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Executive Compensation & Corporate Governance

A study examining compensation in SMI, SMIM and small-cap companies as well as trends in corporate governance

Insights 2017 - Part 2

Table of Contents

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Introduction ExCo Insights 2017, part 2 3

Direct pay-for-performance 4

Indirect pay-for-performance 7

Equity exposure of executives – the wealth lever 9

Summary and outlook to part 3 11

Introduction ExCo Insights 2017, part 2

The first part of ExCo Insights 2017 summarised the key highlights for the largest 100 Swiss listed companies regarding the level of compensation of CEOs and other executives, as well as chairmen and other board members. Then, it studied the much-discussed differences between financial-services (FS) and non-financial-services (non-FS) companies – and unearthed some arguably surprising patterns. Specifically, the overall rise in executive compensation since 2009 has mostly been driven by non-FS companies rather than FS companies.

PwC’s ExCo Insights 2017, part 2 now focuses on pay-for-performance in Switzerland. For an overall assessment of this challenging topic, one has to consider multiple perspectives.

The key findings based on our ten years of data for 100 Swiss companies are:

1. When in a given year a Swiss company achieves a total shareholder return (TSR) in the top tercile of TSRs in the same industry in that year, variable CEO compensation disclosed as given for that performance year increases relative to the previous year by 9.5% at the median. In the bottom tercile of industry-adjusted share performance, variable CEO compensation falls by 3.8% compared with the previous year. This points to a working, but quantitatively modest direct pay-for-performance relation.

2. Indirect effects can be more significant: Companies are more likely to change their CEO when performance is lower. Specifically, in the top tercile of relative TSR, the probability of a CEO turnover is 14%; in the bottom tercile, it is 21%. Because after a turnover for poor performance, CEOs tend to work at smaller companies (if at all), a strong board can induce substantial implicit pay-for-performance and, thus, incentives.

3. Equity-based compensation has risen moderately over the last few years (but has somewhat declined in the most recent year of the sample). The median CEO holds 3.9 times his base salary in terms of equity wealth in the company he manages, inducing substantial exposure to the performance of the firm.

We hope that this analysis provides useful background and benchmark information as companies, boards, managers, and policymakers reflect on the adequacy of incentive systems in Swiss companies. Based on the results presented in this part 2, ExCo Insights 2017, part 3 will discuss new methods of pay design and will offer an analysis of the demands of shareholders in the upcoming annual general meeting season.

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Direct pay-for-performanceAt the end of ExCo Insights 2017, part 1, we presented preliminary evidence of an aggregate connection between pay and performance in Swiss companies: Shareholder wealth grew faster than CEO compensation in each subsample. That aggregate analysis suggested that overall executive compensation and shareholder wealth have moved together when considered over a long time period (or that, indeed, shareholders tend to have seen greater growth in their wealth when compared to the rate compensation has grown at). However, this does not necessarily say much about the pay-performance relationship at individual company level, and it does not say anything about the link on a year-by-year basis.

Is there pay-for-performance when we look more closely? To answer this question, several choices need to be made for the analysis. Box 1 explains these concepts in more detail. Briefly, the following four choices are made. First, we focus on total shareholder return (TSR). Second, we look at industry-adjusted, that is, relative performance. Third, we classify as variable compensation all those compensation elements that companies disclose as variable for a given year. Fourth, we look at changes in variable compensation from the prior year for the same CEO.

Box 1: Technical explanation of choices made in the direct pay-for-performance analysis First, concerning the focus on total shareholder return (share price and dividends, TSR) performance, we note that, of course, in many instances, the CEO cannot directly influence the share price per se – or if he or she can, it is mostly in the downward direction, e.g. through lack of (reputation) risk management. However, all the business decisions the CEO takes (and induces others to take) will ultimately feed into one of two outcome variables: cash flows and/or cost of capital. And these two components determine the share price development. Moreover, for the top 100 companies, it is a reasonable assumption that the capital market reflects the available information efficiently, that current changes in corporate policies – even those that will have an impact on cash flows only further down the road – will be reflected in share prices “today.” Second, for the present purpose, where we wish to isolate the relationship between company-specific performance and changes in variable CEO compensation, an industry-adjusted, relative total shareholder return is the appropriate measure. Third, the definition of variable pay is clearest in the case of the prototypical short-term incentive payment (whether conveyed in cash or in equity). A pure long-term incentive programme, under which, completely regardless of performance in a given year, a CEO receives a fixed number of shares or a fixed value of shares, is not included as variable compensation (although, of course, the ultimate value of this share grant will depend on the future performance of the company). However, even if an equity grant does not depend on the individual performance of a CEO, but according to the company’s description in the compensation report, depends on the company’s overall performance in the past year, then such a grant is classified as variable compensation. To the extent that, despite our best efforts, we assign compensation that is, in fact, a pure, long-term incentive programme (that is regardless of past performance) to variable compensation, we would induce a bias against finding a relationship between pay and performance, because for such a company the (then wrongly classified) “variable” compensation would not, in fact, vary with performance. Fourth, we look at changes in variable compensation from the prior year for the same CEO. This has the big advantage that we do not need to specify the “right” model for determining compensation. Instead, we rely on the idea that, in general, business models do not change substantially from one year to another. Another consequence is that this analysis (deliberately) excludes incoming CEOs, who are in the sample for the first year. Thus, the analysis is not distorted by unusual one-off payments that may be disclosed as variable compensation.

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Figure 6 presents the results for median year-on-year per cent changes in variable compensation of CEOs in the three performance terciles. As can be seen, there is throughout a positive relationship between relative total shareholder return in one year and the change in variable compensation in the following year. As such, changes in shareholders’ wealth and the variable compensation of CEOs are aligned. The left-most three columns show that when in a given year a Swiss company achieves a total shareholder return (TSR) in the top tercile of TSRs in the same industry in that year, variable CEO compensation disclosed as given for that performance year increases relative to the previous year by 9.8% at the median. In the bottom tercile of industry-adjusted share performance, variable CEO compensation falls by 3.8% compared with the previous year.

Figure 6 also shows the results for the three size-buckets (SMI, SMIM, and small-cap) and the two industry groups (financial services and non-financial-services companies). In all cases, there is a monotonic relation between performance and pay. However, the graphs show that variable compensation in SMI firms is, in percentage terms, less sensitive to performance than in either of the two other groups. In the lowest share price performance tercile, variable compensation stays flat for the median SMI CEO, but drops by 8.5% for the median SMIM CEO. In the top tercile, variable compensation increases for an SMI CEO by 5.5% at the median, but increases by 19.1% for the median SMIM CEO. In banks and insurance companies, variable compensation is less performance-driven – as measured by the difference in variable compensation changes in the top vs. the bottom tercile relative TSR – than in non-FS firms.

How big are these effects? Within the lowest tercile of relative TSR, the median relative TSR is –26%. In the top tercile, the median relative TSR is +20%. Thus, being in the top or lowest relative share price performance tercile creates substantial wealth gains or destruction for shareholders in aggregate. The corresponding changes in CEO variable compensation are small in absolute terms. For example, for the median SMIM CEO, when relative TSR is in the top tercile, variable compensation is higher by CHF 180,000 compared with the previous year; when relative TSR is in the lowest tercile, variable compensation decreases by CHF 115,000 compared with the previous year. Thus, the difference in changes in variable

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Median change in variable CEO compensation

Bottom tercile rel. TSR Middle tercile rel. TSR Top tercile rel. TSR

Figure 6: Variable CEO compensation increases when performance is higher

Median change in variable CEO compensation

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compensation in the top tercile minus the change in the lowest tercile is around CHF 300,000 for the median SMIM CEO. Similarly, this difference is around CHF 160,000 for the median SMI CEO and around CHF 40,000 for the median small-cap CEO. One should also keep in mind that we are looking at median variable compensation changes here. Among all groups of companies there are some CEOs, who obtain substantial increases in variable compensation even when performance is poor (and there are some CEOs who see declines in variable compensation even when performance is strong). While in individual circumstances there may be good reasons for such outcomes, they need to be particularly carefully explained to shareholders (and other stakeholders, including the public).

Overall, there is a working direct pay-for-performance relation in Swiss listed companies, but the effects are quantitatively modest. However, as the next two sections show, there are at least two additional effects that need to be taken into account to obtain a balanced assessment of the strength of pay-for-performance incentives.

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Indirect pay-for-performanceBoards and policymakers need to bear in mind that there are other sources of incentives and pay-for-performance than the year-by-year bonus payments. Specifically, pay differentials between companies of different sizes (see ExCo Insights 2017, part 1) bring with them a natural element of “career concern incentives.” Managers arguably also take into account that good performance now opens up better career opportunities in the future – in particular the opportunity to manage a larger, higher-paying firm. Conversely, they are aware that poor performance now is likely to result in fewer such opportunities in the future; indeed, poor managers may find themselves slipping down a notch or two in the size of the company they lead, which implies lower pay. When added up over the duration of a career, these forward-looking incentives can be substantial.

Of course, a necessary condition for career concerns is that there is, in fact, a higher likelihood of keeping one’s job if one performs well. In this section, we investigate the turnover-performance sensitivity, that is, the question: How does the probability of turnover vary with performance? Box 2 explains some technical background.

Overall, on average, each year 17% of CEOs change. The turnover ratio varies somewhat: the lowest rate was in 2010 (13%), the highest in 2008 (20%). SMI firms have lower turnover (15%) than SMIM (19%) and small-cap firms (17%).

Box 2: Technical explanation of choices made in the turnover-performance-sensitivity analysis In this analysis we also include firms, where the CEO is not disclosed in the compensation report (because he/she was not the highest paid in the year). Turnovers here are identified as follows. If the CEO at the end of the prior year is different from the CEO at the end of the year under consideration, this is classified as a turnover. We highlight for the reader two limitations to this analysis which, however, are unlikely to affect the ultimate inferences. First, the method used to identify turnovers may assign a turnover to a year when the new CEO was in fact in office for a large part of the year. More generally, there are necessarily imperfections in the association of the time period, for which performance and turnover are observed. Second, we cannot here distinguish between voluntary and truly forced turnovers. Certainly, some of the turnovers are voluntary. Companies very rarely explicitly state that the board has fired the CEO. The academic literature has resorted to various intricate methods of distinguishing forced and voluntary turnover, but these measures are necessarily imperfect. Some seminal studies use overall turnover as a proxy. For lack of better data, we therefore also use the overall turnover rate in this analysis. To the extent that CEOs are less likely to be fired when performance is good and that the imperfection in the alignment of the timing between observed performance and the firing decision is random across companies, our analysis of the turnover-performance sensitivity will be subject to noise. Such noise would make it less likely to find a relationship between turnover and performance. In this sense, to the extent that we do find a relationship, the results are more compelling.

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Turnover levels by shareholder value created

Bottom tercile rel. TSR Middle tercile rel. TSR Top tercile rel. TSR

Figure 7: CEO turnover is substantially higher when relative share price performance is lower

Figure 7 shows how turnover and total shareholder performance are related. Again, we use the industry-adjusted share price performance as an indicator of the overall performance.

The first three columns show that the probability of a CEO turnover increases when performance is weaker. Specifically, turnover is by far the highest in the lowest relative TSR tercile. At 20.7%, it is substantially higher than the turnover probability in the second and third terciles, at around 13.9%.

The sensitivity of CEO turnover to relative share price performance is very pronounced among the SMIM companies and somewhat pronounced among small-cap companies. By contrast, Figure 7 suggests that it is not operational among SMI firms. This is somewhat puzzling and may raise concerns. One should also note, however, that the consequences to an SMI CEO, if there is a turnover, are, in Swiss Franc terms, substantially more severe than for an SMIM or a small-cap CEO because SMI top management compensation is much higher than for SMIMs or small caps. Thus, even where probability is relatively small, chance can have substantial incentive effects. Moreover, additional analysis, not shown in the figure but available on request, shows that SMI CEO turnover is actually very sensitive to operating performance, that is, internal performance measures. Specifically, in the lowest tercile of industry-adjusted return on assets (ROA), a CEO turnover occurs with 22% probability in SMI firms, while in the highest tercile it occurs with only 12% probability.

Figure 7 also shows that financial-services firms exhibit a somewhat higher turnover-performance sensitivity than companies in other sectors. For example, in a poor performance year, the turnover probability is 23.9%, more than ten percentage points higher than in a strong performance year.

For companies, our advice is to plan ahead actively for the possibility of a CEO turnover (and indeed also of other executives). With high probability, a board which serves for six years, say, will experience at least one CEO change. Every company can be hit by a storm and boards are sometimes forced to find a more suitable CEO if circumstances change. Besides grooming an appropriate pool of potential successors, a central task of the remuneration and governance committee(s) is to have a clear policy in place on, for example, how unvested shares will be treated before a turnover occurs. The disclosure of compensation and the preparation of both prospective and retrospective say-on-pay votes can be significantly affected by CEO turnover, depending on the voting regime in place.

Turnover levels by shareholder value created

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2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Average percentage of base salary (dashed lines) and equity-based pay (solid lines)

SMI SMIM Small-cap SMI SMIM Small-cap

Equity exposure of executives – the wealth leverA third pay-for-performance channel derives from a wealth effect: CEOs who hold a substantial equity stake in their firm are directly exposed to changing shareholder value. CEOs acquire equity either through compensation or by buying shares (voluntarily or due to shareholding guidelines).

As for compensation with equity, Figure 8 shows the development of pay structure over time. In SMI companies, over the years base salary has rarely accounted for more than 30% of the total, the equity-based element never less than 30% (and often close to, or more than, 40%). Indeed, the average percentage of equity-based compensation has been increasing steadily from around 36% in 2010 to 48% in 2015, though it has fallen to just below 40% in 2016. As of now, it is not clear whether this is a temporary dip or the beginning of a more long-term shift in pay structure. In SMIM companies, from 2008 to 2012 base salary (around 35–40%) was a much more important component of compensation than equity-based compensation (around 25%). But these companies, too, are tending towards increased use of equity-based pay for their CEOs. As a consequence, in 2013 to 2016 equity-based pay and base salary both represented around 30% of total compensation. In small-cap companies, equity-based compensation is still at a low level, less than 20%, and has not increased noticeably over the study period. Here, as a rule more than 40% of total compensation derives from base salary.

Figure 8: A higher fraction of compensation is given in the form of equity in larger than in smaller firms

Average percentage of base salary (dashed lines) and equity-based pay (solid lines)

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CEO Equity wealth as a multiple of base salary (medians)

SMI SMIM Small-cap SPI Price Index

Figure 9: The wealth lever has increased substantially over time, indicating strong exposure of CEO wealth to shareholder wealth

As for executive share ownership, shareholding guidelines are more frequent among large-cap companies than among smaller firms. For example, in 2015, 14 out of 20 SMI companies had shareholding guidelines for their executives, but only 5 out of 27 SMIM companies had such guidelines. For board members, 6 out of the SMI companies had guidelines, and only 2 of the SMIM companies had guidelines.

To assess the importance of wealth incentives, we compute, for each CEO, the ratio of wealth to base salary. Figure 9 plots the median of the resulting ratios in the three size groups. In interpreting the results in this section, it is important to keep in mind that the numbers reported here include all shares reported by the companies as shareholdings; they do not include options.

Figure 9 shows that, consistent with international trends, Swiss CEOs of large companies are holding increasing multiples of base salary as equity. While in 2009, the median ratio of equity wealth to base salary was around 2 for both SMI and SMIM companies, respectively, this ratio has increased to 4 and 5, respectively, in 2016. In 2015, the ratio had been above 7 for SMI companies, but it has fallen in the last year. This observation is partially driven by the small number of observations, so should not be overinterpreted. Interestingly, in small-cap companies, equity ownership has been relatively stable throughout the sample period. The graph also shows the development of the SPI price index, which is normalised to 1 for the year 2007.1 The graph suggests that the general development of the stock market explains relatively little of this overall development for SMI and SMIM companies.

1 For this analysis, the price index, not a total return index is relevant. We compute a version of the index which allows one to compare from year to year the increase in the general stock market value, that is, each year, we add the percentage point change of the current year to the index level of the previous year. This is not a buy-and-hold strategy from 2007, which would not be the appropriate comparison for this analysis.

CEO equity wealth as a multiple of base salary (medians)

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Summary and outlook to part 3In sum, several channels contribute to an alignment of executive pay and performance: direct pay-for-performance (variable compensation; “bonuses”), greater job stability in response to stronger performance, and the wealth lever. Not all channels are operating at all times, but a board needs to have an overview of the mechanisms at its disposal. It should do so both (a) for internal management purposes as well as (b) in external communication.

Internally, we recommend that compensation committees and boards adopt a holistic view, rather than one narrowly focused on “bonuses”. As our analysis demonstrates, other factors – the turnover-performance sensitivity, or the wealth-performance sensitivity – may well be quantitatively more important. Our experience suggests that companies should make sure that they do not spend an inordinate amount of time on fine-tuning the specifics of the yearly incentive programme, when the implicit incentives due to other sources receive much less attention.

Externally, too, a holistic value reporting and communication with stakeholders allows for – and indeed requires – a broad, overall picture of how the board assesses executive performance, and how it uses the various channels of securing alignment.

The analysis here raises broader questions: How should an effective incentive system be designed? How should it be communicated? Find out about our views in PwC’s Executive Compensation and Corporate Governance Insights 2017, part 3.

Dr. Robert W. KuipersPartner, People & OrganisationPwCrobert.kuipers@ch.pwc.com+41 58 792 45 30

Remo SchmidPartner, People & OrganisationPwCremo.schmid@ch.pwc.com+41 58 792 46 08

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Prof. Alexander F. Wagner, PhDIndependent Counsel People & OrganisationSwiss Finance Institute University of Zurichalexander.wagner@bf.uzh.ch

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