments made for each board meeting attended • Value is typically less for telephonic meetings • Chairman of the Board/Lead Director Pay • Nonexecutive chairman of the board pay is typically paid above and beyond other board members • In organizations where the CEO is also the chairman and a lead director exists, there is typically an enhanced retainer • Special Pay for Committees • Service on a committee may be paid in addition to board services • Additional committee retainer and/or meeting fees may be provided • Audit committees are typically paid higher than all other committees • In cases where a special committee is formed (CEO search, investigating M&A activity) lasting less than a year, additional pay is typically received and practices vary by situation • Other Pay • Benefits and perquisites are uncommon
Director Compensation Trends • Movement away from classified boards to annual elections • Increase in responsibility, time commitment, liability, and financial expertise; as a result, directors are being paid more • Identification of nonexecutive chairman or lead director • Decreased usage of board and committee meeting fee arrangements, replaced with enhanced retainers • Use of full value stock awards as opposed to stock options • Immediate vesting is most common • Emerging practice is the use of deferred stock • Anticipate going forward outside director total pay levels will increase at 4%–6% per year
How Proxy Advisory Firms Review Executive Compensation Applies recommendations towards the say-on-pay or compensation committee members Only conducts a full compensation-related review if there is a say-on-pay issue and will only apply negative recommendations towards compensation committee members due to responsiveness issues ISS Voting Recommendation Approach Glass Lewis
How Proxy Advisory Firms Review Executive Compensation • Applies to CEO pay levels at Russell 3000 or Russell Microcap companies • Separate from a formal qualitative “Problematic Pay Practices” Policy review (qualitative concerns only impactful if poor quantitative scoring) • Applies to all NEO pay levels at Russell 3000 companies • More qualitative than ISS approach (problematic pay practices carries more weight depending on quantitative scoring) ISS Pay-for- Performance Policy Application Glass Lewis
How Proxy Advisory Firms Review Executive Compensation • “Most” problematic practices—automatic “against” on stand-alone basis • “Other” problematic practices—takes more than one or fairly egregious facts to result in negative recommendation • Impact is based on the pay-for-performance scoring • Does not review contracts in a manner similar to ISS ISS Problematic Pay Practices Policy Application Glass Lewis
Say-on-Pay Exposure Items for 2019 Proxy Season • No company wants to find themselves with lower than expected say-on-pay or compensation committee election results • Higher percentage of companies failing to obtain majority support in 2018 (i.e., 2.6% versus 1.6% in prior year) • ISS and Glass Lewis against recommendations fairly consistent year over year, at ~12-13% • Once in the low results category or even in the failure category, difficult process to get out of the enhanced scrutiny category with proxy advisory firms, investors, and even the media • Hangover effect on subsequent years if mitigating actions are not taken fast enough and/or if actions do not meet all external expectations • It is crucial that you know your fact pattern and your potential exposure to ISS and Glass Lewis • Understand key policy changes that have been made • Pay-for-performance modeling • Problematic pay practices review • Proactively engage with shareholders and/or ISS Research/GL where necessary
Say-on-Pay Exposure Items for 2019 Proxy Season • Transparency of incentive goal-setting process and final payout determinations, especially when underperforming relative to industry and/or index peers • Use of timelines and charts can effectively help communicate the process to investors • Expectation of off-season shareholder engagement • Especially if say-on-pay results are declining or if companies are below formal ISS/GL voting results thresholds (70% and 80%, respectively) • Compensation Committee member attendance can be helpful, but isn’t always necessary unless there is an ongoing say-on-pay problem or a failure • Engagement with ISS and Glass Lewis can be helpful as well • Continued focus on stock price • While investors are willing to give companies the benefit of the doubt regarding non-Total Shareholder Return (TSR) based metrics in the short-run, there is an expectation that final payouts (short- and/or long-term) are adjusted if there is sustained TSR underperformance • Non-employee director compensation is the new red flag item • Plaintiff’s lawsuits increasing every year
Say-on-Pay Exposure Items for 2019 Proxy Season • Learn from the prior year drivers of negative proxy advisory firm recommendations • Perceived quantitative and qualitative disconnects • ISS quantitative testing scores triggering a qualitative review under the CEO Pay-for-Performance Policy • D or F grade under Glass Lewis test triggered qualitative pay-for-performance review • Important to understand quantitative scoring heading into the proxy season • Use of lowered annual or long-term incentive goals relative to prior year and target or above-target payouts, without what ISS or others consider to be appropriate context or rationale • Goes to a performance goal “rigor” analysis: must proactively explain rigor of goals especially if lower than prior year • Exclusion of items that are perceived as being within management’s control (i.e., litigation, business losses) were flagged—companies were flagged for this even if they triggered LOW concerns for all pay-for-performance tests • Ensuring appropriate context/rationale for incentive pay decisions is critical to passing a qualitative assessment
Say-on-Pay Exposure Items for 2019 Proxy Season • Increased target incentive opportunities (especially when stock price is underperforming) • Increasing target STI/LTI pay opportunities when elevated quantitative pay-for-performance concern • Increasing fixed costs, such as base (especially when it is higher relative to ISS’ CEO peer median pay levels) • Especially problematic when a company targets any element of compensation above median • Also, a failure to adequately disclose how target LTI grant sizes are established will be flagged as problematic, and may be cited as discretionary • Increased number of time-based awards disproportionate to the increased number of performance-based awards (time-based stock options not being considered performance-based) • ISS wants to see at least 50% of LTI as performance-based • Glass Lewis wants to see at least 33% of LTI as performance-based
Say-on-Pay Exposure Items for 2019 Proxy Season • Understand the landscape • Be prepared to engage • Get the messaging right in the proxy proposal • Don’t get greedy • Give yourself credit
CEO Pay Ratio – Doing the Calculations • Identification takes place on any day in last quarter of reporting year • Generally all workers (including full-time, part-time, seasonal) must be considered • Rank employees using a pay measure and locate middle worker • Can use total direct compensation, cash wages (in some cases), or other “consistently applied compensation measure” • Can be done every 3 years (provided there are no material changes which would significantly alter the ratio) • Calculation of total compensation generally follows the rules for the Summary Compensation Table total compensation (Reg. S-K Item 402(c)(2)) • Perquisites < $10,000 and non-discriminatory group benefit costs may be added (if also included for the CEO in the calculation) • Quantitative (state the ratio of CEO pay to median employee pay) • Qualitative (describe the approach use to identify, assumptions) • Supplemental (optional wording to provide context)
CEO Pay Ratio – A Look Back at the Results From Year 1 • The two primary drivers of the ratio are size (revenue) and international employees
State Laws That Are Leading Pay Equity • California • Oregon • Pennsylvania • New Jersey • New York • Massachusetts What Do These Laws Have in Common? Comparisons for similar rather than equal jobs Limit use of historical pay when setting starting pay Drive pay transparency
Legislative Landscape New Jersey Pay Equity Act It is unlawful to pay employees of any protected class less than other employees for substantially similar work • Protected classes include sex, race, creed, color, national origin, ancestry, nationality, disability, age, pregnancy or breastfeeding, marital/civil union/domestic partnership status, sexual orientation, gender identity or expression, military status, and genetic information or atypical hereditary cellular or blood traits • Substantially similar work is not defined under the Act, leaving the provision open to interpretation • Exceptions under the law that could justify pay differentials include seniority system and merit system or the employer will need to demonstrate that: • The differential is based on a legitimate factor (e.g., training, education, quantity or quality of production) • The factors are applied reasonably • The factors account for the entire wage differential Massachusetts Pay Equity Act Employers cannot pay workers a salary or wage less than what they pay employees of a different gender for comparable work • Comparable work – similarity of skill, effort, responsibility, and working conditions required for positions, even where the job titles and duties of those positions are different • Wages – not just salary, but also bonuses, benefits, commissions, and housing allowances • Exceptions – performance-based pay, location or employee’s background
Activism & Proxy Advisory Firm Landscape • Most companies tried to keep the calculation simple with energy focused on communication and disclosure • Pretty uneventful for investors and press • Minimal scrutiny from ISS and Glass Lewis • Local press seemed to focus on median employee pay figure rather than ratio • Campaign by 48 institutional investors, including the Comptroller of New York, seeking greater disclosure of pay ratio • Most companies not taking action to add the information requested by this group or others
Activism & Proxy Advisory Firm Landscape Dear Board of Directors: We are writing to you as investors regarding our interest in your company’s pay ratio disclosure. The investor signatories to this letter cumulatively represent $3.3 trillion in assets under management and advisement. Pay ratio disclosure gives investors material information for evaluating companies’ median employee pay as compared to CEO pay levels. The investors signed onto this letter favor ratios that indicate companies are making investments in their employees and that CEO compensation is set within the parameters of the company’s overall compensation philosophy. We believe that a company’s workforce is an asset to be invested in, not a cost to be minimized. Investments in employee compensation can motivate employees to be more productive and engaged in their work. Disclosure of the median employee’s pay provides a reference point for understanding the company’s workforce. We encourage you to help investors put this pay information into context of your company’s overall approach to human capital management. Pay ratio disclosure is also useful for say-on-pay proxy voting decisions regarding the reasonableness of CEO pay levels. A company’s pay ratio and how it changes over time indicates the company’s approach to internal consistency when setting CEO pay levels. The alignment of CEO pay practices with the company’s overall employee compensation philosophy can also bolster employee perceptions of pay equity and fairness. In our review of this year’s pay ratio disclosures, we have identified what we believe to be best practices that we would like to share with you. As permitted by Item 402(u) of Regulation S-K and applicable SEC guidance to the pay ratio disclosure rule, companies may disclose supplemental information about their workforce to provide context and explain their company’s pay ratio data. We believe this supplemental disclosure is helpful to investors. Below are examples of supplemental disclosures we found useful in assessing pay ratios:
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