CHANGES IN ANNUAL INCENTIVE PLAN DESIGN

Overall, 37% of companies made changes to their annual incentive plan design in 2012 or 2013. The most common changes were to increase the target incentive opportunity for the CEO and/or CFO (43% of companies making a change to increase target award opportunities) or to change to the annual incentive performance metrics (35%). Companies continue to review and enhance the pay-for-performance relationship through changes to the annual incentive program.

Type of Change Reported in CD&A	2012 No. of Cos.	% of Cos. Reporting Changes
		2012 (n = 37)	2011 (n = 43)
Increase target award opportunities (CEO and/or CFO)	16	43%	28%
Change in performance metrics used to fund awards	13	35%	42%
Change in performance metric weighting/mix	4	11%	21%
Adopt mandatory deferral mechanism	4	11%	n/a
Change in maximum award payout	3	8%	12%
Other Changes	8	22%	19%

Note: Due to multiple responses, does not add up to 100%.

Change in Target Bonus Opportunity

Last year median target bonus opportunities for the CEO and CFO positions increased by 6 and 1 percentage points to 159% and 101% of salary, respectively. The target bonus opportunity for CEOs in the Technology industry increased by 50 percentage points in 2012 due to an increase in the target opportunity at Apple (from 50% to 100% of salary) and Verizon (from 187.5% to 250%). Conversely, in the Consumer Goods industry, target bonus opportunities decreased year over year due to new incumbents in these roles.

Industry	Median Target Bonus as a % of Salary
	CEO			CFO
	2012	2011	Change in %age Pts.	2012	2011	Change in %age Pts.
Automotive	138%	130%	+8%	88%	88%	0%
Consumer Goods	160%	170%	-10%	90%	100%	-10%
Financial Services	n/m	n/m	n/m	n/m	n/m	n/m
Health Care	145%	145%	0%	101%	100%	+1%
Insurance	200%	200%	0%	130%	120%	+10%
Manufacturing	142%	156%	-14%	93%	95%	-2%
Pharmaceutical	150%	150%	0%	97%	91%	+6%
Retail	190%	168%	+12%	90%	85%	+5%
Technology	250%	200%	+50%	135%	121%	+14%
Total Sample	159%	153%	+6%	101%	100%	+1%

Note: Financial Services industry is excluded since most companies in our study do not disclose target bonus opportunities for the Named Executive Officers.

Change in Performance Metrics

Of the companies that changed or plan to change the performance metric:

• Nine (9) companies added metrics to the current plan
• Two (2) companies reduced the number of metrics, and
• Two (2) companies kept the same number of metrics but replaced a metric in the incentive plan.

Several companies indicated that their rationale for changing annual incentive metrics was, in large part, to better align executive pay with the business strategy and shareholder interests:

• Caterpillar: Incorporated Operating Profit After Capital Charge (OPACC) as a measure, to reflect how the Company is utilizing its assets in order to generate shareholder value
• CIGNA: Added a customer loyalty metric in 2013 to emphasize its business strategy and focus on the customers it serves
• Hewlett Packard: Introduced year over year improvement in Return on Invested Capital as an annual incentive metric to focus executives on the business turnaround

ANNUAL INCENTIVE PLAN DESIGN / PRACTICES

Award Leverage

Most companies reviewed did not disclose a threshold level of performance required to receive a bonus payment. Instead, these companies disclosed a minimum bonus of $0. For the 37 companies that did disclose a threshold bonus, 50% of target is the most prevalent payout percentage. However 20 companies, disclose a minimum bonus payout of less than 50% of target with a majority of these companies paying out for results based on one of multiple plan metrics. A majority of companies (58%) have a maximum bonus opportunity of 200% of target bonus. Thirteen (13) companies have a maximum bonus of 250% of target or higher. Four (4) of these companies are in the Consumer Goods industry and three (3) are in the Technology industry.

Threshold as a % of Target (n=37)
Range	# of Cos.	% of Cos.
< 25%	10	27%
25% < 50%	10	27%
50%	12	32%
50% < 75%	1	3%
75 <100%	4	11%

Maximum as a % of Target (n = 78)
Range	# of Cos.	% of Cos.
100% < 150%	2	3%
150% < 200%	16	21%
200%	45	58%
200% < 250%	2	3%
> 250%	13	17%

Of the six (6) companies that made changes to their maximum bonus potential in 2012/2013, three (3) companies increased the maximum bonus potential and three (3) companies reduced the maximum. Two (2) of these companies (Allstate and Colgate-Palmolive) changed the maximum payout for the CEO only.

Annual Incentive Plan Metrics

Similar to 2011, Revenue, EPS, Cash Flow and Operating Income continue to be the most prevalent metrics used across all companies, although we see some variation in metrics by industry. In 2013, 30% of companies disclose using two (2) metrics in their annual incentive programs, 29% use three (3) metrics, and 12% of companies use four (4) or more metrics. Approximately 85% of these companies use a profit-based metric in combination with Revenue and/or Cash Flow.

Refer to the chart below for the three (3) most prevalent metrics by industry:

Industry	Actual Bonus as a % of Target Bonus – CEO
	2012			2011
	25th%ile	Median	75th%ile	25th%ile	Median	75th%ile
Automotive	69%	102%	131%	130%	153%	186%
Consumer Goods	94%	103%	137%	78%	132%	149%
Financial Services	44%	80%	120%	111%	114%	130%
Health Care	103%	127%	157%	116%	127%	159%
Insurance	112%	130%	144%	85%	106%	130%
Manufacturing	100%	107%	146%	119%	136%	162%
Pharmaceutical	125%	142%	156%	130%	144%	161%
Retail	79%	117%	136%	112%	129%	147%
Technology	90%	99%	124%	75%	100%	149%
Total Sample	93%	112%	144%	105%	133%	156%

Note: Most companies in the Financial Services industry does not disclose target bonus. Figures for the Financial Services industry reflects actual bonus as a percentage of 3-year average actual bonus.

2012 Actual Bonus Payout

Similar to 2011, approximately 95% of companies awarded bonuses to their Named Executive Officers for 2012 performance. Overall, the median CEO bonus was 112% of target compared to 133% in 2011, indicating that 2012 performance generally exceeded par, but was not as strong as 2011 performance. Median 2012 bonus payouts in the Health Care, Insurance, Pharmaceutical and Retail industries exceeded target by 15 – 40 percentage points while payouts in the Automotive, Consumer Goods, Manufacturing and Technology industries were closer to target.

15% of companies in our study require executives to defer all or a portion of their annual incentive payout. Nearly 50% of companies that require a portion of the annual incentive award to be deferred are in the Financial Services industry. Among companies with mandatory deferrals outside of the Financial Services industry, two (2) companies pay a portion of the annual incentive in restricted stock units if the total payout exceeds a specific level:

• HCA Holdings: Any bonus payout above target is delivered 50% in cash and 50% in restricted stock units
• 3M: Annual incentive payouts in excess of 200% of target are paid in the form of restricted stock units

CONCLUSIONS

Companies are continuing to refine their annual incentive program to ensure executive pay is aligned with the Company’s business strategy and key success indicators. These recent trends also indicate that companies are modestly increasing CEO pay through the bonus opportunity and award leverage. Actual payouts for 2012, however, indicate stronger performance goals and moderately above target payouts, yet lower than the previous year. Revenue, EPS, Cash Flow and Operating Income continue to be the most prevalent annual incentive plan metrics with a majority of companies using two (30%) or three (29%) metrics to reward executives for company performance. We expect companies to continue to refine metrics and performance goals / leverage linkages in the annual incentive plan as shareholders and proxy advisory firms scrutinize the executive compensation program.

Among the 100 company sample, median revenue was $33B, median market capitalization was $37B and median Total Shareholder Return (TSR) was 19% in 2012.

What We Found

Although shareholder support for Say on Pay has been increasing year-over-year with a significant majority of companies receiving over 90% support, companies continue to regularly review and modify their executive compensation programs in response to shareholders, proxy advisory firms and good governance practices. Consistent with our findings last year, companies continue to modify clawback policies and scale back perquisites. New to our research in 2013, hedging /pledging polices have also gained traction as a result of Dodd-Frank and ISS’ policies.

Dodd Frank

The Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd Frank) was signed into law in 2010 and will require the following governance practices:

• Companies must implement a clawback policy for executive officers that allows for recoupment of any incentive compensation, with a three-year look back, due to any restatements
• Companies must disclose whether they have a policy that prohibits hedging of company shares (e.g., through the purchase of derivatives that protect executives from stock price swings)
• Companies must disclose whether they have a policy to address pledging of company shares (e.g., as collateral for a loan)

The SEC has yet to release guidance on these areas and the timing of future guidance is uncertain. As such, many companies have taken steps to implement policies on their own.

Clawbacks

Dodd Frank requires a broader definition of clawbacks compared to Section 304 of SOX, which applies to CEOs and CFOs. When clawback policies were first adopted by Dodd Frank many companies took a “wait and see” approach; however, with the continued delay in final regulations, companies have been more proactive in modifying their policies.

Nearly all of our research companies – 94 of 100 (94%) – have some form of clawback policy, compared to 86% and 80% in 2011 and 2010, respectively. In 2012, 10 companies adopted a new policy and 11 modified existing provisions. The two industries that saw the most changes to their clawback polices included automotive (45% of companies) and financial services (45% of companies). Typically financial services firms expanded their clawback policies to cover all incentive awards and situations beyond just financial restatements.

As was the case in prior years, a financial restatement (83%) and misconduct (75%) are the most common triggers for a clawback.

Under nearly all policies, it is most common for companies to include the ability to recoup compensation previously granted and it is less prevalent to clawback any future incentive compensation. While the final rules are not expected to include future compensation, we expect companies that already have this provision may continue to include it.

Compensation Subject to Clawback	2012		2011		2010
	No. of cos	% of Cos. n=94.	No. of cos.	% of Cos. N=98	No. of Cos.	% of Cos. n=89
Prior LTI	88	95%	95	97%	79	89%
Prior Annual Incentive	86	92%	92	94%	81	91%
Future Annual Incentive	19	20%	16	16%	20	22%
Future LTI	18	19%	15	15%	14	16%

Note: Percentages add up to greater than 100% due to multiple responses

Coverage extends to NEOs in 91% of companies, which is consistent with our findings in 2010 and 2011. Of the other 9% of companies, most define coverage as, “executive officers, officers, senior executives or senior management.” Companies are not required to disclose the level of program detail in the proxy, but we expect most program provisions are more broad-based.

Similar to our findings in 2010 and 2011, less than a quarter of companies indicate the length of the look-back period during which compensation can be recovered after a financial restatement. Of the 20 companies that disclosed a time frame, the most common is 1 year (47% of companies) from date of restatement, followed by 3 years (26% of companies). While not common practice, some companies disclose a different time period for annual incentives and long-term incentives.

While many companies are waiting for the SEC to adopt final rules before making comprehensive changes to their policies, companies have been proactive over the last 3 years in adopting clawback policies. On their own merits, such provisions:

• Provide the Board with flexibility to clawback for unforeseen circumstances
• Allow flexibility for the Board to access whether the reinstatement had implications for shareholders (e.g., economic issue or accounting issue)
• Increase executive accountability
• Garner positive reaction from shareholders
• Receive credit by ISS in the QuickScore evaluation (under Equity Risk Mitigation topic)

As we await for the SEC to propose final rules, there are several practical challenges to clawing back compensation, such as how to clawback equity gains, how to claw back from former employees and the tax implications of clawbacks.

HeDGING AND PLEDGING

Hedging and pledging have become shareholder/ corporate governance issues, especially now that ISS views any hedging and significant pledging by insiders to be indicative of a potential failure of risk oversight on behalf of a company’s Board. The Board’s policy regarding these practices is most commonly reflected in the company’s insider trading policy, but it can be addressed through Board resolutions or a stand-alone policy.

Hedging is viewed as a poor practice as it insulates executives from stock price movement and reduces alignment with shareholders. Pledging, in modest amounts, may not be viewed as negatively as hedging, yet can become problematic if there were a significant decline in stock price and which necessitated a sale of shares. Given the potential negative perception of insider hedging and pledging, companies have begun to adopt policies to limit these provisions. Anti-hedging and pledging policies are in place at 91% and 59% of companies studied, respectively; 59% of companies have both policies in place and 32% only have a hedging policy.

Hedging / Pledging Policy	2012
	No. of cos	% of Cos. n=100
Hedging	91	91%
Pledging	59	59%
Both	59	59%
Hedging Only	32	32%

Note: Percentages add up to greater than 100% due to multiple responses

An example of typical disclosure of a prohibition on hedging/pledging is reflected in PepsiCo’s proxy disclosure:

“Our insider trading policy prohibits executive officers from using any strategies or products (such as derivative securities or short-selling techniques) to hedge against the potential changes in the value of PepsiCo Common Stock. In addition, executive officers may not hold PepsiCo securities in a margin account or pledge PepsiCo stock or PepsiCo stock options as collateral for a loan.”

Pledging was not addressed in Dodd-Frank per se, and we do not know what the SEC’s position will be in the future. We do however expect more companies to adopt pledging policies going forward given ISS’ 2012 policy statement that identified pledging of company stock by executives as a poor practice.

To improve Say on Pay results, many companies have already have already implemented policies that prohibit hedging and pledging.

Perquisites

In 2012, companies in our research (91%) provided one or more perquisites to the CEO. Most commonly provided perquisites to the CEO include personal use of aircraft (61%), automobile allowance (51%), financial planning (43%) and personal security (42%).

The value of perquisites offered to executives however, has continued to decrease. Median perquisite values disclosed for the CEO and CFO in 2012 were $99,874 and $21,357, respectively. This is a 32% decrease for CEOs and a 70% decrease in value for CFOs in our research. The manufacturing industry had the highest median perquisite values of $319,793 and $69,069 for the CEO and CFO, respectively.

Perquisites tend to be a small proportion of an executive’s total compensation, yet are often highly visible. Shareholders prefer to see pay delivered in performance-based vehicles vs. perquisite programs. Over the past few years, companies have been making changes to these programs in reaction to increased shareholder scrutiny and specific feedback received from shareholders or the likes of ISS or Glass Lewis. In 2012, 9 of 100 companies (9%) disclosed making a change to their perquisite program, a continuation of the trend to reduce perquisites that took hold several years ago.

Perquisite Change Reported in 2012 CD&A	2012		2011		2010
	No. of Cos.	% of Cos. n=9	No. of Cos.	% of Cos. n=14	No. of Cos.	% of Cos. n=20
Eliminated tax gross-ups on perquisites	4	44%	6	43%	8	40%
Eliminated perquisite	2	22%	9	64%	11	55%
Reduced perquisite program/value	1	11%	1	7%	2	10%
Changed perquisite program	1	11%	0	0%	3	15%

Note: Percentages add up to greater than 100% due to multiple responses

Occasionally, a company eliminates a perquisite and offsets some of the lost value or reduction through a salary increase or a one-time payment. An example from 2012 is Lear Corp, which disclosed the following:

“Effective January 1, 2012, we eliminated a separate annual perquisite allowance by adding this amount to the base salary of our Named Executive Officers. However, for purposes of determining incentive awards in 2012 and 2013, which are specified as a multiple of salary, the prior perquisite amount is excluded.”

Importantly, Lear excluded the amount of this increase for purposes of incentives, eliminating the potential to provide an even greater, unintentional increase, in total.

The changes in 2012 include two companies eliminating perquisite allowances, one company approving residential security measures for the CEO and one company reducing the allowance for personal use of aircraft for the CEO and CFO. We expect this trend to sustain as more and more companies are responding to the concerns of their shareholders, which can be voiced through a company’s Say on Pay vote.

Conclusions

With Say on Pay votes held annually for a majority of companies, we continue to see companies stay ahead of the curve and track “best practices” in order to satisfy shareholders and proxy advisory firms. This results in reevaluations of company pay and governance practices, and as our research shows, continued modification of perquisite programs and clawback policies, and adoption of hedging and pledging policies. The goal continues to be closer alignment of executive compensation with shareholder interests. We expect companies and Boards to more proactively monitor proxy advisory firm policies and Dodd-Frank legislation when considering changes to pay programs.

ISS Policy Update – RDA Test

For the past two years ISS has used three quantitative pay vs. performance tests related to CEO pay and company performance (absolute Pay-TSR Alignment / PTA; Multiple of Median / MOM; and Relative Degree of Alignment / RDA) to screen for companies where a potential pay-for-performance misalignment may exist. In addition to the quantitative screen, ISS will always conduct a qualitative analysis of the pay program. If Medium or High concern is identified through the quantitative pay vs. performance screen, the qualitative analysis will be more robust.

For 2014, ISS modified the RDA test. In the past the RDA screen had been calculated as the difference between the company’s TSR rank and the CEO’s total pay rank within a peer group, as measured over one-year and three-year periods. The one-year and three-year periods were weighted 40% and 60%, respectively. The new methodology is focused on three years only. In addition, the RDA policy updates indicates that companies with less than three years of pay and performance data will still be subject to the RDA test, which reflects a change versus past practice.

CAP Perspective: We agree with ISS’ decision to apply a longer-term focus to the quantitative RDA test; i.e., solely a three-year timeframe for both pay and performance. However, we believe that recent Committee decisions best relate to company performance over time.

Board Response to Majority Supported Shareholder Proposals

For 2014, ISS made three changes to its policy on Board responsiveness to majority-supported shareholder proposals.

1. ISS will review the responsiveness of a Board to any shareholder proposal that receives one year of a majority of votes cast support (rather than the previous “triggers” of either two years of a majority of votes cast in a three-year period, or one year of a majority of shares outstanding);
2. ISS adopted a case-by-case approach, including a list of factors for Analysts to consider, for assessing implementation of majority vote proposals;
3. Finally, ISS provided Analysts with broader discretion when determining which directors to hold accountable in the event the level of responsiveness is found to be insufficient.

We note here that ISS included “the Board’s rationale as provided in the proxy statement” as one of the factors in the case-by-case analysis.

CAP Perspective: Using the proxy statement as a communication (marketing) document in addition to a compliance document has been an often stated best practice over the past few years, which gains additional support from this ISS policy update.

This “comply or explain” policy update from ISS encourages the Board to enact a majority supported shareholder proposal, but gives an important second route. We believe there are instances where the Board should be able to exercise its discretion to respond in a manner that it believes is in the best interest of the company. However, we believe that providing rationale in these instances is also important.

Conclusion

ISS policies and tests should not determine, but rather be one input to the compensation program design and annual decision making process. Therefore, an understanding of ISS’ policies and tests, both retrospectively and prospectively (projection) is important. We encourage our clients to review how ISS’ 2014 policy updates are likely to impact them.

CAP submitted comments to ISS on the draft policy updates, which can be found at: http://www.issgovernance.com/2014draftpolicycommentperiod.

Reflecting a change with past practice, ISS is opening a new consultation period on approaches to certain benchmark policies for consideration for longer term policy changes (beyond 2014). An example of the type of area that this will cover is evaluation of new share requests. As more information on the consultation period and related topics becomes available, we will update our clients. The current consultation period closes in February 2014, which will eventually be followed by the more traditional process which includes a policy survey followed by release of draft policies for comment.

Management Say-on-Pay Proposals (U.S.)

ISS will recommend voting against advisory Say on Pay resolutions related to executive compensation if there is a perceived misalignment between CEO pay and company performance, based on both quantitative tests and a qualitative review of the pay program and related Compensation Committee decisions.

ISS is considering the following policy change for 2014:

Simplify the methodology for calculating the Relative Degree of Alignment (RDA) pay-for-performance screen. The proposed new methodology is to calculate the difference between the subject company’s TSR rank and the CEO’s total pay rank within a peer group, as measured over a three-year period (or for as many fiscal years that the company has been publicly traded and has disclosed pay data, if less than three years).

Currently the RDA screen is calculated as the difference between the company’s TSR rank and the CEO’s total pay rank within a peer group, as measured over one-year and three-year periods. The one-year and three-year periods are weighted 40% and 60%, respectively.

ISS Request for Comment – Proposed RDA Policy Change

Are there circumstances under which performance or pay from the most recent year should weigh more heavily in a pay-for-performance analysis?

CAP Perspective: We agree with ISS’ preliminary decision to apply a longer-term focus to the quantitative RDA test; i.e., solely a three-year timeframe for both pay and performance. However, we believe that recent Committee decisions best relate to company performance over time. We urge ISS to state that the qualitative assessment will place particular emphasis on recent Committee decisions that apply prospectively in a year following:

• Below par shareholder support for an advisory Say on Pay resolution (less than 70%)
• A CEO transition
• A corporate transformation (merger, major acquisition, etc.)

We also urge ISS to use realizable pay in the RDA test (with ISS’ current definition and assumptions), instead of grant date pay. Realizable pay would better show if pay was aligned with performance over time. This methodology change could also apply to the PTA test.

Finally, we urge ISS to address the following questions and concerns in its 2014 policy release.

• Under the ISS 2014 policy, as proposed, a three-year point-to-point TSR will be used for the quantitative RDA test, which in practice reflects a compound annual growth rate. This approach could lead to volatile RDA results since it uses a single day as the starting point and ending point in the performance analysis. An alternative approach that ISS should consider is to calculate TSR using the average starting and ending stock prices over a 20-trading-day period. This will reduce volatility and add credibility to the results.
• ISS should also consider adopting an alternative approach for calculating TSR performance that reflects the average relative position of TSR during each of the three most recent one-year periods, rather than a compound annual growth rate. Looking at performance trends over multiple time periods may yield additional insight into performance and related pay decisions.
• Also under the ISS 2014 policy, as proposed, three-year average (arithmetic mean) compensation will be used in the RDA test. We support this approach, but certain issues should be acknowledged. This approach does not fully address the problematic timing of proxy reporting where a Compensation Committee evaluates performance in the year just ended and makes a long-term incentive award in the beginning of the following year. This award is reported in the proxy in the following year and does not impact ISS’ analysis. We urge ISS to acknowledge that this timing (reporting) difference will be considered in its qualitative assessment of the pay program and related decision making. Given the imperfections in the compensation data analyzed, we support the simple, straightforward approach that is proposed for the compensation data included in the RDA quantitative test that focuses solely on a longer time horizon vs. the current approach. The approach, as proposed, will also smooth out some of the extremes seen in individual years.
• We ask ISS to provide its reasoning as to why it is appropriate to weigh recent pay and performance more in the PTA test, but not in the RDA test. Why does it make sense for these tests to incorporate inconsistent timeframes and weightings?

ISS Request for Comment – Proposed RDA Policy Change (cont’d)

Are there any unintended consequences from using a simple, unweighted three-year pay and performance measure as the basis for the RDA screen?

CAP Perspective: We believe the proposed approach for performance measurement is potentially too volatile since it depends heavily on a single “start” point and a single “end” point.

As stated above, we urge ISS to use an average stock price at the beginning and end points of the TSR calculations for its pay versus performance tests, which would align with methodology used in the ISS SVT tool. We believe that use of a 20-trading-day average stock price would limit the impact of very short-term stock price fluctuations on the results.

A second alternative, also noted above, would be to use the average relative position of TSR during each of the three most recent one-year periods, rather than a compound annual growth rate. This would be beneficial since it would reduce volatility in the TSR calculation.

ISS Request for Comment – Other

Please feel free to add any additional information or comments on the proposed policy change.

CAP Perspective: We have additional comments that relate to ISS Say on Pay vote recommendations. Outlined below, we describe additional changes that we urge ISS to consider.

RDA and PTA Tests – Time Period

We urge ISS to provide its reasoning for why the timeframe used for the RDA quantitative test (three years) is different than the timeframe used for the PTA quantitative test (five years). Why is the use of inconsistent time frames appropriate?

RDA Quantitative Thresholds

ISS has indicated that the thresholds for the Medium and High level of quantitative concern have not yet been set by ISS Research for 2014 pay vs. performance analyses. We urge ISS to expand the thresholds for the RDA test so that fewer companies are flagged with “Medium” or “High” concern levels and, in turn, increase consistency between the RDA test and the PTA test.

In the December 20, 2011 ISS white paper titled “Evaluating Pay for Performance Alignment”, in the “Back-testing the Measures” section, a table was included:

Measure	Level that may trigger high concern in conjunction with other measures (“Medium” concern)	Level that triggers high concern by itself (“High” concern)
RDA	-30 (~25th percentile)	-50 (~10th percentile)
MOM	2.33x (~92nd percentile)	3.33x (~97th percentile)
PTA	-30% (~10th percentile)	-45% (~5th percentile)

 

As shown above, 1 in 4 companies is expected to receive “Medium” concern from the RDA test, but only 1 in 10 companies is expected to receive “Medium” concern from the PTA test.

• We believe the amount of companies expected to receive “Medium” and “High” concern within each of ISS’ quantitative screens should be more consistent
• We find the thresholds (~10th percentile and ~5th percentile) in the PTA test to be most reasonable to identify outliers, and believe expecting one in four companies to receive “Medium” concern from the RDA test is unreasonably high

Performance Goals – Evaluation of “Rigor”

ISS reviews the rigor of performance goals in its qualitative pay-for-performance assessment. We urge ISS to be more transparent regarding the parameters for this assessment.

Multi-year Long-term Grants

When recruiting new CEOs, companies often grant long-term incentives that are intended to make up for compensation forfeited from a previous employer (often called “make-whole” grants). In these instances, we urge ISS to exclude these grants from the pay-for-performance testing since the grants fill a very specific need and would not be granted in the absence of forfeited compensation.

Time-based Stock Options

In our experience, many investors and most corporate directors view time-based stock options as a performance-based long-term incentive vehicle; i.e., they disagree with ISS’ classification of this form of compensation as “non-performance-based pay”. We urge ISS to include questions on this topic in its next policy survey.

Among the 100 company sample, median revenue was $33B, median market capitalization was $37B and median Total Shareholder Return (TSR) was 19% in 2012. As indicated in the charts below, there is significant variation in company size and performance by industry.

COMPENSATION PHILOSOPHY

Nearly 60% of companies in our study disclose a target total pay position for the Named Executive Officers (“NEOs”). Of these companies, approximately 75% target total pay at median, up from 60% a year ago; indicating that companies are shifting their compensation pay philosophy to a market median standard in reaction to increased scrutiny from shareholders and proxy advisory firms.

Target Total Compensation Pay Positioning (n=57)	CEO	CFO
Below Median	1%	0%
At Median	74%	75%
Above Median	25%	25%

 

CAP Perspective: Change in targeted pay position to median reflects movement to adopt more conservative target pay practices that demonstrate a strong link to performance.

PAY MIX

Overall, companies did not make significant shifts in the total pay mix in 2012 vs. 2011. CEO and CFO total pay continues to place significant emphasis on long-term incentives (“LTI”); on average, LTI reflects 66% of pay for CEOs and 63% for CFOs.

CHANGES IN TARGET PAY LEVELS

The chart below shows average year over year change in target pay levels for CEOs and CFOs in our study.

Note: Excludes newly hired/promoted executives and one-time sign-on/retention equity awards. Percentages include zeroes.

CAP Perspective: We see increases in target pay levels in the low single digits, though the most significant increase is in target annual incentive opportunities suggesting that companies are increasing performance-based pay to reinforce the pay-for-performance link.

Base Salary

CEO base salaries in 2012 increased 3%, on average, though only 46% of companies provided salary increases. Base salaries for CFOs increased by 5% though fewer companies provided an increase in 2012 (68%) vs. 2011 (78%) suggesting salary increases were made less frequently for senior executives than other employees.

Executives in the Health Care and Pharmaceutical industries were more likely to receive a salary increase (70% of CEOs in the Health Care industry and 90% of CFOs in the Pharmaceutical industry) than those in other industries. Financial Services, Insurance and Technology industries were less likely to provide a salary increase for the CEO in 2012.

Base Salary Action	CEO		CFO
	2012	2011	2012	2011
Increase	46%	47%	68%	78%
No Change	52%	50%	26%	20%

 

Note: Does not include newly hired CEOs or CFOs. Therefore, percentages do not add up to 100%.

Target Bonus

Target bonus for both the CEO and CFO increased modestly at median levels. At the 75th percentile, the bonus opportunity for CFOs increased by almost 20 percentage points. Target bonuses for CEOs in the Automotive, Consumer Goods and Technology industries increased the most in 2012. CFOs in the Automotive, Retail and Technology industries saw significant increases as well.

Summary Statistics	Target Bonus as a % of Salary
	CEO			CFO
	2012	2011	Change in %age Pts.	2012	2011	Change in %age Pts.
75th Percentile	200%	200%	0%	143%	125%	+18%
Median	157%	153%	+3%	103%	100%	+3%
25th Percentile	133%	135%	-2%	90%	85%	+5%

Target Total Cash Compensation

Target total cash compensation increased for both the CEO (5%) and CFO (9%) in 2012, mainly due to increases in annual incentive opportunities.

Total Long-term Incentives (LTI)

Increases in total LTI in 2012, on average, were fairly modest; total LTI increased by 3% for CEOs and 5% for CFOs. However, some industries saw significant increases in LTI year over year: CEOs in the Health Care and Consumer Goods industries, on average, received increases in LTI of 30% and 20%, respectively. CFOs in the Technology and Retail industries received the highest increases of 24% and 9%, respectively.

Target Total Compensation

Target total compensation increased over 2011 levels primarily through increases in target annual incentives and, in some industries, through increases in LTI. These findings varied by industry. Financial Services, Pharmaceutical and Retail companies, on average, provided the most significant increases in target annual incentives over other pay components, while Consumer Goods and Health Care industries had the greatest increase in target LTI opportunities.

CONCLUSIONS

Overall, companies had modest increases in target pay levels for the CEO and CFO, through changes in annual and long-term incentives. The Consumer Goods and Health Care industries saw increases in the 15%-20% range driven by higher LTI opportunity while other industries saw more modest changes in total pay levels. Compensation philosophies continue to migrate to median as companies adopt a more conservative pay philosophy. Overall pay mix for the CEO continues to maintain a strong LTI component (66% of pay) with salary representing smaller component of pay (14%), on average. We expect shareholders and proxy advisory firms to continue to influence company pay strategy, as companies to continue to provide modest increases in target total pay mainly through incentive compensation.

Industry	Average Year over Year Change in CEO Target Pay – Top 3 Industries and Overall Sample
	Base	Target Bonus	LTI	Target Total Compensation
Health Care	2%	4%	30%	19%
Consumer Goods	3%	13%	20%	17%
Automotive	4%	7%	7%	6%
Overall Sample	3%	8%	3%	3%

Notable Findings

Total Board Compensation

At median, non-employee director compensation increased three percent in 2012, to $257K, after a six percent increase in 2011 and a flat period in 2010. Year-over-year, median Total Board Compensation increased from $250,000 to $257,0003.

In line with emerging practices, large companies are relying on annual retainers to compensate outside directors. Use of Board meeting fees remained a minority practice in 2012, with only 18 percent of companies paying board meeting fees. This is similar to 2011 and 2010, where 19 percent and 23 percent of companies provided meeting fees, respectively.

Pay Mix

The mix of cash and equity paid to outside directors was generally consistent between 2010 and 2012. On average, the majority of compensation delivered to directors continues to be in the form of equity.

Equity Compensation

Full-value share equity, including restricted stock units, restricted stock, deferred stock units and outright awards of common stock, continues to be by far the most common form of equity delivered to non-employee directors, with only seven percent of companies using stock options as part of the director compensation package.

In the recent years, equity awards denominated as a fixed value increased in prevalence, as opposed to awards based on a fixed number of shares.

CAP Perspective: Over the next few years, we expect the following changes in director compensation to take place: 1) low-to-mid single-digit annual increases in Total Board Compensation; 2) more companies moving to fixed retainer pay structures with a component in cash and a component in equity as opposed to paying meeting fees; and 3) a continued emphasis on full-value equity awards. Delivering a majority of compensation in the form of equity coupled with stock ownership / retention requirements creates strong alignment with long-term shareholders and is considered a best practice.

Committee Compensation

Companies have de-emphasized committee member compensation, instead focusing on overall Board compensation. Our research found that just over 50 percent of companies pay no committee-specific fees to members of any of the three major committees4, similar to 2011 and up from just over one-third in 2010. Since a slight majority of companies do not pay separate fees for committee service, at median committee member compensation is now $05. Among companies that do pay separate fees for committee service, median committee member compensation is $16K.

From 2011 to 2012, median additional compensation for committee Chairs remained flat for the Audit and Compensation committees, and increased +17 percent for the Nominating / Governance Committee. Relatively flat year-over-year changes may be associated with a better understanding of the time requirement of the leadership role versus that of a committee member.

CAP Perspective: We expect the trend away from committee member fees to continue, at a slow-to-moderate pace, with the value being rolled into Board cash or equity retainers.

Serving as a committee Chair is generally viewed as a Board leadership role, with additional time requirements, responsibilities, and reputational risk; as a result, additional compensation is often provided for the role.

Near-term, we expect a differential to continue between the additional compensation paid to the Chair of the three major board committees.

Lead/Presiding Directors and Non-Executive Chairmen of the Board

During 2012, the prevalence of providing additional compensation for Lead/Presiding Directors and non-Executive Board Chairs increased to nearly 80 percent, up from approximately 70 percent in 2011 and 65 percent in 2010. In terms of additional compensation for the role, median pay was unchanged at $25,000 in from 2010 to 2012 for Lead/Presiding Directors, and increased slightly for non-Executive Chairs.

CAP Perspective: While not all non-executive Board leaders receive additional pay for the role, prevalence of additional compensation for these roles is expected to continue to increase over time. The differential in pay between Lead/Presiding directors and non-Executive Chairs is in line with the typical responsibilities of each position.

Conclusion

With the increased scrutiny Boards are under and the time commitment required, in the last five years we have seen a relatively significant increase in non-employee director compensation, though at this point we have hit more of a “steady state” and expect more modest pay level changes going forward. In terms of practices, pay programs have continued a trend towards simplification, as director compensation has become viewed more as an “advisory fee” than an “attendance fee.”

It continues to be important to comprehensively evaluate director pay programs on a regular basis or risk falling behind the curve in terms of desired market positioning and best in class program design. When programs are evaluated, the process and practices listed below should be considered.

Best in Class Director Compensation PROCESS

Establish director pay levels and structure in an informed, deliberate and objective way, with consideration given to market data, trends and outlook Define target market positioning for total pay Generally, the 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 Use compensation as a tool to align the interests of non-employee directors and long-term shareholders Disclose the director compensation philosophy and rationale for the program

Best in Class Director Compensation PRACTICES

Align pay levels with an organization’s size and complexity; in turn, provide appropriate pay for time 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 Structure pay so that equity represents at least half of the total The pay program should be viewed as an “advisory fee” vs. an “attendance fee” Establish meaningful equity ownership requirements that must be achieved within 5 years Eliminate benefit / perquisite programs unless there is a strong business case for maintaining them