2.2 Comprehensive Guiding Principles – Powerful Tools for ... · Comprehensive Guiding Principles – Powerful Tools for Executive Pay Decision Making Sven Slavenburg, Director,

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]



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]



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


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]


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


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]


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


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]



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


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]



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


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]


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


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]


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


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]


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

[email protected]

Sven SlavenburgTowers Watson

[email protected]

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2.2 Comprehensive Guiding Principles – Powerful Tools for ... · Comprehensive Guiding Principles – Powerful Tools for Executive Pay Decision Making Sven Slavenburg, Director,