Nearly three months after President Trump signed the Tax Cuts and Jobs Act (“Tax Reform”) into law, company management, Compensation Committees, and outside advisors have been evaluating the impact the notable changes to Internal Revenue Code Section 162(m) (“Section 162(m)”) will have on executive compensation.

Tax Reform now eliminates the loophole of exceptions of performance-based pay and expands the list of “covered employees.” With these changes, companies face the challenge of understanding what impact this will have on their executive compensation programs, often specifically designed to qualify for the performance-based tax deduction, and the loss of tax deductibility.

Section 162(m) was first passed into law in 1993, with the intent to rein in executive compensation by eliminating the tax deductibility of executive compensation above $1 million for “covered employees”, effectively named executive officers (NEOs), unless the compensation was performance-based. The purpose of the tax law was to “punish” firms paying excessive executive compensation; however unforeseen was the performance-based loophole that has led to the unintended consequence of increased executive compensation post-1993.

Flash forward to 2018; 25 years later, Tax Reform now eliminates the loophole of exceptions of performance-based pay and expands the list of “covered employees.” With these changes, companies face the challenge of understanding what impact this will have on their executive compensation programs, often specifically designed to qualify for the performance-based tax deduction, and the loss of tax deductibility.

This article explores CAP’s perspective on the implications of these significant changes on compensation programs in 2018 and beyond.

Highlights of the Changes to Section 162(m)

Change: The new rule expands coverage to include any person serving as the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) during the tax year, as well as the three highest paid executive officers other than the CEO and CFO (commonly referred to as NEOs). If a “covered employee” is paid $1 million a year in base salary, that is all the company will be able to deduct and annual performance-based bonuses, stock options, performance-based equity and deferred compensation will no longer be deductible.

Previously, a covered employee was an employee who, on the last day of the company’s fiscal year, was the CEO and the highest four paid executive officers. The CFO was excluded due to a change in the SEC’s definition of an NEO in 2006. Under the Tax Reform, CFO’s will be considered a covered employee as SEC and Section 162(m) rules now align.

CAP Perspective on Incentive Plan Design: We do not expect wholesale changes to compensation arrangements for executives.

The table below highlights the potential impact on the three major elements of pay for executives.

Pay Element

Impact on Plan Design

Salary

  • We do not expect significant changes to base salaries
  • We may see some companies who have historically capped salary at $1 million slowly exceed it
  • Driving force in setting base salaries is market competitiveness and not tax deductibility
  • Expect to continue to see base salary represent 15-20% of the total pay mix for executives

Annual Incentive

  • We expect companies to maintain the performance-based design of annual incentive plans, and many to keep current design features (i.e., goal attainment plans, threshold, target and maximum payout opportunities)
  • Investors and proxy advisory firms endorse transparent and performance-based plans and therefore we do not expect these types of plans to go away
  • Companies will now have more flexibility in simplifying incentive plan design and administration
    • Ability to use either negative or positive discretion on final bonus payouts; previously only negative discretion was permitted under the old tax code
    • Ability to adjust performance goals for any unforeseen circumstance that impacts the financial results; any adjustment to a performance goal will not need to be objective and stipulated in advance
    • However, companies will still need compelling rationale for use of discretion or adjustments to address shareholder expectations
  • Individual performance metrics and other more qualitative metrics may increase in prevalence as measures no longer need to be ‘objective’
  • Expect to continue to see annual incentives represent 25-30% of the total pay mix for executives

Long-Term Incentive (LTI)

  • While the elimination of the performance-based exception removes a tax incentive to grant stock options, we expect that companies that currently use stock options will continue to do, as they attract, motivate and retain talent
    • We expect any shifts away from stock options due to lost tax deductibility to be very modest
  • We expect performance-based LTI to continue to represent at least 50% of the total LTI mix
    • Performance-based compensation will still be an important tool in supporting business objectives
    • Proxy advisory firms and institutional investors alike still expect to see companies align pay and performance, with performance-based LTI representing the largest piece of the pie at >50%
    • Similar to annual incentives, we may see modestly more discretion and adjustments with accompanying rationale
  • We may see some companies adopting longer vesting schedules to spread out the income realized to maximize tax deductibility
  • Restricted stock often reflects a smaller piece of the LTI pie for the most senior executives as they are viewed as less performance based; we do not expect that to change
  • Expect to continue to see LTI represent the largest piece of the total pay mix at 60-65% of the total pay mix for executives

CAP Perspective on Administrative Requirements: Going forward, companies no longer need to follow certain administrative requirements around incentive plans and may need to revisit severance payment timing as certain practices were adopted based on the old tax code.

Additionally, once an executive is a covered employee, they will always be considered a covered employee, even if they appear in the proxy for just one year. Thus, compensation of covered employees for all future years of employment will be impacted, potentially creating an ever-growing group of covered employees subject to the $1 million cap.

The table below highlights the potential impact on these three key areas.

Administrative Requirements

Impact on Plan Design

Incentive Plans

  • Stockholder re-approval of incentive plans every 5 years are no longer necessary
  • Approval is only necessary when there is a need to increase shares available, the plan term is set to expire or if there are changes in the plan document
    • Companies will likely be adopting new plans, rather than amending existing plans to minimize the risk of losing the grandfather status which is further explained later in this article
  • Tax Reform removes the following:
    • Requirement for shareholders to approve performance metrics and adjustments of performance goals
      • Companies will be able to use any performance metrics and will not be limited to the shareholder-approved performance goals and adjustments
    • Requirement to set goals within the first 90 days of a performance period
      • We do not expect this to change given this is a formality for most companies though it gives committees and management more flexibility if needed
    • Shareholder approval of individual award limits (other than incentive stock options); however, shareholders may view the elimination of these limits negatively

Severance Payments

  • Previously, payments to executives leaving the company were fully tax deductible, as it only applied to NEOs who were employed on the last day of the taxable year in which the deduction was being claimed
  • Under Tax Reform, severance payments, including distribution of deferred compensation are subject to the deduction limitation
  • Bonuses or performance-based LTI can now be paid out at target in the year of termination without a different tax consequence; prior to Tax Reform, a company could only claim a tax deduction if the payout was based on actual performance

List of Covered Employees

  • The list of covered employees can now grow and may have tax implications of compensation and severance arrangements from an expanded group that will increase over time
  • To the extent possible, companies should try to have a consistent or narrow group of NEOs
  • Companies will want to be careful about unintentionally moving an executive into the proxy for a one year due to one-time payments
    • If possible, companies should structure those one-time payments in a way that would not cause an individual who would not typically be one of the three highest compensated executive officers to become an NEO for just one year
    • Companies need to maintain an ongoing list of all “covered employees” and monitor the compensation arrangements that apply to such individuals

Change: Tax Reform included some transition relief. The elimination of the performance-based exception applies to taxable years beginning after December 31, 2017. However, the changes do not apply to compensation provided pursuant to a written binding contract in effect as of November 2, 2017, and are not “modified in any material respect” as of November 2, 2017.

CAP Perspective: Under the “transition rule,” deductibility is preserved for compensation provided under a written binding contract in effect as of November 2, 2017, as long as there is not a subsequent material modification. At this time, it is not clear how the transition rule will be interpreted and implemented. While we await further clarification, companies will have to evaluate if they plan to claim a tax deduction under the transition rule based on the limited guidance provided to date, and the specific facts related to the grants / award agreements. During this waiting period, companies should carefully consider any changes to existing arrangements, including outstanding long-term incentive grants, as they could disqualify those arrangements from being grandfathered under the transition rule.

Change: Prior to Tax Reform, under Section 162(m) the definition for “outside directors” was different than the stock exchange rules of “independent directors.” The difference is that a former officer could never be considered an outside director but can be independent.

CAP Perspective: The Compensation Committee can now include independent directors who are not “outside directors”. We are not seeing companies make changes at this time, as they still need to approve (outstanding) payouts that are grandfathered under annual incentive or performance-based plans. However, we still expect the Compensation Committee to be comprised of “outside directors” given the independence factors. Companies may want to amend Compensation Committee charters to remove any references to Section 162(m) outside director or procedural requirements.

Planning for 2018 and Beyond

Beginning in 2018 companies will lose the tax deduction on compensation over $1 million for covered employees; however, the reduced corporate tax rate will provide an offset to the lost deduction. As companies evaluate the effect of the lost tax deduction and full impact of Tax Reform on their compensation programs, we would recommend companies to work with outside advisors to determine the impact the changes will have their compensation program design, particularly grandfathered performance-based compensation arrangements.

Companies should await further guidance from the IRS, proxy advisory firms and stock exchanges before making substantial changes to their compensation programs. Any change should ensure the appropriate behaviors and results are being rewarded, performance targets are reflective of the long-term strategy, and incentive plan design supports current business needs, while considering good governance practices.

Compensation Advisory Partners (CAP) reviewed executive compensation pay levels and trends at 50 companies (Early Filers) that filed their most recent proxy statement between November 2017 and January 2018 (fiscal year ends from July 2017 to October 2017; 35 companies have September 30 fiscal year ends). Industry sectors reviewed include: Consumer Discretionary, Consumer Staples, Financials, Health Care, Industrials, Information Technology and Materials. Among these 50 companies, median Revenue was $7.5B, median Market Capitalization (based on each company’s fiscal year-end) was $13.0B and 1-year Total Shareholder Return, or TSR (based on each company’s fiscal year-end) was 19.3%.

Overall Findings

Performance: 2017 performance (based on Revenue growth, EBIT growth, EPS growth and 1-year TSR) was strong. Revenue and EBIT grew by approximately 6%, EPS was up 4% and TSR was up nearly 20% vs. prior year.

CEO Pay: Median CEO pay increased slightly by 3.3% mainly driven by actual annual incentive payouts. The grant date value of long-term incentives (LTI) was generally flat.

Annual Incentive Payout: Overall, the median 2017 annual incentive payout was 115% of target, reflective of strong financial performance.

2017 Performance

CAP reviewed Revenue growth, EBIT growth, EPS growth and TSR performance for the Early Filer and the S&P 500 companies. Overall, 2017 median performance for Early Filers was strong. Revenue and EBIT grew approximately 6%, EPS grew around 4% and TSR was up nearly 20%. TSR among the Early Filers showed double-digit growth for the second year in a row; this growth is due to strong financial performance as well as market expectations around tax reform in light of the current political climate.

Financial Metric (1)

2016 Median 1-year Performance

2017 Median 1-year Performance

S&P 500

Early Filers

S&P 500

Early Filers

Revenue Growth

2.1%

2.0%

6.3%

5.7%

EBIT Growth

2.2%

7.6%

6.6%

6.0%

EPS Growth

4.2%

5.2%

9.9%

3.9%

TSR

3.3%

18.4%

17.0%

19.3%

(1) TSR and Financial performance for the S&P 500 is as of September 30, 2016 and September 30, 2017. Financial performance and TSR for Early Filers is as of each company’s fiscal year end.

CEO Total Direct Compensation

Among Early Filers with CEOs in their role for at least two years (n=39), median total direct compensation increased 3.3%. This increase was mainly due to higher actual annual incentive payouts in 2017; the grant-date value of LTI was generally flat year over year. Actual annual incentive payout was up nearly 4% reflective of strong financial performance while LTI, the largest component of CEO pay, was up only 1%. Median base salary for CEOs in our sample was unchanged from 2016.

3.3% 0.6% 6.2% 3.8% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 1-Year Median Change in CEO Compensation Actual Annual Incentive Actual Total Cash Grant-Date LTI Value Total Comp

Annual Incentive Plan Payout

The median actual annual incentive payout in 2017 was 115% of target, higher than the median payout in 2016 of 106% of target. In fact, the 25th percentile bonus payout in 2017 was at target, noticeably higher than last year (86% of target).

Summary Statistics

Annual Incentive Payout as a % of Target

2015

2016

2017

75th Percentile

134%

141%

147%

Median

106%

106%

115%

25th Percentile

97%

86%

100%

Performance for companies with at or above target annual incentive payouts was substantially stronger than that of companies with below target payouts. Companies with payouts at or above target had strong EPS (10.9%) and TSR (23.2%) growth and solid Revenue (6.3%) and EBIT (7.2%) growth. Performance for companies with below target payouts was flat or declining from prior year.

Financial Metric (1)

2016 Median 1-year Performance

2017 Median 1-year Performance

Below target payout (n=21)

At/above target payout (n=29)

Below target payout (n=12)

At/above target payout (n=38)

Revenue Growth

(0.7%)

3.0%

2.1%

6.3%

EBIT Growth

(2.8%)

15.9%

1.0%

7.2%

EPS Growth

(3.9%)

16.9%

(4.3%)

10.9%

TSR

16.9%

19.6%

(3.9%)

23.2%

(1) Financial performance and TSR is as of each company’s fiscal year end.

76% of companies in 2017 provided a payout at or above target which is considerably higher than 2016 and 2015 (58% and 62%, respectively). In 2017, significantly more companies provided a payout between 100 – 150% of target than below target. This distribution is more evenly split in prior years. The distribution of payouts in 2017 aligns with stronger overall performance than 2016 and 2015.

8% 10% 8% 30% 32% 16% 42% 38% 54% 20% 20% 22% 2015 2016 2017 Annual Incentive Payout as a Percentage of Target < 50% 50% - 100% 100% - 150% > 150%

Incentive Plan Design

Among Early Filers, 75% of companies use 2 – 3 financial metrics in the annual incentive plan and nearly 83% use 1 – 2 measures in the LTI plan.  Metrics in the annual incentive plan typically focus on growth and profitability, while LTI plans are more likely to reward executives based on profits, return measures or stock price performance. A growing number of companies are beginning to use non-financial strategic goals, primarily diversity and inclusion and creating a more engaged workforce, in the annual incentive plan design. With the recent amendment to 162(m) due to the Tax Cuts and Jobs Act, we anticipate more companies will use strategic measures and individual objectives to reward executives in the future.

As performance-based compensation continues to be championed by both shareholders and proxy advisory firms, the use of performance-based LTI continues to be very prevalent. Performance plan usage remains high, at 90% of Early Filers. Option use declined among the Early Filers (54% down from 62%) and shifted to use of restricted stock.

86% 66% 62% 54% 30% 16% 90% 76% 54% 52% 34% 14% Perf Awards Time-basedRS/RSU Stock Options 2 Vehicles 3 Vehicles 1 Vehicle LTI Prevalence 2016 2017 Vehicle Prevalence Vehicle Mix

TSR continues to be the most prevalent LTI metric, with approximately 60% of companies using a performance-based plan with this metric. Of the companies that use TSR, 25% use it as a modifier, 50% use it as a stand-alone metric in conjunction with a financial measure and 25% use it as the sole measure. The prevalence of TSR as the sole measure has decreased somewhat over the last several years as companies use a balanced approach to reward executives for long-term financial and stock price results. We anticipate its usage as a sole measure to plateau or continue to decline particularly given ISS’ recent shift towards the use of other financial measures in its quantitative pay for performance assessment (ISS and Glass Lewis Policy for the 2018 Proxy Season).

Governance Practices

Over the last decade, many companies adopted good governance practices. Increased scrutiny from shareholders and proxy advisory firms has quickened the pace with which companies incorporated clawback, or recoupment, policies as well as hedging and pledging policies. It is no surprise that more than 90% of companies in our sample have a clawback policy in place. 85% of companies also have implemented hedging and pledging policies for their executives.

Nearly all companies (96%) in our sample have stock ownership guidelines in place; these guidelines encourage executives to hold a meaningful equity stake and align with shareholder interests. The guideline is most commonly expressed as a multiple of salary, with a median CEO multiple of 5x base salary and other NEOs with a multiple of 3x base salary. About one-third of companies also require executives to hold stock (typically 50 – 100% of net shares received) until stock ownership guidelines are met. It is less common for companies to require executives to hold shares for a period of time (e.g., 1 year) in lieu of stock ownership guidelines. Good governance practices continue to be a focus of shareholders, and companies are routinely implementing and updating policies as appropriate in the current regulatory environment.

Conclusion

2017 was a year of strong financial performance for the Early Filers, which resulted in above target annual incentive payouts for approximately 75% of companies. CEO actual total cash compensation increased by 6%, and when combined with generally flat LTI award values, total pay increased by 3%.

2018 will be the first performance year after the passage of tax reform. We do not expect companies to unwind their use of performance-based pay and good governance practices, yet we foresee greater use of individual and strategic performance measures, along with increased use of discretionary pay decisions, in moderation.


For questions or more information, please contact:

Lauren Peek Principal
lauren.peek@capartners.com 212-921-9374

Joanna Czyzewski Associate
joanna.czyzwski@capartners.com 646-486-9746

Melissa Burek Partner
melissa.burek@capartners.com 212-921-9354

Each year CAP analyzes non-employee director compensation programs among the 100 largest companies. We believe these companies provide insight into where the market will be going in terms of practices. This report is a summary of trends – for pay levels and pay practices – based on 2017 proxy filings.

CAP Findings

Board Compensation pay levels increased modestly

  • Total Fees. Increased 3 percent (median is $290K, versus $282K in prior year); board compensation has reached a steady state, and low single digit increases have been and are expected to continue to be the norm.
  • Retainers. Large companies rely on annual retainers (cash and equity) to compensate directors. Pay programs are typically simple and tend to rely less on meeting fees or committee member retainers.
  • Meeting Fees. Paid by only 11 percent of companies, consistent with prior year. In general, companies have moved to a fixed retainer pay structure, with a component in cash and a component in equity. We support this approach as it simplifies administration and eliminates the need to define “what counts as a meeting.” However, companies may want to consider having a mechanism for paying meeting fees if the number of meetings in a single year far exceeds the norm (“hybrid approach”). Five companies in our dataset used this approach to meeting fees, with the threshold ranging between 6 and 10 meetings.
  • Equity. Full-value awards (shares/units) are most common; only 7 percent of companies used stock options. 97 percent of companies denominated equity awards as a fixed value, versus a fixed number of shares, which is considered best practice as it manages the value awarded each year. Approximately two-thirds of equity awards vest within 1 year of grant (either immediately or cliff vest after 1 year).
  • Pay Mix. On average, 61 percent equity-based and 39 percent cash-based, consistent with prior year. Alignment with long-term shareholders is reinforced by delivering a majority of board compensation in equity.

Committee Member Compensation little/no change

  • Overall Prevalence. Half of companies paid committee-specific member fees for Audit Committee service and approximately one-third of companies paid member fees for Compensation or Nominating/Governance Committee service. The majority of companies rely on board-level compensation to recognize committee service, with the general expectation that all independent directors contribute to committee service needs1.
  • Total Fees. Of the companies that paid committee member compensation, the median was $17.8K.

Committee Chair Compensation higher Audit Chair premium

  • Overall Prevalence. More than 90 percent of companies provided additional compensation to committee Chairs, typically through an additional retainer and not meeting fees, to recognize additional time requirements, responsibilities, and reputational risk.
  • Fees. Median additional compensation for Audit Committee Chairs increased to $25K from $20K last year. Median additional compensation for Compensation and Nominating/Governance Committee Chairs was $20K and $15K, respectively, consistent with prior year.

Independent Board Leader Compensation higher Lead Director premiums

  • Non-Exec Chair. Additional compensation is provided by all companies with this role, $220K at median. As a multiple of total Board Compensation, total Board Chair pay is 1.83x a standard Board member, at median.
  • Lead Director. Median additional compensation increased to $35K, up from $30K in the prior year. Additional compensation is provided by nearly all companies with this role2. The differential in pay versus non-executive Chairs is in line with typical differences in responsibilities.

Pay Limits prevalence of limits continues to go up

  • Similar to last year, a majority of companies (55%) that amended or adopted an equity plan in 2017 – that did not already have a limit in place – implemented an award limit for director compensation.
  • In total, 47 percent of the largest 100 companies now have such limits, up from 39 percent in the prior year.
  • Limits range from $250K to $4.7 million, with the median limit being at $750K. Companies that denominate the limit in shares tend to have a higher dollar-equivalent limit, with a median of $1M. The median for the companies with value-based limits is $600K.
    Limit Range Prevalence
    <= $500,000 28%
    $500,001 – $1,000,000 55%
    $1,000,001 – $2,000,000 13%
    > $2,000,001 4%
  • The limits tend to be much higher than annual equity grants. Approximately 72% of limits are greater than 3x the annual equity grants.
    Limit Multiple Range Prevalence
    <= 3x annual equity 28%
    3.01x – 5x annual equity 36%
    5.01x – 7x annual equity 25%
    > 5x annual equity 11%
  • Limits typically apply to just equity-based compensation; however, some companies have applied the limits to both cash and equity-based compensation (i.e., total pay) and we anticipate the prevalence of this practice will increase further. Other companies exclude initial at-election equity awards, committee Chair pay, and/or additional pay for Board leadership roles from the limit.
  • The limits are largely due to advancement of litigation where the issue has been that directors approve their own annual compensation and are therefore deemed to be inherently conflicted.

Appendix

Range between 25th and 75th percentiles Median Value

Total Board Compensation ($000s)3

$250 $260 $274 $265 $282 $290 $293 $300 $319 $225 $275 $325 2014 2015 2016

Additional Compensation for Independent Board Leaders ($000s)

$325 $200 $200 $193 $225 $225 $220 $281 $288 $275 $125 $175 $225 $275 2014 2015 2016 $50 $25 $26 $29 $30 $30 $35 $40 $20 $30 $40 2014 2015 2016 Lead/Presiding Directors Non-Executive Chairs $50 $50

Total Company Cost for Board Service ($000s)

$2,525 $2,648 $2,674 $2,955 $3,160 $3,130 $3,290 $3,490 $3,669 $2,250 $2,500 $2,750 $3,000 $3,250 $3,500 $3,750 $4,000 2014 2015 2016

1 Audit, Compensation and/or Nominating and Governance committees.

2 Excludes controlled companies. Also excludes instances where Lead Director role is assumed by Chair of Nominating and Governance Committee, who receives compensation for the role.

3 Total Board Compensation reflects all cash and equity compensation for Board and committee service, excluding compensation for leadership roles such as committee Chair, Lead/Presiding Director, or non-executive Board Chair.

On a panel of leading executive compensation experts, Margaret Engel discusses some of the top executive compensation issues and trends including: the current public mistrust of executive compensation programs, the importance and the rigorous process of target goal setting, the challenges that many companies face with long-term performance awards, and the likely increase in the use of performance-based stock options in the future.

Each year CAP analyzes non-employee director compensation programs among the 100 largest companies. We believe these companies provide insight into where the market will be going in terms of practices. Below is a summary of trends – for pay levels and pay practices – based on 2016 proxy filings.

Key CAP Findings

Board Compensation. pay levels went up

  • Total Fees. Increased 6 percent (median is $282K, versus $265K in prior year), which is the biggest single year increase we have seen in more than 4 years, though still within historic norms
  • Retainers. Large companies rely on annual retainers (cash and equity) to compensate directors. Pay programs are typically simple and viewed more as an “advisory fee” than an “attendance fee.”
  • Meeting fees. Provided by only 11 percent of companies (versus 12 percent in prior year). In general, companies have moved to a fixed retainer pay structure, with a component in cash and a component in equity. We support this approach as it simplifies administration and the need to define “what counts as a meeting.” However, companies may want to consider having a mechanism for paying meeting fees if the number of meetings in a single year far exceeds the norm. For example, if the number of meetings is well above historic norms (e.g., 12 meetings/year), companies could consider paying meeting fees above a specified number of meetings. Three companies in our dataset use this approach to meeting fees.
  • Equity. Full-value awards (shares/units) are most common. Only 8 percent of companies use stock options with, surprisingly, only one of these companies being in the traditional technology sector. 97 percent of companies denominate equity awards (stock or options) as a fixed value, versus a fixed number of shares, which is considered best practice as it manages the value each year. Approximately two-thirds of equity awards vest within 1 year of grant (either immediately or cliff vest after 1 year). Nearly 60 percent of equity awards settle at vest, with the remainder settling at or post retirement.
  • Pay Mix. On average, 61 percent equity-based versus 39 percent cash-based. Alignment with long-term shareholders is reinforced by delivering a majority of compensation in equity.

Committee Member Compensation. little/no change

  • Overall Prevalence. Only 48% of companies paid committee-specific member fees, relying on board-level compensation to recognize committee service, with the general expectation being that all independent directors contribute to committee service needs1.
  • Total Fees. Of the companies that pay committee member compensation, the median is $16.8K.

Committee Chair Compensation. little/no change

  • Overall Prevalence. Approximately 90 percent of companies provide additional compensation to committee Chairs, typically through an additional retainer and not meeting fees, to recognize additional time requirements, responsibilities, and reputational risk1.
  • Fees. At median, $20K in additional compensation (vs. members) was provided to Audit and Compensation Committee Chairs, and $15K additional to Nominating/Governance Committee Chairs.

Independent Board Leader Compensation. little/no change

  • Non-Exec Chair. Additional compensation is provided by all companies with this role, $225K at median. As a multiple of total Board Compensation, total Board Chair pay is 1.9x a standard Board member, at median.
  • Lead Director. Additional compensation – $30K, at median – is provided by nearly all companies with this role3. The differential in pay versus non-executive Chairs is in line with typical differences in responsibilities. 75th percentile additional compensation was $50K, up from $40K last year and up from $35K two years ago.

Pay Limits. prevalence of limits went up

  • There were 17 companies in our data set that amended an equity plan this year; 2 of these companies already had a shareholder approved limit in place for director compensation. Among the remaining 15 companies, 9 of them (60 percent) implemented a new shareholder approved limit for director compensation.
  • In total, 39 percent of the largest 100 companies now have such limits, up from 27 percent in prior year.
  • Limits range from $250K to $3.6 million, and were $760K at median. Among companies that denominate the limit in shares, the median is $1.05M, while the median for the companies with value-based limits is $525K.
  • Limits typically apply to just equity-based compensation; however, some companies have applied the limits to both cash and equity-based compensation (i.e., total pay) and we anticipate the prevalence of this practice will increase further. Other companies exclude initial at-election equity awards, committee Chair pay, and/or additional pay for Board leadership roles from the limit.
  • The limits are largely due to advancement of litigation where the issue has been that directors approve their own annual compensation and are therefore inherently conflicted. Companies have a stronger legal defense – protecting them under the business judgement rule – by having “meaningful limits” approved by shareholders on the maximum award that could be granted to a director. The “business judgment rule” is judicial presumption that directors acted “on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” An action protected by the business judgment rule will not be second-guessed by the courts. There is a chance that the business judgement rule can be called into question without a meaningful limit. When the business judgment rule does not protect directors’ awards of compensation to themselves, the awards are subject to heightened scrutiny under the “entire fairness test” under which both the process and the amount of the compensation must be found to be entirely fair to the company.

Appendix

Total Board Compensation ($000s)

Equity Compensation

Equity Vehicle

2013

2014

2015

Full-Value Equity (Shares/Units)

95%

96%

92%

Stock Options

2%

1%

1%

Both

3%

3%

7%

Award Denomination

2013

2014

2015

Fixed Valued

88%

90%

92%

Fixed Shares

8%

6%

3%

Both

4%

4%

5%

Additional Compensation for Independent Board Leaders ($000s)

Lead/Presiding Directors

Non-Executive Chairs

Total Company Cost for Board Service ($000s)


1 Audit, Compensation and/or Nominating and Governance committees.

2 Excludes controlled companies. Also excludes instances where Lead Director role is assumed by Chair of Nominating and Governance Committee, who receives compensation for the role.

For many years, common practice in U.S. public companies has been to combine the roles of chief executive officer (“CEO”) and chairman of the board (“COB”), typically assigning the COB title and responsibilities to the sitting CEO. More recently, due to increased focus on governance and risk management, companies frequently separate the two roles. In some cases, companies will transition outgoing CEOs to the COB role. The duties of a separate COB can vary a great deal between companies, and expectations for the role as well as time served in the role will impact compensation. This review focuses primarily on the transition from CEO to COB and highlights compensation practices and factors influencing pay.

Prevalence of COB Role

Based on a review of companies ranging from $1 billion to $20 billion in revenue, we found that approximately 10% of companies operate with an Executive Chair and 45% have a Non-Executive Chair. Among the 10% with an Executive Chair, approximately one-half are founders (or have significant ownership in the company, i.e., more than 15% of shares outstanding), and the majority were former CEOs. This fact pattern is a very rational and effective progression, providing a smooth transition and advantages to the new CEO, shareholders, and the company’s overall operating efficiency. In the case of Non-Executive chairs, it is more common for the role to be filled from outside the company or by a member of the board of directors.

The need for and role of a separate COB evolves for different reasons. The responsibilities and time commitment of this role can vary greatly by company. Many founders step out of the CEO role to reduce their time commitment, but continue on as COB for many years so they can oversee the results of the company and weigh in on the company’s performance and strategy. Alternatively, the board may ask an exiting CEO to stay on for a year to help with the transition to a new CEO and provide continuity to the organization. It may be that an exiting CEO stays on to oversee a major initiative that needs dedicated oversight. The role could evolve as a result of a spin-off from an existing public entity. While difficult to generalize, there are certain duties that may be a part of any separate COB role such as executive coaching and mentoring, succession planning, and long-term strategy development. The COB is most often an advisory role, with no oversight of daily operations. These responsibilities dictate the planned timing of the role itself, be it short or long-term service in the position.

Overall Pay Levels and Pay Practices for Chairman Role

Pay Levels

While there is variation in pay practices that we discuss below, our research shows that the following pay practices, expressed as a relationship between compensation of the Executive COB and CEO roles.

Pay Summary Stats

Scenario (at Median)

Base

Bonus

LTI

TDC

CEO Transition to Chairman

Chair Role Pay as a Percentage of Pay while Serving as CEO

~100%

~100%

~40%

~50%

Chair Role Pay as a % of New CEO Pay

95 – 105%

85 – 95%

55 – 65%

65 – 75%

Chairman that is founder/significant shareholder

Chair Role Pay as a % Current CEO Pay

~90%

~85%

~25%

~60

The background of the incumbent assuming the COB role may create some variations to pay levels and practices. For example, Executive Chairs that are founders/significant owners of their company make about 35% more, at median, than non-founder Executive COBs.

Pay Practices

We frequently see the following pay practices:

  • Since many COBs have transitioned from the CEO role and have accumulated a large equity stake, or are founders with significant equity ownership, equity compensation tends to account for a smaller portion of the compensation package when compared to current CEOs.
  • More companies grant stock options or restricted stock with time-based vesting, instead of granting long-term performance-based compensation. We believe time-based vesting is appropriate because the Executive COB role is often more advisory in nature, rather than contributing to operational decisions that impact long-term financial performance. There may also be uncertainty associated with the length of the role.
  • Equity awards may include a one-time grant or annual grants, depending on the estimated timeframe of the role. Vesting of equity awards is generally in installments over 3 or 4 years or vesting that aligns with the time in the role or the time that the Chair might remain an employee of the company.
  • Executive COBs most often participate in the company’s bonus program, using the same corporate performance metrics that apply to the CEO. Individualized metrics are rarely used.

Transition of an Active CEO to an Executive COB Role

When a successful, long-tenured Chairman and CEO begins to plan for retirement, companies may strategically approach the succession process over time. Boards may keep the retiring CEO on as an employee of the company, as Executive COB, for a period of time. This period allows for a smooth succession of responsibilities. It may also mitigate uncertainty about new leadership. It is possible that a Lead Director, outside Board member, or other executive may fill the role of Executive (or Non-Executive) Chair, yet most often the role is filled by a retiring CEO.

Executive Chair Scenarios and Fact Patterns Influencing Compensation:

While pay practices vary, there are considerations to be made as it relates to compensation based on the expected timing that the Chairman role will exist or that the individual incumbent will be in the role. There are some patterns in the compensation structure if the role is shorter or longer- term.

Fact Pattern

Practice

Short Time Period of COB Role (1-year or less)

  • Frequently, no adjustment is made to salary or annual incentive
  • If annual equity grant date is before the transition, vesting practices are mixed (some companies allow equity to vest according to plan, others use enhanced vesting)
  • If annual equity grant date is after the transition, companies tend to reduce (or eliminate) the equity grant

Longer Time Period of COB Role (more than 1-year)

  • Salary and annual incentive opportunity may be reduced
  • Equity may be decreased to 40% of what it was while serving as CEO

Executive COB whot is a Founder/Significant Shareholder

  • Generally paid approximately 35% more than Executive Chairman that are not founders/significant shareholders
  • Majority of pay is in the form of cash

Consultant or Special / Senior Advisor

  • At some companies, the CEO becomes a Consultant or Advisor
  • Typically receive salary, or provided special cash stipend or 1x LTI award depending on role and duration of assignment

Non-Executive COB – Executive COB, outside Director or New Hire transition

  • Receive normal Board cash and equity plus additional (premium) compensation for Chair duties in cash or equity. Amount depends on nature of role, hours worked, duration of role, and is often a multiple of the regular director cash or equity retainer

Executive COB Role – Short Time Period (1 year or less)

When a CEO transitions to an Executive COB role, planned for a shorter period of time, the CEO often changes roles near the end of the fiscal year or near the annual shareholder meeting. There tends to be minimal adjustment to the base salary or annual incentive target for this period in the role. If the annual equity grant has not been made for the year, companies tend to reduce the value of the equity award and the form of the award may be modified. Companies differ on the treatment of outstanding equity awards. There are two potential scenarios:

  1. The company may allow outstanding equity to vest normally, according to the plan (retirement vesting if the executive is eligible), or
  2. The company provides some type of “enhanced-vesting” for the time that the retiring executive serves as chairman

If the transition is made after the annual equity grant, companies tend not to decrease the equity grant amount in the year of the change. Companies should consider which approach is most appropriate given the vesting period that remains, the type of outstanding award (e.g., 10-year option, 3-year performance award), the cumulative value that the COB may receive due to any enhancement, and potential shareholder reaction.

Executive COB Role – Longer Time Period (Greater than 1 year)

When the Executive COB role is expected to be greater than one year, adjustments are made to the level of pay and the forms of compensation used. Overall, base salary and annual incentive targets may be 85% to 95% of the current CEO’s pay levels. Equity may be decreased to 40% of what it was while serving as CEO, resulting in total direct compensation that is 65% and 75% of the compensation of the current CEO.

Equity awards tend to have time based vesting and are commonly not tied to longer term company performance. Vesting schedules may be modified, if necessary, to align with the expected timeframe of the Executive COB’s service. Companies often make annual equity awards, yet those that have clarity around expected timeframes may grant one-time awards intended to cover the entire time in the role.

A related benefit for CEOs in this situation may be the continued vesting of large outstanding equity grants that were received while serving as CEO. When award vesting follows the normal course, shareholders and proxy advisory services firms may view this more favorably than enhanced vesting arrangements that may be provided when the CEO retires sooner.

Non-Executive COB Role

Non-Executive COBs have a smaller time commitment. They tend not to have a specific strategic or operational oversight role, yet they do lead the board of directors. Non-Executive COBs often serve as the primary liaison between the board and the CEO and provide additional leadership and guidance. Most commonly, Non-Executive COBs participate in the regular compensation program for the company’s outside directors and receive a premium. When the premium is added to the regular board compensation, median Non-Executive COB compensation is approximately 1.6x – 1.8x the compensation paid to regular outside directors.

Conclusion

Pay for Executive COBs varies a great deal and depends on a company’s particular situation. However, when specific situations are examined closely, patterns do emerge. For example, our research indicates that a COB who is a founder or significant shareholder tends to get paid more than COBs who are not founders or significant shareholders. We also found that exiting CEOs who transition into a COB role for a short period of time may frequently receive preferable equity vesting treatment. General pay norms will help provide direction, but the responsibilities, time commitment, incumbent’s tenure with the company, ownership status, etc. should all be factored into the compensation program provided.

Case Studies

Key CAP Findings

Board Compensation. little/no change

  • Total Fees. Generally flat year-over-year (median is $265K, versus $260K in prior year).
  • Retainers. Large companies rely on annual retainers (cash and equity) to compensate directors. Pay programs are typically simple and viewed more as an “advisory fee” than an “attendance fee.”
  • Meeting fees. Provided by only 12 percent of companies (versus 15 percent in prior year). In general, companies have moved to a fixed retainer pay structure, with a component in cash and a component in equity.
  • Equity. Full-value awards (shares/units) are most common and only four percent of companies use stock options. 94 percent of companies denominate equity awards (stock or options) as a fixed value, versus a fixed number of shares which is considered best practice as it manages the value each year.
  • Pay Mix. On average, 58 percent equity-based vs. 42 percent cash-based. Alignment with long-term shareholders is reinforced by delivering a majority of compensation in equity.

Committee Member Compensation. little/no change

  • Overall Prevalence. 45 percent of companies paid committee-specific member fees1.
  • Total Fees. Among companies paying committee member fees, the median is $15.5K.

Committee Chair Compensation. little/no change

  • Overall Prevalence. Approximately 90 percent of companies provide additional compensation to committee Chairs, typically through an additional retainer, to recognize additional time requirements, responsibilities, and reputational risk.
  • Fees. At median, $20K in additional compensation (vs. members) was provided to Audit and Compensation Committee Chairs, and $15K additional to Nominating/Governance Committee Chairs.

Independent Board Leader Compensation. little/no change

  • Non-Exec Chair. Additional compensation is provided by all companies with this role, $225K at median. As a multiple of total Board Compensation, total Board Chair pay is 1.84x a standard Board member, at median.
  • Lead Director. Additional compensation – $30K, at median – is provided by nearly all companies with this role2. The differential in pay versus non-executive Chairs is in line with typical differences in responsibilities. Median additional compensation was flat – $25K – for the five years prior to 2013 (median in 2013 was $28K).

Perquisites. little/no change

  • Prevalence. Overall, limited use. One-third of companies provide gift matching/charitable contribution.

Pay Limits. little/no change

  • 21 percent of companies that amended or adopted new equity plans in 2015 implemented specific limits for director compensation. In total, 27 percent of Fortune 100 companies now have such limits.

CAP Perspective

Board Pay Levels and Structure

We believe director compensation has leveled off – for the time being – and expect to see only modest increases in the next year.

In terms of pay program, fixed retainer structures are now the norm and meeting fees – already minority practice – continue to decline in prevalence as director compensation is now often viewed more as an “advisory fee” than an “attendance fee.”

Director Pay Limits

A number of companies have implemented limits on director compensation. The limits are largely due to advancement of litigation in Delaware court where the issue has been that directors approve their own annual compensation, and the shareholder approved long-term incentive plan did not provide “meaningful limits” on the maximum award that could be granted to a director.

Currently, 27 percent of companies studied (vs. 23 percent in prior year) have included limits for non-employee director compensation in their shareholder approved long-term incentive plan. These limits range from $250K to $3.5 million, $770K at median (vs. $800K in prior year), and typically apply to just equity-based compensation. Some companies have applied the limits to both cash and equity-based compensation, while others have excluded initial at-election equity awards, committee Chair pay, and/or additional pay for Board leadership roles from the limit.

We expect director pay limits to become majority practice within the next few years.

Lead Director Compensation

The Lead Director role has evolved, especially in companies where the CEO and Chairman roles are combined. For example, Boards are engaging in more outreach and meeting with shareholders to talk about governance practices, CEO succession and executive compensation, among other issues, and many investors want to hear from the Lead Director. Nearly all companies studied now provide additional compensation for the Lead Director role.3 However, additional compensation provided for the Lead Director role continues to be quite different than the non-executive Chair role. At median, an additional $30K was provided for the Lead Director role, versus $225K for the non-executive Chair role. The differential in pay is generally in line with typical differences in responsibilities.

Providing additional compensation to the Lead Director sends a signal to investors regarding expectations for the role, including time commitment, responsibilities, and authority. Many times, companies have been able to settle (or argue against) shareholder proposals to split the CEO and Chairman roles by instituting (or emphasizing) a strong Lead Director role and delineating the specific responsibilities of the position. Boards can also reassure investors concerned about overall governance practices at a company by increasing Lead Director responsibilities.

Best in Class Director Compensation Process & Practices

Best in Class

PROCESS

  • Establish pay levels and structure with consideration given to market data, trends and outlook
  • Define target market positioning for total pay
  • Generally, target should align with the executive compensation philosophy
  • “Market” should reflect the peer group used for executive compensation benchmarking and/or size-appropriate general industry data
  • Disclose the philosophy and rationale for the program
  • Use compensation as a tool to reinforce alignment of the interests of non-employee directors and long-term shareholders

Best in Class

PRACTICES

  • Align pay levels with organization size and complexity, considering organization-specific time commitments and responsibilities
  • Review director pay programs focusing on aggregate pay (Total Board Compensation), with consideration given to the ratio of cash compensation to equity compensation and additional pay for Board leadership roles
  • The pay program should be viewed as a “advisory fee” vs. an “attendance fee”
  • Structure pay so that equity represents at least half of the total
  • Establish meaningful equity ownership requirements
  • Eliminate benefit and/or perquisite programs unless a strong business case exists

Appendix

4


1 Audit, Compensation and/or Nominating and Governance committee members.

2 Excludes controlled companies. Also excludes instances where Lead Director role is assumed by Chair of Nominating and Governance Committee, who receives compensation for that role.

3 Excludes controlled companies. Also excludes instances where Lead Director role is assumed by Chair of Nominating and Governance Committee, who receives compensation for that role

4 Total Board Compensation reflects all cash and equity compensation for Board and committee service, excluding compensation for leadership roles such as committee Chair, Lead/Presiding Director, or non-executive Board Chair.