The past year has been characterized by significant stock price volatility. Research indicates that the S&P 500 index has either gained 1% or more or lost 1% or more in a single day on 102 days during 2015. Individual stocks have experienced even higher volatility, with some industries (e.g., oil and gas, financial services) being hardest hit. This extreme variability in stock prices has continued through the period when most companies make annual grants of equity-based compensation to their directors, officers and employees. Since the overall stock price movement over this period has been down, many companies are finding that they need to grant more shares than they anticipated to deliver their targeted long-term incentive values to employees. In this CAPflash, we will lay out the nature of the issue and address alternative approaches that companies can use to respond to stock price decreases.

Date

S&P 500

S&P 500 Financials Sector

S&P 500 Energy Sector

S&P 500 Health Care Sector

Value

? vs. 8/15

Value

? vs. 8/15

Value

? vs. 8/15

Value

? vs. 8/15

8/1/15

$2,104

$339

$508

$885

1/31/16

$1,940

-7.78%

$293

-13.56%

$435

-14.44%

$769

-13.03%

2/15/16

$1,865

-11.36%

$276

-18.69%

$417

-17.98%

$743

-15.97%

3/1/16

$1,978

-5.96%

$294

-13.33%

$433

-14.78%

$780

-11.79%

3/15/16

$2,016

-4.18%

$301

-11.24%

$458

-9.77%

$775

-12.44%

4/1/16

$2,073

-1.48%

$306

-9.64%

$456

-10.24%

$794

-10.28%

RECENT STOCK PRICES: A DOWNWARD TREND

In August 2015, around when many companies began their year-end compensation planning process, the S&P500 Index was at $2,104 and the S&P 500 Financials, Energy and Health Care sectors were at $339, $508 and $885, respectively. Scroll forward to January 31, 2016 and the S&P 500 Index was at $1,940 and the S&P 500 Financials, Energy and Health Care sectors were at $293, $435 and $769, respectively. The table below lays out the movements from August 1, 2015 into the current year, highlighting five common equity award dates.

While the overall indices moved significantly, the 25th percentile change through each of the above dates for companies in each of the above indices was as follows, indicating that for the lowest-performing one quarter of companies, stock prices fell by about 15% to 30%, or more, over this period.

Date

S&P 500

S&P 500 Financials

S&P 500 Energy

S&P 500 Health Care

25th %ile ? vs. 8/15

25th %ile ? vs. 8/15

25th %ile ? vs. 8/15

25th %ile ? vs. 8/15

8/1/15

1/31/16

-20.21%

-21.14%

-35.26%

-22.72%

2/15/16

-25.24%

-29.25%

-45.40%

-25.25%

3/1/16

-18.29%

-22.02%

-37.35%

-21.86%

3/15/16

-17.22%

-19.37%

-27.40%

-22.76%

4/1/16

-14.78%

-18.10%

-31.67%

-19.32%

MARKET NORMS FOR BURN RATE

CAP’s research indicates that burn rate (i.e., the number of shares granted during a given year divided by the weighted average number of common shares outstanding) among large public companies in the S&P 500 Index trends toward 1% of common shares outstanding when calculated excluding the factor of approximately 2X that ISS applies to full value awards to create equivalency with stock options. When the ISS conversion factor of approximately 2X is included, burn rate trends toward approximately 1.5% at median. On the lower end, burn rate of .5% or 1%, excluding or including the 2X conversion factor, respectively, is common. At the 75th percentile, burn rate of 2% to 4% is seen. This suggests that for a broad swath of public companies, ranging from $1 billion to $100 billion in revenues, burn rate in excess of 2% to 4% is difficult to sustain. Research on specific company peer groups could provide more refined comparisons, but this data gives the reader a general benchmark that applies across industries and size categories.

Summary Statistics

Three-Year Average Burn Rate (including ISS Conversion Factor)

S&P Top 50

S&P $5 B Cos.

S&P $1 B Cos.

75th Percentile

2.13%

2.55%

3.82%

Median

1.36%

1.70%

1.68%

25th Percentile

1.01%

1.12%

1.11%

Summary Statistics

Three-Year Average Burn Rate (excluding ISS Conversion Factor)

S&P Top 50

S&P $5 B Cos.

S&P $1 B Cos.

75th Percentile

1.03%

1.32%

1.88%

Median

0.79%

0.90%

1.02%

25th Percentile

0.47%

0.53%

0.56%

Note: S&P Top 50 reflects the 50 largest companies in the S&P 500 in terms of revenue with average trailing twelve month revenue of $108 billion. S&P $5 B Cos. reflects a 50 company subset of the S&P 500 with an average trailing twelve month revenue of $5 B. S&P $1 B Cos. reflects a 50 company subset of the S&P MidCap 400 with an average trailing twelve month revenue of $1 B.

IMPACT ON EQUITY GRANTS

Most companies make their annually equity grants based on a target dollar value for the long-term incentive award, rather than as a fixed number of shares. For example, a company may target a long-term incentive grant of $200,000 per year to a Vice President. For simplicity’s sake, let’s assume that the grant is made 100% in Restricted Share Units (RSUs). Most companies determine the number of shares to grant by dividing the target long-term incentive value by a stock price. Since companies are required to use the stock price on the date of grant for purposes of the disclosed value of equity grants, many companies use the stock price on the date of grant for converting award values into shares.

When the stock price declines significantly over a short period of time, there will be a significant increase in the number of shares required to deliver the target value. For example, let’s assume that the stock price was trading at $50.00 in September of 2015 when the company began their compensation planning and fell by 40% to $30.00 on March 1, 2016 when they make equity awards. In this situation, the number of shares required to deliver a $200,000 equity grant would increase by 67% from 4,000 shares to 6,667.

If the company is granting stock options, the share usage resulting from a decline in stock price is even more pronounced. Assuming a 3:1 ratio of options to RSUs, the grant required to deliver a $200,000 equity grant would increase from 12,000 options to 20,000 options.

Applied across the total employee population, this can create major concerns for the company with the potential to exhaust the reserve of shares available for grant under shareholder approved plans more quickly than anticipated. This will also increase the company’s annual share usage.

To the extent that equity plans reserves are exhausted and burn rates exceed industry norms, companies can run into difficulty when seeking shareholder approval of additional shares. If share usage is judged to be imprudent, or if shareholders see disconnects between pay and performance, particularly if facilitated by the equity plan, they are much less likely to support a request for new shares. The potential for perceived disconnects is heightened since higher burn rates typically occur when share prices are lower.

APPROACHES TO ADDRESS EQUITY GRANTS WHEN STOCK PRICE DECLINES

In our experience, companies address declining stock price in several different ways. The following are a few of the most common approaches:

Approach 1. Continue granting based on stock price at date of grant (i.e., do nothing)

In some cases, companies may feel that continuing to use their standard operating procedure for converting long-term incentive value into shares is the best approach. This could be because the company has been conservative in using shares in the past and has adequate shares available to cover multiple years of equity grants even with a significant stock price decline. The company may feel that a one year spike in their share usage will not raise significant concerns with shareholders or shareholder advisory firms. Another rationale that these companies may use for making grants as usual is that the value of any outstanding equity that executives hold will have fallen with the stock price. If the company reduces the value of equity grants as well, this may be a “double whammy” for long-term incentive participants. In our experience, Approach 1 can be untenable if the stock price falls by 30% or more.

  • Advantages: Maintains target LTI award value for employees
  • Disadvantages: Dilutive to shareholders; potential for “windfall” if stock price quickly recovers

Approach 2. Use an average stock price over a period of time to establish grants

This is a common approach companies use to mitigate the impact of short-term swings in stock price on the number of shares granted. Among companies that do not convert grant values into shares based on the stock price on the date of grant, the most common approach is to use an average stock price over a relatively short time period. We see a 20-trading day average most frequently. This approach avoids significant swings in the number of shares granted (up or down) based on stock price movement on the date of grant away from its near-term average. When companies have significant volatility over a sustained period of time, they may use a longer term average stock price (e.g., six months or one year) to mitigate the impact of volatility on grant size. The following chart lays out an illustration of this approach:

Price Used

Target Value

Price

Shares

Acctng Value

Date of grant

$200,000

$30.00

6,667

$200,000

20-day average

$200,000

$35.00

5,714

$171,429

90-day average

$200,000

$40.00

5,000

$150,000

180-day average

$200,000

$45.00

4,444

$133,333

While using an average stock price helps manage the share usage when there is a stock decline, it will create disconnects between the target value of long-term incentives and the accounting value of the awards. Supplemental communication to employees is typically required to explain why the company thinks the average stock price methodology is a better estimate of value than the stock price on the date of grant. If the company uses this approach consistently over time, employees may recognize that the average price can be above or below the stock price on the date of grant.

  • Advantages: Limits dilutive impact of stock price decrease
  • Disadvantages: Potentially challenging to communicate to employees; disconnect between target LTI value and accounting value

Approach 3. Cap the run rate and pro rate grants accordingly

Some companies have committed to a maximum level of annual share usage or run rate. For example, a company may have committed to its shareholders or Compensation Committee that its annual run rate will not exceed 1.5% of common shares outstanding. If their stock price falls significantly, they may find that to deliver the target long-term incentive values under their program, they would need to grant 2.25% of common shares outstanding. In this situation, the company can pro rate all grants to keep the run rate at 1.5% of common shares outstanding. For example, if an executive’s target long-term incentive value was $200,000 and the stock price was $30.00, they would require 6,667 shares for this executive. Each grant would have to be multiplied by a factor of 1.5/2.25 or 2/3. In this case, the grant to the executive would be reduced from 6,667 shares to 4,444 shares and the accounting value of the award would be $133,333 instead of $200,000.

  • Advantages: Limits dilutive impact of stock price decrease; simple; equitable treatment across employees
  • Disadvantages: Reduces value of long-term incentive award to all employees

Approach 4. Limit participation in equity grants to conserve shares

Instead of making an across the board reduction in all equity grants, some companies will eliminate or significantly reduce long-term incentive awards for a portion of the population, while maintaining full awards for the remainder of the population. In practice, this often involves maintaining awards for senior executives where long-term incentives are viewed as most critical from a competitive perspective. For lower level long-term incentive participants, the company may limit grants to only those employees with performance that exceeds expectations or with critical skills. This approach may be acceptable if it is applied for one year, but may raise internal equity issues if extended beyond one year.

  • Advantages: Limits dilutive impact of stock price decrease; targets awards at most critical employees
  • Disadvantages: Potential strong negative response from excluded employees

Approach 5. Apply a discount to long-term incentive award guidelines

Another fairly simple way to address the issue of a stock price decline is to apply a discount to the long-term incentive award guidelines. Suppose that the stock price has fallen from $50 to $30 (or a 40% decline). In such a situation, the company would have to grant 67% more to maintain the LTI award target values. To mitigate the pressure that this will put on share usage, the company can apply a discount to the LTI target award value that partially adjusts for the impact of the stock price decline. For example, they could discount their LTI award guidelines by 25%. In this case, a $200,000 LTI award would be reduced to $150,000 and the grant would require 5,000 shares at a $30.00 stock price. This is more than the 4,000 shares that would have been required to deliver $200,000 at a $50.00 stock price, but is significantly less than the 6,667 shares required to deliver the full $200,000 at $30.00.

  • Advantages: Limits dilutive impact of stock price decrease; simple; equitable treatment across employees
  • Disadvantages: Reduces value of long-term incentive award to all employees

Approach 6. Use RSUs instead of stock options

To deliver a given long-term incentive award value, stock options require more shares than full value awards like RSUs or PSUs. Depending on the Black-Scholes value of stock options, the ratio of options to full value shares may be as low as 2:1 or as high as 5:1. For companies with equity plans that are not based on a fungible pool that treat options and full value shares the same, shifting the long-term incentive mix away from stock options towards full value shares can help ensure that equity grants will not exhaust the available pool.

For example, suppose a company has a mix of 50% stock options and 50% RSUs for its long-term incentive program. The company was planning on granting 1 million RSUs and 3 million stock options, but the stock price falls by 1/3 and now the company needs to grant 1.5 million RSUs and 4.5 million stock options. Unfortunately, their shareholder approved plan only has 5 million shares available for grant and the current 50%/50% LTI mix requires 6 million shares (1.5 million RSUs plus 4.5 million stock options). If they shift the mix from 50% RSUs / 50% stock options to 100% RSUs, the company will only need 3 million shares to deliver the target long-term incentive award value and they will not exhaust the share reserve.

  • Advantages: Maintains target long-term incentive award value, potentially avoids exhausting share reserve, simple; equitable treatment across employees
  • Disadvantages: Shareholders/Compensation Committee may prefer use of stock options to RSUs; shareholder advisors view RSUs as more dilutive than options on a per share basis

Approach 7. Use long-term cash instead of full value equity awards

Companies can conserve shares and reduce burn rate by replacing equity awards with cash. The most common approach is to grant long-term cash incentive awards instead of performance shares. Both types of award can be constructed with similar time frames, identical metrics and identical target values. But there are two significant differences. First, the ultimate value of performance shares will leverage up or down over the performance period in line with the value of the underlying shares. This exposes compensation realized by participants to additional volatility during periods when stock prices are uncertain. Cash awards will have more certainty and may therefore be valued more highly. Second, long-term cash awards are almost always settled in cash. Therefore, ancillary considerations, such as stock ownership guidelines, post-vesting holding periods, blackouts and insider trading policies are off the table.

In addition, long-term cash awards are not factored into burn rate calculations or into the estimates shareholders apply to the cost of equity plans. For example, ISS’ Equity Plan Scorecard does not value long-term cash, but would value outstanding performance shares. Similarly, long-term cash awards are not counted in calculations of overhang from equity plans or counted against equity plan share reserves, provided the awards are not denominated in share units settled in cash. Companies are required to book an accounting charge for the full cost of cash compensation, but effectively get a free pass on cash for other formulations of equity plan impact.

Awards of deferred cash designed to replace time-vested RSUs are seen less frequently, but could also be offered. The biggest decision involves whether to award fixed amount of cash for satisfying future service requirements or to provide either an interest component or some leverage tied to stock price performance.

  • Advantages: Maintains target long-term incentive award value, potentially avoids exhausting share reserve, simple; equitable treatment across employees
  • Disadvantages: Shareholders/Compensation Committee may prefer use of stock to cash to maintain alignment with shareholders

ADDITIONAL EQUITY COMPENSATION CONSIDERATIONS

In a time of severe stock price volatility, a company’s compensation program may be under pressure from multiple dimensions, beyond the current year’s equity grants:

  • Reduced value of outstanding unvested full value shares: As the stock price declines, the value of any unvested equity held by employees will fall as well. This can reduce the value of outstanding equity as retention “handcuffs” and lowers the cost for competitors to buy executives out of their unvested equity. To the extent that all companies are affected equally by a stock price decline, this is not a major issue, but if the company’s stock price has declined more than the market overall, retention concerns will be heightened. If the company has a performance share plan, based on relative TSR and is underperforming on an absolute and relative basis, the retention issues will be even worse as the performance shares may be at risk of having no value
  • Underwater stock options: A decline in stock price can reduce the intrinsic value of full value share awards, but as long as the stock price is above zero they still maintain some value. With stock options, the impact of a stock price decline can be more acute, as once the stock price falls below the exercise price the stock options no longer have any intrinsic value and employees may not place much value on the options at all.
  • Economic uncertainty: To the extent that the stock price decline is driven by economic fundamentals (e.g., lower growth or lower profits), the company may have uncertainty about the likelihood of achieving its annual budget or long-term financial plan. This can further devalue the compensation program from the perspective of employees.

Unless the stock price decline is severe and sustained, it is uncommon for companies to cancel and replace underwater stock options or to make supplemental awards of full value shares to restore value to executives. However, when making compensation decisions in a year where the stock price has declined, it is useful to consider the context of employees’ total equity holdings and to err on the side of generosity for going forward equity grants to the extent possible.

CONCLUSIONS

Sudden stock price decreases can upset plans for annual equity grants by significantly straining the available share reserve and increasing the annual equity run rate. While there is no silver bullet approach that works for all companies, there are a number of alternative approaches that companies use to address stock price fluctuations. In choosing the approach that works best for your company, it is critical to determine the appropriate balance between the competing concerns of attracting and retaining employees with managing share dilution and protecting shareholder interests.

We believe Mr. Fink raises an important point on linking incentives to business strategy. A clearly communicated business strategy would help to avoid pitfalls that we see frequently today. These include incentives that are designed primarily to respond to pressure from proxy advisory firms, often driving a “one size – fits all” approach or encouraging short-term thinking.

“We are asking that every CEO lay out for shareholders each year a strategic framework for long-term value creation. Additionally, because boards have a critical role to play in strategic planning, we believe CEOs should explicitly affirm that their boards have reviewed those plans. BlackRock’s corporate governance team, in their engagement with companies, will be looking for this framework and board review.”
Larry Fink, BlackRock CEO

As highlighted by our articles Are You Rewarding Short-Termism? in The Corporate Board and Balancing pay for performance with shareholder alignment in the Ethical Boardroom, it is important that compensation, in particular long-term incentive compensation, links directly to the company’s strategy. We agree that providing shareholders with a voice on compensation programs through Say on Pay has been beneficial, but we have observed a chilling effect on creative compensation programs. Today most public companies are very reluctant to be an outlier on compensation. If we look at CAP’s sample of 100 large market cap companies, 51% use Total Shareholder Return (TSR) and 34% use EPS as metrics in their long-term incentive plans. Are these universal metrics appropriate in almost any situation? We question that premise. Why do so many companies have similar metrics when they have unique business strategies, operate in diverse industries and are positioned at different points in their lifecycle?

The good news is that we have observed modest increases in the use of return metrics, from 41% in 2011 to 47% in 2014 (e.g., return on assets, return on capital and return on equity). In several cases, activist investors have intervened to champion the adoption of return metrics. Traditional institutional investors with concerns over the effectiveness of corporate business strategies have also been vocal in encouraging companies to focus on returns. Both camps frequently push companies to move to adopt balanced metrics that encourage profitability in combination with growth as opposed to growth alone.

The chart below provides a snapshot of how long-term incentive plan metrics have evolved over time. Use of TSR has grown most since 2011, from 36% to 51% and this is after dramatic increases prior to 2011. We believe this is the direct outcome of the influence of proxy advisory firms, who have pushed hard on companies to incorporate relative TSR in their programs. The good news is that since 2011, the number of companies relying on a single metric has declined, with over 1/3 of companies using 3 or more metrics which may indicate they are tailoring plans more to their specific situation.

# of Metrics

2011

2014

1

33%

26%

2

40%

37%

3 or More

27%

37%

While EPS and TSR may make sense for many companies, companies should consider various factors when selecting measures, including:

  • Is relative TSR the best answer for your company? We see it as an outcome-oriented metric that lacks a clear linkage to strategic priorities and is not well suited to driving behaviors that create shareholder value.
  • Does over-reliance on TSR encourage risk-taking behaviors? Companies may make decisions that drive TSR in the short-term (e.g., share buybacks or higher dividends), rather than identifying better uses of capital that can lead to sustained long-term growth.
  • Does an EPS metric create an incentive to buy back shares rather than re-investing for growth? Financial experts have mixed views on the utility of share buybacks. The jury is still out.
  • Are the current time horizons for TSR performance optimal? Almost all plans measure TSR over 3 years. Why is a 3-year time frame the default for most companies? Since TSR is usually defined as a relative metric, eliminating the need to set goals in advance, should companies be evaluating longer timeframes that align with their business cycles?
  • If relative TSR is your company’s metric, where are you in the cycle? Companies and boards need to ask and analyze whether relative TSR goals will pay out for sustained long-term stock price appreciation or for volatility in relative stock price performance. Companies and boards need to understand whether the stock is only recovering from earlier losses that occurred prior to the start of the performance period.

We don’t believe that either EPS or TSR are inherently poor metrics. In many cases, it makes sense for companies to incorporate these metrics into their overall incentive framework. However, it is critical to determine if these metrics are right for a particular company at a -particular time in its life cycle. Keep in mind that long-term incentives are the largest component of pay for many executives. As companies and boards design long-term incentives, they should consider the following questions:

  • Does the compensation program support our strategy and do the metrics and goals align with our long-term business plan?
  • Can we communicate clearly and succinctly how the program ties to our strategic framework for both shareholders and program participants?
  • What behaviors, good or bad, could the design encourage? For example:
    • Does it send clear signals throughout the organization on the strategic priorities?
    • Is short-term upside emphasized at the expense of long-term sustained value?
    • Do we encourage growth at the expense of returns that exceed our cost of capital?
  • Does the program encourage excessive or inappropriate risk-taking?
  • For metrics other than TSR, will achievement of goals lead to company and shareholder value creation?
  • Are there alternative metrics, including strategic metrics (e.g., increase in market share, diversification of revenue, etc.) that might be better indicators of successful execution of the strategy?

Overall, we think Mr. Fink’s commentary on the importance of defining and communicating a company’s strategic framework for value creation serve shareholders well. His comments point to a fundamental principle of compensation design: incentive compensation should be used to reward the company’s success in achieving its strategy and creating long-term value for shareholders. The performance measures used to determine incentive compensation need to track progress on the strategy over the near term and over the long-term. We believe we will see a migration in this direction as long-term incentives evolve, companies continue to dialogue with their shareholders and perhaps as they enhance disclosure around their strategic framework as Mr. Fink suggests.


KEY TAKEAWAYS

  • The use of performance-based long-term incentives (“LTI”) continues to be the prevailing practice, constituting more than 50% of the typical LTI program for Named Executive Officers (“NEO”)
  • Companies have been re-examining the mix of components in their LTI program and actively increasing performance-based awards, while de-emphasizing stock options and time-based restricted stock
  • While used to a lesser extent, stock options and time-based restricted stock continue to be part of the LTI program for many NEOs
  • The most prevalent metrics used in performance-based LTI plans are return measures, such as ROI, Total Shareholder Return (“TSR”) and Earnings Per Share (“EPS”)
  • Many companies have decided that the use of a two-pronged approach of measuring performance results against both internal goals and relative to the external market is a best practice

Compensation Advisory Partners (“CAP”) reviewed 2014 proxy disclosures for a 100 company subset of the Fortune 500 representing a cross-section of nine industry groups. The industry groups included: Automotive, Consumer Goods, Financial Services, Health Care, Insurance, Manufacturing, Pharmaceutical, Retail, and Technology. Our research examined changes in executive compensation practices in 2013, or indicated for 2014, and observations on current trends and pay program design. This CAPflash focuses on long-term incentive plan design and notable trends including changes made in 2013 or planned for 2014.

The companies included in this study have a median revenue size and market capitalization of $32B and $52B, respectively. The median total shareholder return was 43% for 2013.

TRENDS IN LONG-TERM INCENTIVE PLAN DESIGN

51% of companies in our study made changes to the LTI plan design in 2013 or for 2014. Companies continue to reduce the emphasis on time-based restricted stock and stock options and deliver a greater portion of LTI compensation in the form of performance-based equity or cash awards. Among companies that changed their LTI mix, most companies reduced the emphasis on stock options (71%) and/or increased the emphasis on performance-based LTI (67%). 33% of companies that changed the LTI mix reduced the emphasis on time-based restricted stock.

This continued shift towards performance-based LTI compensation reflects an effort by companies to respond to shareholder feedback and align executives’ pay with performance. Target Corporation, for example, responded to a number of shareholder comments calling for a greater link between pay and performance. In 2013, Target eliminated the use of stock options (which represented 75% of total LTI in 2012) in favor of a 100% performance-based LTI program.

The overarching priority for many companies is to use LTI vehicles that best align with their business strategy and unique shareholder value proposition. For example, Aetna, Inc. replaced performance-based market share units (“MSUs”) with time-based stock appreciation rights (“SARs”) in 2014. Aetna disclosed that the longer term nature (10 years) of SARs “…supports the Company’s long-term strategic focus to drive change in the healthcare industry and to create long-term shareholder value.” Another example is Pfizer, Inc. which grants 5- and 7-year Total Shareholder Return Units (“TSRUs”). Pfizer discloses that the value executives realize from TSRUs “…is consistent with the value received by Pfizer’s shareholders.”

The table below outlines the reported changes among companies in our study:

Type of Change Reported in CD&A

2013

No. of Cos.

% of Cos.
Reporting Changes

2013

(n = 51)

2012

(n = 55)

Change in mix of LTI award vehicles

21

41%

44%

Change in performance plan metric

17

33%

27%

Add or eliminate LTI vehicle

10

20%

36%

Change in LTI award target opportunity level

7

14%

13%

Change in performance plan comparison/peer group

2

4%

5%

Other

10

20%

20%

Note: Percentages add to greater than 100% due to multiple changes by certain companies.

PREVALENCE OF LONG-TERM INCENTIVE VEHICLES

Over the past three years, the prevalence of stock options has declined slightly and the use of time-based restricted stock has been relatively flat. Companies tend to grant these vehicles as a supplement to performance-based LTI.

Below is the breakdown of the percentage of companies granting each LTI vehicle to NEOs from 2011-2013:

Note: Percentages add to greater than 100% because most companies grant a variety of vehicles.

Companies continue to use multiple vehicles to deliver LTI to executives. 51% of companies in our study deliver LTI in the form of two vehicles, 29% use three vehicles and 20% use only one vehicle. Among the companies that deliver LTI compensation through one vehicle, 60% grant only performance-based LTI.

LONG-TERM AWARD MIX

The average LTI mix in 2013 is generally consistent with 2012. Performance-based LTI continues to represent more than half of the LTI mix (approximately 55% of total LTI) while stock options represent approximately 25% and time-based restricted stock represents 20%.

The chart below depicts the average LTI mix for NEOs as disclosed in the CD&A:

PERFORMANCE-BASED LTI METRICS

Companies routinely reassess their LTI plan design, including the performance metrics used, to ensure that the design reflects the company’s business strategy and objectives to attract, incentivize and retain executives. Among performance-based LTI plans, the use of a return measure increased to 49% in 2013 (up from 41% in 2011) indicating that companies are trying to encourage operational efficiency, along with profitability and growth. Among the companies that use return measures, 47% use ROI or ROIC, 37% use ROE and 16% use ROA. TSR and EPS are also prevalent long-term incentive metrics, used by 42% and 36% of companies, respectively. In our study, most companies with performance-based LTI plans use two metrics.

Companies are also more likely to use LTI metrics that reflect key measures of success in their industry. The Automotive industry frequently uses Cash Flow as a metric, focusing executives on liquidity to manage the significant cash requirements associated with the industry. In the Pharmaceutical and Technology industries, where the success of a company’s pipeline and current product offerings is reflected in their stock price, TSR is used more frequently as a metric.

Overall, 49% of companies in our study measure performance relative to the external market (typically using TSR) and 89% measure performance against pre-established goals (typically internal financial metrics). Although the use of relative TSR has increased slightly since 2011, the use of absolute internal financial metrics is most prevalent. Approximately 92% of companies that use TSR, measure performance relative to a defined comparator group (54% use a defined peer group, 40% use a broader industry index and 6% use both) while nearly 95% of companies measure financial performance against pre-established goals based on the business plan.

In recent years, companies have moved away from using only absolute or relative performance measures and instead frequently use a two-pronged approach. In 2013, 37% of companies used both absolute and relative performance measures compared with 24% in 2011. The use of both absolute and relative performance measures allows companies to evaluate performance from a balanced perspective, considering both internal and external results.

The chart below displays the prevalence of LTI metrics for performance-based awards in 2011-2013:

Note: Percentages add to greater than 100% due to multiple responses. Return measures reflect ROE, ROIC and ROA

CONCLUSIONS

The role played by performance-based LTI within LTI programs continues to grow. Performance-based LTI constitutes 54% of total LTI, on average, for NEOs. As performance-based LTI grows, the use of stock options and time-based restricted stock has been declining; however, these vehicles often have a role in a well-designed LTI program since stock option value depends on longer-term stock price appreciation and time-based restricted stock serves as an excellent retention vehicle.

The most commonly used metrics are return measures, such as ROI, as well as TSR and EPS. These metrics demonstrate that companies are attempting to use LTI to incentivize operational efficiency, profitability and growth. While most companies evaluate financial performance against internal goals, a growing number of companies have adopted a two-pronged approach to long-term performance measurement. These companies use internal financial goals and also incorporate a relative goal (typically TSR) to measure company performance in the context of the external market.

While most companies have already implemented changes that provide for a stronger link between executive pay and company performance, we expect to see companies continue to refine their performance-based LTI plans to support their business strategy. Additionally, we expect that setting meaningful long-term financial goals will continue to be a challenge for many companies leading some to incorporate relative performance metrics in the LTI program.

Underlying the Fed’s input to financial institutions is a legitimate concern about the potential for incentives to encourage excessive risk taking. The Fed has stated that: “risk-taking incentives provided by incentive compensation arrangements in the financial services industry were a contributing factor to the financial crisis that began in 2007” and “Before the crisis, large banking organizations did not pay adequate attention to risk when designing and operating their incentive compensation systems.” Agree or disagree with these points, over the past several years compensation-related risk management processes have vastly improved.

In this CAPflash, we provide an overview of how compensation practices have evolved following the Fed’s guidance, what (in our view) the Fed has got “right” and where they may have gone too far, and what we expect to see from banks and regulators in the near future.

Where We Are Now

The Final Guidance was principles-based, leaving leeway for implementation to consider differences among the institutions subject to this new level of oversight. For example, companies with significant differences in their businesses, such as select investment banks, custody banks, regional banks, and credit card companies were all subject to the same guidance. In its October 2011 publication, the Federal Reserve noted, “The interagency guidance helps to avoid the potential hazards or unintended consequences that would be associated with rigid, one-size-fits-all supervisory limits or formulas.” In our experience, banks devoted considerable time and resources to demonstrate substantial conformance with the new requirements, but went about responding and demonstrating conformance to regulators in different ways.

The Interagency Guidance was founded on three key principles:

  1. Balance between risks and results. Incentive compensation arrangements should balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risks;
  2. Processes and controls that reinforce balance. A banking organization’s risk-management processes and internal controls should reinforce and support the development and maintenance of balanced incentive compensation arrangements; and
  3. Effective corporate governance. Banking organizations should have strong and effective corporate governance to help ensure sound incentive compensation practices, including active and effective oversight by the board of directors.

Improved Risk Management

In our experience, companies have come a long way in addressing all three key principles. Most banks have greatly strengthened their risk management processes and ensured that the risk function has a defined role in reviewing compensation design, as well as performance outcomes and their impact on compensation payments. Where the risk function seldom had any role in the incentive compensation process in the past, they are now integrated into the process. Similarly, great strides have been made to ensure that Compensation Committees are informed about risk-taking within the organization and how incentive compensation designs across the company address risk. Many banks have also formed internal committees responsible for maintaining controls and risk oversight of incentive compensation plans across their organizations.

Prescribing Plan Design

The Fed and other agencies have become more prescriptive in their “guidance” to banks, at times almost to the point of allowing for limited leeway in compensation practices. The table below provides a summary of the methods for linking compensation and risk outcomes described in the Final Guidance, and select examples of how current compensation design practices have evolved based on input from regulators.

Areas of Principles- based Interagency Guidance

Select Examples of Design Practices Reacting to Fed Direction

Deferred Incentive Compensation

Significant Changes

Reduced upside leverage in long-term performance plans (from 200% to 125%-150% of target)

Elimination of stock options (or significant reduction to modest percentage of total long-term)

Risk Adjustment of Incentives

Significant Changes

Risk-adjusting incentive pools

Performance-based adjustments that apply to deferrals/long-term incentives over the full vesting period with ability to reduce awards to zero based on risk outcomes

Other Methods that Promote Balanced Risk-Taking Incentives

Modest Changes

Discretionary annual incentives most common (some shifts where formula-based payouts had existed)

Reduced upside leverage in annual incentive plans, at times with corresponding increases to fixed pay (salaries)

Some reduction in the use of relative performance measures in annual and/or long-term incentive plans

Enhanced Control Functions

Modest Changes

Risk management and internal control functions involved in designing, implementing, and evaluating incentive arrangements to ensure proper risk-balancing in a more formal way

Strong Corporate Governance

Modest Changes

Increased Board/Committee oversight of incentive compensation arrangements below senior executive level, for other covered employees (including non-executives)

Mechanisms to facilitate communication between the Compensation Committee and Risk and Audit Committees

 

In our view, the area where the Federal Reserve has had the most positive impact on incentive compensation design is in requiring deferrals to be subject to performance adjustment, before and after grant, based on risk outcomes (generally not the case before the guidance). Other changes encouraged by the Fed (e.g., eliminating/reducing stock options, reducing upside incentive plan leverage to 125%-150% of target, reducing the use of relative measures, etc.) seem to be less well founded in the principles of risk balancing and more arbitrary. It is difficult to identify the role that these incentive design features played in the financial crisis and it seems to us that Fed input on these areas is based more on theoretical objections than any empirical data supporting the hypothesis that these incentive design features encouraged excessive risk-taking among executives at financial institutions.

Future Concerns and Expectations

U.S. regulators should be commended for maintaining a largely hands off approach thus far with respect to pay levels, focusing primarily on incentive compensation design and control features. This approach provides a strong focus on risk balancing of incentive compensation, while recognizing the need for the industry to maintain competitive compensation programs. In contrast, in the European Union, CRD-IV places caps on the level of incentive pay that may be delivered (as a ratio of fixed pay). This type of regulation severely limits the ability to implement a pay-for-performance compensation design and, in response, has led many companies to increase fixed pay. As a result, CRD-IV has potentially harmed shareholders by weakening the pay-for-performance relationship. Thankfully, to-date, the Fed has avoided this kind of heavy-handed approach in addressing compensation in U.S. financial institutions.

Still, we may have unanticipated consequences in the U.S. Many shareholders and shareholder advisory groups prefer formulaic performance-based incentive arrangements to discretionary incentives, as they fear that discretion will be used for the benefit of management. However, because regulators have discouraged formulaic, performance-based upside in incentive compensation plans, many financial institutions have moved to more discretionary incentive arrangements to allow for greater flexibility to compensate executives. Another potential response to the Fed’s input is that, over time, financial institutions may increase pay levels to address concerns that executive talent will depart for other industries (e.g., hedge funds, private equity, asset management) where there are no restrictions on incentive design.

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Going forward, we expect regulators to provide more guidance on monitoring and validation processes and results. Many companies developed approaches to retrospectively review risk outcomes and the corresponding impact on compensation decisions, but communicating these processes and results for all covered employees to regulators is still, generally, in early stages. Regarding incentive plan upside leverage, regulators have started to state more and more directly a belief that 125% is most appropriate, but many banks have held their ground at 150%. Some of the banks that moved to 125% may start to re-evaluate their program and consider moving back to 150% to remain competitive.

As companies and Committees try to “live with” the restrictions of the guidance, we expect to see a continued move away from formal targets and increased use of discretion, increases in pay levels to recognize decreased incentive plan upside leverage, and challenges in applying risk adjustments and clawbacks.

Conclusion

Incentive compensation processes and designs among financial institutions have changed a great deal over the past four years, to a large degree driven by regulatory input. If we look back at the principles (Final Guidance), most banks have come a long way in addressing them. At this point, we hope that regulators can step back and consider how much progress has been made and consider taking a pause to begin to evaluate what changes were necessary and effective and what changes may have been excessive.

Appendix – Summary Market Data

[company-by-company data available upon request]

Methodology

CAP reviewed 2012, 2013, and 2014 proxy statements and the most recent equity award agreements of the 23 large publicly-traded banks1 that were included as part of the Federal Reserve’s horizontal review of incentive compensation. Our analysis looked for year-over-year changes in compensation structure, annual and long-term incentive design, performance-based vesting, recoupment policies and stock ownership guidelines/retention requirements.

Select summary data is shown below. Findings have been divided into two data sets, large complex banking organizations (LCBOs) and other large banks with assets exceeds $50 billion. LCBOs are one year ahead of the other large banks in terms of their interaction with the Fed, and the related implications on compensation program design.

Long-term Incentive Mix, 2012-2014

Long-term Incentive Absolute vs. Relative Performance Metrics, 2012-2014

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Long-term Performance Plan Maximum Upside Leverage, 2012-2014

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Stock Ownership Requirements

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Some companies differentiate stock retention requirements for the CEO versus Other NEOs. Therefore in some instances the prevalence shown is greater than 100 percent.

Research assistance was provided by: Myron Lising, Roman Beleuta, Michael Biagi, Michael Bonner, Rachael Holland, and Jasmine Yanes.

1 Companies reviewed include American Express, Bank of America, BNY Mellon, Citigroup, Capital One Financial, Discover Financial Services, Goldman Sachs, JPMorgan Chase, Morgan Stanley, Northern Trust, PNC, State Street, SunTrust Bank, US Bancorp, Wells Fargo, BB&T, Comerica, Fifth Third, Huntington Bancshares, KeyCorp, M&T Bank, Regions and Zions Bancorp.

Underlying the Federal Reserve’s input to financial institutions is a legitimate concern about the potential for incentives to take on excessive risk. From our interactions with clients and observing the practices of the industry as a whole, there is no doubt that financial services firms have made significant progress addressing risk in a much more comprehensive way, with cross-functional teams addressing a wide variety/forms of organizational risk. Much of the work that financial services firms have done initially has less to do with compensation and has been primarily focused on understanding the nature of the risks in their organizations and developing robust processes to effectively control and monitor risk.

While financial services companies have made great strides in improving risk management, they have not been let off the hook by regulators when it comes to compensation design. Instead, over the past three years, as risk management processes have vastly improved, the Federal Reserve has become progressively more detailed in the compensation-related input they provide to regulated institutions. The Federal Reserve has provided guidance to companies on specific areas of executive compensation calling for some of the following types of changes, beyond the mandated deferral of compensation for the most senior executives (Tier 1 covered employees):

  • Include Risk Review in Annual Incentive Design: Pressure to include some form of a formal risk review at the individual and company-wide level in annual incentive decisions [Early Principle]. This has been accomplished through the development of enterprise risk frameworks that monitor company-wide risk and individual evaluations that heavily weight individual activities that could promote negative risk outcomes in the assessment.
  • Performance-Based Vesting of Long-term Incentives: The Federal Reserve expects companies to be able to affect the initial grant size, and even more importantly, the amount that ultimately vests (even down to zero) based on these risk assessments of the individual and/or the company.
  • Reduce Use of Stock Options: The Federal Reserve has long been concerned that the asymmetrical nature of stock options can create incentives for employees to take on excessive risk and therefore has encouraged companies to eliminate, or at a minimum, reduce stock options as a percentage of total incentive compensation.
  • Reduce Incentive Plan Upside Leverage (Annual and Long-term Incentive Plans): Companies with plans that stipulate a specified maximum award have been directed to reduce incentive plan leverage from the historical industry and broader market standard maximum incentive opportunity of 200% of target to 125%-150% of target.
  • Reduce or Eliminate Relative Performance Measures: The Federal Reserve is concerned that relative measures may reward companies for under-performance and could lead companies to take on excessive risk to “chase after” leading performers. They prefer absolute performance objectives that are more easily communicated to executives.

Methodology and Findings

CAP reviewed the 2012 and 2013 proxy statements of the 23 publicly-traded financial services companies1 that were included as part of the Federal Reserve’s horizontal review of incentive compensation. Our analysis looked for year-over-year changes in compensation structure, annual and long-term incentive design, performance-based vesting, recoupment policies, stock ownership guidelines, and retention requirements.

It should be noted that not all banks with assets >$50 billion have fully disclosed the changes to their compensation programs, because some of these institutions are in an earlier stage of the process of interaction with the Federal Reserve. For them, 2013 will be an active year for the evolution of their executive compensation programs.

The most significant findings are among the LCBOs since they have been undergoing the review process for a longer period of time. Among these companies, we have seen a great deal of year-over-year change, with many adopting the features discussed above; however, management and Compensation Committees also recognize that the Federal Reserve is one of multiple constituencies that they need to address in compensation design. While the Federal Reserve is actively involved, shareholders also have expectations and an ability to express these views through Say on Pay votes and other constituencies who are active as well (e.g., employees, retirees, shareholder advisory groups). As a result, companies are more adamant about retaining aspects of the compensation program design (e.g., relative performance metrics in performance share plans, stock options, incentive plan upside opportunity at or above 150% of target) to address the views of these groups.

Compensation Structure

Financial services firms generally operate under two main types of compensation structures. The first approach is an “investment banking” style of compensation model (e.g., Bank of America, Goldman Sachs, JPMorgan Chase). Under this approach, each year a total incentive is determined based on a review of the prior year’s performance. The total incentive is delivered to executives as a mix of annual cash incentive and long-term incentives. In the past the long-term incentive piece was often delivered as time-vested restricted stock and potentially stock options, but this mix has changed over time.

The second approach is a more traditional compensation model common across most other industries, where the annual incentive is based on the prior year’s performance and the long-term incentive grant is viewed as a separate decision, with the target long-term compensation opportunity based on future performance and the grant value is independent of prior year performance.

A recent development over the past two years is that companies that have historically used either the investment banking structure or the more traditional structure have moved to adopt a hybrid approach where the annual incentive is determined based on prior year performance and delivered in a mix of current cash and/or deferred equity/cash and a separate long-term incentive is also provided:

  • Morgan Stanley: Moved from an investment banking style to have two separate incentives: 1) annual incentive delivered through a mix of deferred cash and stock options, 2) long-term incentive delivered as a performance LTIP
  • Citigroup: Maintains an investment banking structure, but this year added a performance scorecard approach to determine size of incentive compensation and changed delivery to 40% annual cash, 30% deferred stock, 30% performance share units
  • BNY Mellon: Historically used a more traditional pay model approach and has shifted its performance scorecard to determine a larger portion of overall incentive compensation. Seventy percent of the total incentive is delivered in a mix of cash and restricted stock, with the remaining thirty percent of total incentive in a performance share plan.

Risk Adjustment in Annual Incentive

All companies now include corporate and individual risk assessments in the process for determining the size of annual incentive pools and individual awards. Frequently these adjustments are intended to provide an ability for the Compensation Committee to apply negative discretion to reduce or eliminate the annual incentive payout if the company or an executive is found to have incurred a material negative risk event or to cover any individual who has failed to demonstrate adequate sensitivity to risk or the firm as a whole had subpar risk results. Both recoupment and/or clawback policies are now widespread.

Incentive Plan Upside Leverage

An area where the Federal Reserve appears to be surprisingly prescriptive is in encouraging companies to reduce incentive plan upside opportunities. From a compensation perspective, this runs counter to designs that are preferred by shareholders who expect a strong pay-for-performance program. The Federal Reserve is opposed to formulaic plans that can lead to substantial payouts when performance is strong, but does not necessarily understand that discretionary plans can lead to comparable payouts. A potentially unintended consequence of this point of view is to encourage companies to reduce the transparency of incentive plan design leading to reduced line-of-sight for executives. An important tenet of compensation theory is that executives have a clear understanding of the process and approach that will be used to determine their incentive. Given the Federal Reserve’s preference for discretion, the relationship between performance results and incentive payouts may be weakened, particularly at higher performance levels. Again, regulatory guidance may lead to a major misalignment with shareholders.

Shareholders also prefer incentive plans with direct linkage between payouts and pre-established performance objectives. They are concerned that discretion is frequently used to the advantage of executives and at the expense of shareholders. However, recognizing the concerns of the Federal Reserve, firms have reduced the maximum opportunity from 200% of target (a broad industry company standard) to 150% or 125% of target so they can continue to address shareholder desires for a more formulaic structure while mitigating Federal Reserve concerns about leverage.

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Other potential unintended consequences we may see in the future are: 1) an increase in the value assigned to target incentive opportunities to provide more motivation (and compensation) to executives, thereby increasing pay at lower performance levels, or 2) a move toward a more discretionary determination of incentive payouts to avoid the need to establish a target/maximum incentive opportunity. Neither of these approaches is particularly attractive from a shareholder perspective since both are less performance-based.

Reduce/Eliminate Use of Relative Measures

The Federal Reserve believes that relative performance measures may provide the wrong incentives to management teams. The rationale appears to be based on three concerns:

  • Relative performance measures do not communicate a clear goal to management teams, as the performance objective is a moving target, based not only on the firm’s performance, but also on the performance of its peers
  • Performance can be strong on a relative basis, but be poor on an absolute basis (for example, the best performing banks in 2008 and 2009 were still poor performers on an absolute basis)
  • If a firm falls behind its peers, they may have incentives to take on excessive risk in an attempt to “catch up” with the competition

Benchmarking/indexing is common in many business areas (e.g., investment performance, financial performance, etc.) that do not relate, necessarily, to pay. Historically, shareholders and other external constituents have pushed for more companies to use relative performance measures as they are viewed as a “truer” measure of company performance that is less subject to “sandbagging” by management or the influence of market or other external factors (all boats rise…). In addition, shareholder advisors rely heavily on relative performance comparisons in making Say on Pay vote recommendations.

Based on our analysis, this is an area where companies have been reluctant to make a shift. About 60% of the companies that we analyzed continue to use relative performance measures as part of their long-term incentive design. It is a fairly even mix between relative TSR and relative Return on Equity, with a few companies using other financial metrics. The majority of companies now combine the relative measures with an absolute financial performance measure, most typically Return on Equity to provide the appropriate risk-balancing the Federal Reserve has been seeking.

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Reduced Use of Stock Options

To state it plainly, the Federal Reserve does not like stock options as an incentive vehicle. Its concerns are similar to those raised by other critics of stock options in the past. Stock options may encourage executives to take on additional risk to increase the stock price, but do not focus management on avoiding decreases in the stock price. From a shareholder perspective, stock options have historically been an attractive vehicle because executives only receive value when the stock price appreciates. Many Compensation Committee members also like that stock options do not require the negotiation of goal setting associated with long-term performance plans. When used in combination with ownership guidelines and post-exercise holding requirements, many of the concerns with options can be addressed.

Most companies in the financial services industry have recently reduced or eliminated the use of stock options (eliminated by Bank of America, BNY Mellon, Citigroup, Discover Financial, Goldman Sachs, PNC, Regions, and Wells Fargo; reduced by BB&T, Comerica, Fifth Third, Huntington Bancshares, KeyCorp, Northern Trust, and US Bancorp). We expect this trend to continue. Stock options have largely been replaced by performance shares. While the Federal Reserve tends to like time-vested restricted stock, shareholders are not enamored by the vehicle as it is often viewed as a form of semi-guaranteed (i.e., non-performance-based) compensation.

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Performance–Based Vesting of Long-term Incentives

As part of the Federal Reserve’s original guidance, they required deferral of at least 50% of incentive compensation for Tier 1 executives, and strongly encouraged that deferred compensation be subject to potential reduction (company-wide or individually) if performance was poor in subsequent periods. This is an area where substantially all banks have responded with recoupment and clawback policies effective in 2012 or 2013.

Companies have added adjustments to long-term incentives in a few ways:

  1. Added a risk-based vesting measure to what would otherwise be a time-vested award of stock options or restricted stock. Typically a threshold level of performance is required for each year of the vesting period. Measures include a threshold level of Return on Equity, Tier 1 Capital, Return on Assets, Credit Rating, or avoiding a loss
  2. Added a discretionary assessment of whether or not executives took inappropriate risks that could potentially lead to a material loss for the company and subject deferred compensation to a potential reduction or elimination based on this assessment
  3. A combination of a quantitative threshold (e.g., a loss, or a return below a threshold level) that triggers a qualitative review that could lead to a reduction or elimination of outstanding deferred awards

Stock Ownership Guidelines and Retention

While the Federal Reserve has not mandated ownership guidelines or requirements for executives to hold on to shares post-exercise of stock options or post-vesting of other vehicles, a number of companies within the financial services industry have implemented rigorous share retention requirements. Shareholder advisory groups and shareholder activists have been pushing the idea of requiring that shares be held to retirement or post-retirement. In most industries, there has been little movement in response. Among the financial services firms we reviewed, several require holding for at least one year post-vesting of shares or exercise of stock options, and nearly 50% of LCBOs have a requirement that executives hold a portion (typically 50%) of net after-tax shares to retirement. A few firms require that shares be held post-vest or exercise for one year following retirement.

Though this is not a specific requirement of the Federal Reserve, we suspect that companies feel that required share retention to retirement encourages executives to focus on preserving the long-term value of shares and provides a strong “risk-balancing” feature sought by the Federal Reserve to the overall program.

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Conclusions

For financial institutions subject to review by the Federal Reserve, compensation programs will continue to evolve over the coming years. It has taken some time for the regulators to develop points of view on compensation programs, and we anticipate that their perspective of what constitutes “substantial conformance” with their guidelines will continue to evolve. One area of concern is ensuring that in addressing appropriate and important concerns about risk, companies are not forced to dilute their pay-for-performance relationship and alignment of executive compensation with shareholder outcomes.

We believe companies will continue to engage with the Federal Reserve in dialogue around pay-for-performance, shareholder expectations and the “overall” structure of their plans vs. any single design feature. It is possible that with ongoing engagement with the regional Federal Reserve Banks and the Federal Reserve Board that the banks (collectively) will be able to share some of their perspectives and use their actual experience, sensitivity analysis and back-testing to provide a better understanding of the risks and the mitigating features underlying their compensation programs. It is our hope that this engagement will allow companies to strike the appropriate balance between pay-for-performance, alignment with shareholders and the Federal Reserve’s valid concerns about managing and averting unnecessary risk.

1 Companies reviewed include American Express, Bank of America, BNY Mellon, Citigroup, Capital One Financial, Discover Financial Services, Goldman Sachs, JPMorgan Chase, Morgan Stanley, Northern Trust, PNC, State Street, SunTrust Bank, US Bancorp, Wells Fargo, BB&T, Comerica, Fifth Third, Huntington Bancshares, KeyCorp, M&T Bank, Regions and Zions Bancorp.

This resulted in significant new reporting requirements for banks and other financial institutions with $1 billion or more in consolidated assets regarding incentive compensation arrangements for Tier 1, Tier 2 and Tier 3 Covered Employees.1,2

cpaflash31-chart-01

  • The Federal Reserve Board (“FRB”) first proposed guidance on incentive compensation in 2009 that was adopted by all the federal banking agencies in 2010 (“Final Guidance”).
  • As a result, the focus of compensation program design at large banking institutions expanded. Beyond pay-for-performance and attracting / retaining talent, the programs must provide a greater focus on appropriately balancing risk and rewards.

To “improve” practices and require conformance with the Sound Guidance, in late 2009 the FRB began a multi-disciplinary horizontal review of incentive compensation arrangements at 25 large complex banking organizations (“LCBOs”). This led to an iterative pay program design process, as regulators now need to “sign off” on compensation program design for all Covered Employees. Based on client experience and a review of 2012 LCBO proxy statements, we have identified key themes concerning what has been done to-date to move towards substantial conformance with FRB requirements.3

Key Themes
1. The Fed is highly involved in the compensation design process at large bank holding companies for a sizeable number of employees (ranging from senior executives to employees well below that level)
2. A majority of variable executive compensation is linked to long-term performance and risk outcomes; it is now typical that more than the required 50% of incentive pay (annual + long-term) be deferred over at least 3 years
3. Performance adjustments are now expected before and after the grant of incentive compensation, and the role of the Risk function and formal risk assessments in that process has increased
4. Long-term incentive goals must now balance business plan and shareholder goals (EPS, TSR, etc.) with risk-based ex-post performance features (capital goals, etc.)
5. It is majority practice to have stock ownership requirements for senior executives that go beyond a more traditional guideline (multiple of base or number of shares achieved within a certain number of years)
6. Clawback provisions go beyond what is required by Sarbanes-Oxley or expected under Dodd-Frank

 

Overall Incentive Compensation: Annual and
Long-term

With the goal of “de-leveraging” incentive pay programs and placing more focus on long-term performance and risk outcomes, some LCBOs have re-balanced the pay mix for senior executives. This typically includes a combination of: 1) increasing base salaries; 2) reducing annual incentive award opportunities; 3) increasing the mandatory deferral rate for a portion of annual incentive awards.

To ensure alignment of compensation with long-term performance and risk outcomes, proposed regulations require that at least 50 percent of incentive compensation (annual + long-term) be deferred over a period of at least 3 years (ratable vesting is acceptable), for specific Tier 1 executives at covered financial institutions with total assets of at least $50 billion (minimum deferral under proposed regulations; Dodd-Frank §956).

approx. (rounded) % of Incentive Compensation Deferred Over At Least 3 Years
(Actual Bonus + Grant Date LTI Value)
CEO NEOs (avg.)
75th%ile 80% 75%
50th%ile 70% 65%
25th%ile 65% 60%

 

Currently, the portion of incentive compensation deferred at LCBOs is substantial and exceeds the minimum guideline. Many of these companies have additional stock retention requirements after deferred compensation vests.

CAP Perspective: These high deferral rates reflect a meaningful shift from historic industry practice.

CAP Perspective: Near-term, medium-sized financial institutions are likely to migrate their practices towards increased deferral rates leading to a change in typical senior executive pay mix.

Regulators also require that the deferred amounts be subject to: “performance adjustment for losses (or other measures or aspects of performance) that are realized or become better known during the deferral period.” These risk (and performance) adjustments are expected prior to the grant of incentive compensation (ex-ante / upfront) as well as post-grant and prior to vesting (ex-post / look-back).

In terms of ex-ante adjustments, all but one LCBO (93 percent) disclosed in its most recent proxy statement an annual risk review prior to payment of incentive compensation that can modify payout. Most companies disclosed a highly discretionary process (more structure likely exists), while 20 percent specifically described use of a risk/compliance scorecard.

CAP Perspective: These new concepts / design will cascade down in organizations, and create additional work for cross-functional teams.

In terms of ex-post adjustments, companies are introducing formulaic and/or discretionary reduction features (see LTI discussion below).

CAP Perspective: The FRB does not recognize market-based (stock price) adjustments alone as an adequate form of risk-based performance adjustment.

Incentive Compensation: Annual Incentives

Measuring absolute (internal) performance against pre-established goals is the most common approach used by the LCBOs to determine bonus payments for senior executives. The goals are most often made up of multiple performance measures. The most prevalent metrics relate to profitability (for example, EPS), followed by return/efficiency metrics (for example, ROE).

Additionally, as a risk management technique, we observed that about 20 percent of LCBOs have reduced annual incentive plan upside leverage, by either reducing target opportunities or capping maximum payout opportunities.

Annual Incentive Plan Measurement
Relative vs. Absolute

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CAP Perspective: Near-term, we expect large bank holding companies to add more structure to the annual incentive decision making process, including increased documentation and back-testing of decisions.

CAP Perspective: We also expect to see an increased use of risk-focused measures, such as use of a minimum capital level as a 162(m) funding requirement.

Incentive Compensation: Long-term Incentives

Most companies use two long-term incentive vehicles. Some form of long-term performance plan (LTPP; performance shares / cash) is the most widely used vehicle, followed by stock options. The most common LTPP performance period is 3 years, and the most common LTPP upside leverage is 150 percent of target.

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CAP Perspective: Stock options have been de-emphasized in the proportion of the long-term incentive award that they represent due to recent stock price volatility and outside criticisms.

CAP Perspective: Stock options are not seen as appropriately performance-based among regulators. There is concern that value can be realized based on macro economic conditions, rather than company-specific events/financials, particularly over a 10 year timeframe. Attaching some form of ex-post performance-based adjustment can provide risk-balancing features.

In addition to traditional long-term goals tied to the business plan, relative performance or stock price, companies have been adopting secondary performance conditions, in reaction to the Final Guidance, intended to significantly reduce or eliminate unvested deferred incentive payments (post grant, an ex-post adjustment) if a risk event were to occur. These adjustments are designed to be done on a formulaic basis, discretionary basis, or both.

Select Examples
PNC
  • Performance-based restricted stock units pay out based on relative EPS growth and ROCE
  • 100% of the payout could be eliminated due to risk-based trigger, whether or not ROEC exceeds the cost of capital
Goldman Sachs
  • Long-term performance plan payouts, if any, based on ROE and increase in book value per share during the performance period
  • In addition, these awards are subject to forfeiture based on discretionary risk considerations and formulaic capital requirements
BNY Mellon
  • Primary plan includes stock option grants which require stock price appreciation for any value to be realized
  • Awards are subject to forfeiture if a minimum ROTCE is not maintained during vesting period

 

When designing a long-term incentive program, it is also important for financial institutions to consider accounting implications.

CAP Perspective: Truly new designs are being implemented, and it seems that some may lead to variable accounting for equity vehicles. Awards may lack a true grant date, resulting in variable accounting, if a discretionary risk assessment subjects the awards to reduction up until vesting. This can lead to increased cost / volatility in expense and therefore create a reason to consider providing a portion of long-term incentive compensation through a cash-based vehicle.

Stock Ownership Requirements

While all of the LCBOs have some form of stock ownership requirement, most have requirements for senior executives that go beyond traditional ownership guidelines (multiple of base and/or number of shares that must be achieved within a certain number of years).

04-chart

CAP Perspective: The most rigorous requirement for executives – an ongoing retention ratio – is most common.

CAP Perspective: Senior executive ownership standards in this industry exceed those typically found in the general industry.

Clawbacks

As most public companies await final SEC regulations, the horizontal review banks have begun to make comprehensive changes to their existing clawback policies. The horizontal review banks have a clawback provision that goes beyond what is required under Sarbanes-Oxley or Dodd-Frank legislation (SEC has not yet proposed rules). These clawback provisions are part of multiple programs and can impact different employee populations or pay elements for varying reasons.

CAP Perspective: Based on disclosed policies, it is noteworthy that “inattention to risk” is a triggering event among 40 percent of the horizontal review banks.

CAP Perspective: In our experience, most companies have yet to think through how they would implement a clawback of previously paid compensation, should one be triggered. This will likely be a complicated process, with a number of legal and tax considerations for both the employee and the company.

Conclusion

Compensation design and governance practices have been changing at LCBOs at an accelerated pace since the horizontal review process began and the Final Guidance was issued. Change will continue among these organizations, and will spread to other large (and smaller) financial institutions. While the regulations are focused on the largest banks ($50B+ in consolidated assets), the design practices discussed above will be increasingly relevant for financial institutions of all sizes.

There are now greater expectations for Board oversight, enhanced controls and related policies, and documentation for incentive plans and risk mitigation strategies. To comply, the Compensation Committee and a cross-functional senior management team must be fully involved, well-informed and possess an in-depth understanding of incentive arrangements for all Covered Employees.

Research assistance for this CAPFlash was provided by: Deep Patel, Devika Ray and Chelsea Carter.

 

1 These companies are required to disclose the structure of their incentive-based compensation arrangements to appropriate federal agencies.

2 As described in the Interagency Guidance, the full set of employees who may individually or collectively expose the firm to material amounts of risk are together referred to as “Covered Employees.”

3 16 LCBOs are U.S.-based. Our analysis focuses on these companies excluding Ally Financial (where the U.S. government remains the majority owner). Data found in proxy disclosures is most relevant to Tier 1 Covered Employees (senior executives).

This leads to a number of questions, such as:

  1. How is the benchmark group of companies defined?
  2. What metric is used most often to measure relative performance?
  3. What level of performance should equate to maximum, target and/or minimum payouts?
  4. What other considerations should be taken into account when designing these programs?

This CAPFlash tracks companies’ response to these questions through our proprietary research database. Each year, Compensation Advisory Partners (“CAP”) reviews proxy disclosures for a cross-industry sample of Fortune 250 companies. In 2011, our study included 111 companies, with 26 companies, or 24% of our sample, incorporating relative performance measurement into their long-term incentive program as a primary performance measure. An additional 7 companies, or 6% of our sample, incorporate relative performance measurement into their long-term incentive program through the use of a modifier.

How is the Benchmark Group of Companies Defined?

For relative performance measurement in long-term incentive (“LTI”) plans, the benchmark group of companies that performance is most often compared to is the executive compensation peer group. We found that 45% of companies measure pay and performance against a consistent group of companies. As shown below, just over half of companies take a different approach. For example, 42% of companies measure performance against an index that differs from the group of companies used to benchmark compensation levels.

No. of % of Cos.
Comparator Groups Used to Measure Relative Performance Cos. n=33
Compensation Peer Group 15 45%
General Industry Index (e.g., S&P 500) 9 27%
Industry Specific Group (Non-Compensation) 6 18%
Industry Specific Index 5 15%
Subset of Compensation Peer Group 1 3%

Note: Percentages add up to greater than 100% due to companies using multiple comparator groups.

Some companies use more than one comparator group. For example: AT&T measures performance relative to the Dow Jones Industrial Average constituents as well as a group of 11 domestic and global telecommunications companies. Intel measures relative Total Shareholder Return (“TSR”) against its executive compensation peer group as well as against the S&P 100; and Northrop Grumman measures relative TSR against a group of leading U.S. and European aerospace and defense companies and the S&P Industrials Index.

Companies tend to use industry peer groups or indices when economic factors have a unique impact on the industry. Companies that use a broader market group, such as a general industry index like the S&P 500, believe that companies compete broadly for investor dollars. They may also operate in industries with a small number of players, making it difficult to identify peers in the same industry.

What Metric is Used Most Often to Measure Long-Term Relative Performance?

As shown below, relative performance plans most often measure company TSR. While EPS is the second most common metric used, it is only used by 15% of companies studied and is typically given less weight than TSR in a relative long-term performance plan.

Relative Financial Metrics Used in Long-Term Incentive Plans

Relative Metric
TSR EPS Other
Overall Prevalence 73% 15% 23%
Most Prevalent Weighting Given To Relative Metric 100% 50% 100%

Note: Excludes companies with TSR used as a modifier (n=7). Percentages do not add up to 100% due to certain companies using multiple relative metrics.

Some companies use more than one measure of relative performance. PNC Financial Services (EPS & ROCE) is one example and MetLife (TSR & EPS) is another. Approximately half of the companies studied (52%) combine relative metrics with absolute financial metrics in long-term performance plans. The most prevalent metric used to measure absolute financial performance, alongside a relative performance metric, is EPS.

What Level of Performance Should Equate to Maximum, Target or Minimum Payouts?

The chart below shows that the relative performance benchmarks used for maximum, target and/or minimum payouts of relative long-term performance plans vary by company. The most common approach is to set threshold, target and maximum payouts at the 25th, 50th and 75th percentiles compared to peers, as highlighted below:

Relative Long-Term Incentive Plan Performance Percentiles

Threshold Prevalence Target Prevalence Max Prevalence
(relative position) (relative position) (relative position)
10th %ile 6% 40th %ile 5% 75th %ile 33%
20th %ile1 29% 45th %ile 5% 80th %ile 22%
25th %ile 29% 50th %ile 68% 85th %ile 11%
30th %ile 6% 55th %ile 12% 90th %ile 6%
35th %ile 24% 60th %ile 5% 95th %ile 6%
40th %ile 6% 65th %ile 5% 100th %ile 22%

Note: In cases where a rank approach is uses, percentile was interpolated.

Companies use two approaches to define relative market positioning: either “percentile” or “rank.” As shown below, the percentile approach is most common. Examples of companies that use a ranking system include Motorola Solutions, Pfizer and Target. Examples of companies that use a percentile system include Lockheed Martin, Chubb and Express Scripts.

Relative Long-Term Incentive Plan Payout Measurement

Payout Based On
Percentile Rank
Number of Companies 17 10
Prevalence 63% 37%

Note: Excludes companies (n=6) that do not specifically disclose basis for relative long-term performance plan payout.

Leverage is another feature of long-term performance plans. Plans must define what percentage of the target opportunity threshold or maximum performance will yield. The chart below describes the leverage in relative performance plans among the companies in our study. It is most common for threshold performance to result in a payout of 50% of target, and for maximum performance to result in a payout of 200% of target.

Relative Long-Term Incentive Plan Payouts

Threshold Prevalence Max Prevalence
(as % of target) (as % of target)
15% 9% 120% 4%
20% 5% 125% 4%
25% 22% 150% 8%
30% 9% 200% 80%
35% 14% 250% 4%
40% 5%
50% 31%
60% 5%

Note: Percents have been rounded to nearest 5%.

What Other Considerations Should Be Taken into Account When Designing These Programs?

Accounting Implications

When determining what long-term incentive design to implement, it is important to consider accounting implications. If the award is denominated and paid in cash, then it requires mark-to-market accounting where the charge is generally “trued up” to the value of the final payout. A share-based award that utilizes a financial metric has a somewhat similar treatment, where the accounting charge is trued up for the number of shares earned, but the equity value is fixed at grant. Differently, for a share-based award that uses a market-based metric (such as TSR) the accounting charge is fixed on the grant date and the expense does not change to reflect the final payout. While some view this design feature as a positive as it avoids “volatile” period-to-period accounting, others are uncomfortable with the fact that the charge cannot be reversed if performance is below threshold and a payout does not occur.

A properly designed modifier approach (where the primary award determinant is an internal financial metric) is an alternative for companies not wanting to have a “fixed charge” while still utilizing a market-based relative metric. In this case, if internal financial goals are not met, there is no expense as the impact of the market condition was considered and locked in as part of the grant-date fair value per share. The final total expense equals the grant-date fair value per share times the number of shares earned under the EPS goal. Thus, total expense is trued up for the outcome of the performance condition – but not for the outcome of the market condition, which was incorporated in the grant date value per share.

Important: Before selecting a specific go-forward design for your unique circumstance, we recommend that you confirm accounting treatment for all designs under considerations with outside advisors.

Discretion

Relative performance plans help reduce the need for discretionary adjustments to performance goals, which is often viewed as a positive feature of these plans. However, attraction / retention issues can occur when relative performance plans do not pay out. Annual grants with overlapping performance cycles are a common way of maintaining motivational impact, even when performance is down in one or two years. While not seen frequently, we have observed some companies attempt to solve for these issues by using alternative approaches. Some approaches include:

  • Providing an added opportunity to earn an award if a financial metric (such as EPS) exceeds a pre-determined level of absolute performance;
  • Adjusting earned awards down by a small amount if absolute results do not reflect improvement;
  • Limiting payout based on relative TSR to no higher than target if a company has negative TSR while it is outperforming its benchmark group; or
  • Guaranteeing a minimum payout (threshold).

In most cases, annual grants are the approach that makes the most sense, since it clearly aligns with shareholder interests.

TSR Modifier

Of the 33 companies studied with relative performance plans, 7 companies or 21%, incorporate relative financial performance into their LTI program using a TSR modifier. These companies’ LTI plans are measured against absolute metrics and then a TSR modifier is used to adjust the payout up or down. Companies with plans that incorporate a TSR modifier measure relative TSR performance against a variety of benchmarks.

No. of % of Cos.
Comparator Groups Used to Measure Relative Performance Cos. n=7
Compensation Peer Group 3 43%
General Industry Index 3 43%
Industry Specific Index 1 14%

A TSR modifier typically applies in all cases. However, some companies intend for a TSR modifier to only operate in “fringe” situations where absolute performance results differ substantially from relative performance. For example, a modifier could function so that if relative three-year TSR is in the bottom quartile, the performance share payout will be reduced by 25%. Conversely, if relative three-year TSR is in the top quartile, the performance share payout will be increased by 25%.

Views of Proxy Advisory Firms are Important

Glass Lewis recently wrote that: “[the] sole use of absolute metrics under long-term incentive plans is inappropriate as they may reflect economic factors or industry-wide trends beyond the control of executives on individual performance.” This statement seems to indicate that they believe incorporating a relative measure into a long-term incentive plan can provide balance. Likely under a similar premise, ISS reviews both relative and absolute performance as part of its pay-for-performance analysis (specifically focused on TSR). Therefore, support of proxy advisory firms is another reason to consider relative performance measurement.

Conclusion

When designing long-term incentives, we recommend that companies start by defining their objectives (business, employee and shareholder), and then assess their ability to set long-term goals. When companies determine that a relative performance metric could help management drive performance, these plans should be considered. In the current Say on Pay environment, a properly calibrated relative long-term performance plan is one way to say: “we only pay above target for outperformance.”

1 For companies that set threshold performance/payout at the 20th percentile, maximum performance/payout is typically set above the 75th percentile.