Managing Employee Performance and Reward Concepts, Practices, Strategies 2nd edition

1. Managing Employee Performance and Reward Concepts, Practices, Strategies 2nd edition

2. CEO performance and reward • Corporate governance basics • Executive pay – theory and evidence • Reward components • Trends • Short-term incentives (STIs) • Long-term incentives (LTIs) • Reward disclosure • A multi-stakeholder perspective

3. The impact of the global financialcrisis (GFC) • Scrutiny from the public, media, policy makers and academics increased following the GFC of 2007–08, particularly the role of consultants, boards of directors and shareholders in setting rewards. • Some argue the GFC was caused in part by the way executive incentives were organised. • Since the GFC there have been greater requirements in many developed countries for public companies to be more transparent and open about remuneration.

4. The board–CEO power relationship – theoretical perspectives and prescriptions • Tournament theory • Agency theory (‘adverse selection’ and ‘moral hazard’; ‘optimal contracting’; PRP) • Managerial power theory (‘rent extraction’)

5. Executive ‘total reward’ components Fixed/guaranteed: • Annual base salary • Fringe benefits • Non-contributory superannuation/pension • Entry, exit and long-service payments (‘golden hellos’, ‘goodbyes’, ‘handshakes’, ‘parachutes’) • Post-employment payments and benefits (consultancy fees, travel, etc.) Contingent/variable/‘at risk’: • Short-term incentives (STIs) – annual, cash • Long-term incentives (LTIs) – multi-year, equity (share grantsor options)

6. Average remuneration of United States CEOS in Standard and Poors 500 Firms, 1992–2011 Source: Adapted with permission from Murphy, 2013: 16

7. Average percentage composition of remuneration of Australian CEOs and senior executives, 1990–2014 Note: STI = short-term incentive; LTI = long-term incentive. Source: Neuhold & Hay Group, 2014; O’Neill & Berry, 2002.

8. Average percentage composition of remuneration of Australian CEOs and senior executives, 1990–2014 Source: Neuhold & Hay Group, 2014; O’Neill & Berry, 2002. Note: STI = short-term incentive; LTI = long-term incentive.

9. Short-term cash incentive plans Discretionary bonuses Results-based bonuses: • Annual financial goals/‘hurdles’: • Operating expenses compared to budget • Revenue growth • Net earnings, or net income • Net operating profit after taxes (NOPAT) • Earnings before interest and taxes (EBIT), or operating income • Earnings before interest, taxes, depreciation and amortisation (EBITDA) • Earnings per share (EPS), or net income divided by the average number of shares outstanding • Return on assets (ROA), or net income divided by total assets • Return on equity (ROE), or net income divided by total shareholders equity • Economic value added (EVA), or economic profit

10. Long-term (equity-based) incentive plans Restricted share plans • Conditional free grants • Non-disposal period • May be subject to forfeiture for early departure • Performance hurdles for vesting: • Total shareholder returns (TSR) • Absolute/relative Share purchase plans • Discounted price • Interest-free loans with repayment from dividend earnings • Progressive vesting • Tax deferred • Compulsory acquisition • Not expensed against profit and loss • ‘Skin in the game’ • Favoured in private firms

11. Fixed-price option plans • Executive receives right to buy a specified number of company shares at a predetermined price at some point in the future • Options typically vest three, four or five years from grant date, but may also vest progressively • Price payable to convert the option to a share – the ‘strike price’ – is usually set at the market value of the shares at the time the option is granted • Nil apparent cost to firm at grant • Low or no interest loans to fund acquisition of vested options • No downside risk for executive • Performance hurdles now applied as a vesting condition • Premium pricing (‘out of the money’ at grant)

12. Fixed-price option plans Problems: • No real risk • Encourage speculative behaviour • Market manipulation/‘insider trading’ • Dilution • Are a cost to the company • Are remuneration, thus value should be included in reported annual remuneration • Repricing • Reloading • Relative hurdles may be too soft (50th percentile= ‘Joe average’!) • Hurdles encourage volume increase • Risk hedging – ‘cap and collar’ products

13. Performance shares/ZEPOs • Zero exercise price options (or ZEPOs) plans allow the executive to take up shares at no cost but only on condition of a performance hurdle being satisfied over a designated performance period • Since fewer ZEPOs will be needed to deliver a level of reward comparable to that of a fixed price option plan, there is less potential for dilution, especially when the shares are market purchased rather than new issue • Do not encourage speculative behaviour

14. Share rights plans • Non-compulsory share purchase plans, with option-like characteristics • Gives the holder the right, but not the obligation, to buy shares in the company • The purchase price is typically the market price at the date of grant • Some emulate direct grant and ZEPO plans by allowing shares to be acquired without payment, but such plans generally involve performance hurdles

15. Share appreciation rights • Take account of dividend earnings as well as share price appreciation • No requirement to acquire shares of the shares • Often granted as a companion to share options in order to cover the holder for capital gains tax (CGT) liability arising from gain on exercise of an option

16. Share appreciation rights vs fixed price options

17. Long-term incentive plan types and hurdles, Australia • Dual hurdles may be ‘either/or’ or 50/50. Source: Neuhold & Hay Group, 2005.

18. Option valuation • Current option holdings do constitute potential future income and should therefore be factored into any estimate of annual total remuneration • Options granted generally have an expected cost to the firm of 30–40% of the fair market value • ‘Present value’/grant date approach takes the projected future value of new option grants, and discounts it to a present value in order to estimate the level of annual total remuneration • Most widely used approach to estimating present value is Black-Scholes, which takes account of: • Strike price • Projected price of an underlying security • Share price volatility • Risk-free rate of return • Expected dividend yield • Term of grant • Where a performance hurdle applies, the probability that this will be met

19. Explaining executive pay – the theory wars Tournament theory • Lazear and Rosen, 1981 • Many contestants, one prize • Internal pay hierarchy is necessary and desirable Agency theory • Berle and Means, 1933; Jensen and Meckling, 1976 • Separation of ownership and control; ‘principals’ and ‘agents’ • ‘Information asymmetry’ and ‘moral hazard’ principal-agent problem and agency costs • Solution: ‘optimal contracting’ via performance-related rewards Managerial power theory • Finkelstein, 1992; Bebchuk and Fried, 2004 • Intimate nature of executive power • Director ‘independence’ problematic • Absence of ‘arms-length bargaining’ • ‘Rent extraction’ = sub-optimal contracting

20. Executive reward level and firm performance – research evidence Size matters • A 10% increase in firm size leads to a 3–4% increase in CEO pay • Has merger and acquisition (M&A) implications • The high correlation between size and reward level certainly suggests that CEOs have a strong vested interest in rapid firm growth

21. Executive reward level and firm performance – research evidence Pay for performance: weak on the downside and in high risk • Some evidence that executive incentive rewards are sensitive to prior increases in firm performance • But relationship only weakly positive on the upside and negligible on the downside • In 1969–83 US CEO wealth increased US$3.25 for every US$1,000 increase in shareholder wealth, while CEOs lost 24.4 cents for every $1,000 lost by shareholders (Jensen & Murphy, 1990) • Sensitivity in the US almost doubled between 1988 and 1996, driven chiefly by share options and direct equity ownership (Murphy, 1999) • Australian CEO wealth (excluding option grants) increased AU$1.82 for two consecutive AU$1,000 increases in shareholder wealth during the 1990s (Merhebi, Swan & Zhou, 2006) • Pay-performance sensitivity (PPS) is related inversely to the degree of business uncertainty and risk (Aggrawal & Samwick, 1999), which supports agency theory predictions regarding agent risk-aversion • Implication: riskier firms that have lower PPS will out-perform high-risk firms that have high pay performance sensitivity (Bloom & Milkovich, 1998)

22. Executive reward level and firm performance – research evidence Performance for pay: strongest for share ownership • Strongest evidence relates to level of executive share ownership (Jenson, Murphy & Wruck, 2004; Kay, 1999, 2005) • Option holdings have little performance effect

23. Board composition and CEO reward – mixed US/UK research evidence • Balance of power between CEO and board influences reward level, adjustment and pay-performance sensitivity (PPS) • Board composition, particularly the degree of director independence, influences both reward levels and PPS • CEO ‘entrenchment’ on board reduces PPS: • Combining CEO and chair positions reduces PPS • Fewer independent directors reduces PPS • Internal CEO appointees reduces PPS • More internal directors increases PPS; more external directors increases total reward level • Greater ownership by external directors reduces total reward level • Ownership concentration (‘block-holding’) increases PPS (= owner-controlled firms), while ownership diffusion reduces PPS (= manager controlled firms) • External CEO hires receive higher reward than internal hires

24. ‘Rent extraction’ –fact or fiction? Symptoms of rent extraction/sub-optimal contracting in the US (Bebchuk & Fried): • Un-hurdled options plans • Options that vest at grant • Repricing ‘out-of-the-money’ options • Automatic ‘reloading’ of options following exercise of an existing option holding • ‘Stealth compensation’: • Golden hellos/goodbyes • Retention and long-service bonuses • No-interest company loans • Post-termination consulting fees • Special payments for termination following takeover or merger (or ‘golden parachutes’) • Retirement benefits are not performance-linked and amount to one-third of total accumulated earnings

25. ‘Rent extraction’ – fact or fiction? Solutions (Bebchuk & Fried): • Increase in shareholder power over directors • Exclusion of all but independent directors from board compensation committees • Mandatory shareholder ratification of all components of top executive remuneration • Use of indexed options • Compulsory share ownership • Full disclosure of all post-employment benefits

26. ‘Rent extraction’ – fact or fiction? Counter-arguments (Murphy, Conyon): • Average length of CEO tenure is declining not rising • Growth in CEO pay has coincided with increased presence of independent directors • Pay growth is due to global market pressures • Boards not manipulable, just ignorant of LTI cost complexities Which returns us to the issue of the relationship betweenthe board and the CEO.

27. Executive reward disclosure – for and against For: • Accountability • Controlling excess • Transparency Against: • Executive privacy • Ratcheting (and role of surveys and consultants) • Perverse outcomes – e.g. 1992 $1 million cash cap on tax deductibility in USA

28. Beyond ‘shareholder value’– a multi-stakeholder perspective Effective management of senior executive performance and reward, and CEO reward in particular, involves striking a positive balance between the potentially competing expectations of five key stakeholder groupings: • Shareholders • The board • Executives • The firm’s employees • External stakeholders, including corporate regulators, the media, customers, suppliers and the general community