Setting a High Bar: What Does

Incentive Plan Rigor Look Like?

The slide deck will be made available

following the webinar.

Chris McGoldrick

Research Manager

Equilar

Chad Norton

Vice President

Capital Group

Steve Pakela

Partner

Pay Governance

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Panelists Chad Norton Vice President

Capital Group

Chad Norton co-manages the firm’s proxy

voting efforts for the American Funds group

of mutual funds. He works extensively with

investment analysts and portfolio managers

on corporate governance, executive

compensation, social and environmental

issues. Chad also participates in the

formation of Capital’s proxy voting policies,

as well as the firm’s engagement efforts

with portfolio companies. Chad joined

Capital in 1983 and previously held

positions with American Funds Service

Company, Capital’s in-house transfer agent,

and served as the corporate secretary for

three of the American Funds. Chad

received his MBA from Pepperdine

University’s Graziadio School of Business

and Management and a BA in political

science from the University of Redlands.

Chris McGoldrick Research Manager

Equilar Chris McGoldrick is Research Manager at

Equilar, where he supports the firm’s

research on executive compensation,

corporate governance, and disclosure

practices. Chris is responsible for the

company’s thought leadership and oversees

the production of Equilar’s industry leading

content. He has contributed analysis and

commentary on numerous topics that have

appeared in leading media outlets that

include the Associated Press, CNBC, The

Washington Post, and Bloomberg. He has

spent the majority of his career specializing

in executive compensation and corporate

governance, with experience at the

University of Delaware’s John L. Weinberg

Center for Corporate Governance and the

Council of Institutional Investors in

Washington, D.C. Prior to joining Equilar,

Chris served as a Teach For America corps

member and taught at a KIPP charter

school in Newark, New Jersey. Chris holds

a B.S. in finance and economics from the

University of Delaware.

Steve Pakela Partner

Pay Governance

Steve Pakela is a Partner at Pay

Governance. He advises clients in areas

such as compensation strategy

development, incentive plan design (both

short- and long-term), executive severance

and all forms of competitive compensation

review. He also advises on director

compensation and corporate governance

issues. Steve has extensive experience

functioning as an advisor to client

Compensation Committees. He works with

a broad range of companies that represent

such industries as manufacturing, mining,

financial services, consumer products,

technology, higher education and

healthcare. Steve was a former Principal

and leader of the executive compensation

practice at Towers Perrin's Pittsburgh office

where he practiced for 13 years. Steve is a

Certified Public Accountant and a member

of both the American and Pennsylvania

Institutes of Certified Public Accountants.

Steve is a graduate of Westminster College

with a B.A. in Business Administration,

concentrating in Accounting.

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Agenda

Prognostications

Evaluating

Selection & Goal Setting

Background

4

Background

5

Say on Pay Results

2.2% 2.1% 3.9%

6.0%

14%

72%

0.0%

20.0%

40.0%

60.0%

80.0%

<50% 50-59% 60-69% 70-79% 80-89% 90-100%

Distribution of Russell 3000 Say on Pay Approval Rates

2011 Year-End

2012 Year-End

2013 Year-End

2014 YTD (9/15/2014)

● Russell 3000 2014 YTD voting results are generally consistent with 2011-2013 full-year

trends.

● Currently 63 Russell 3000 companies have failed Say-on-Pay in 2014 YTD versus 56 in

2013, 58 in 2012, and 38 in 2011.

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Annual Performance Metrics

41.6%

38.5% 36.9%

34.6%

23.3%

12.7% 10.9%

15.6%

10.9%

7.5%

44.6%

41.3%

35.8% 35.3%

25.4%

19.2%

16.1% 15.9% 14.1%

11.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

Revenue OperatingIncome

Other Non-Financial

EPS Cash Flow Cost Ratio IndustrySpecific

Net Income Safety DivisionPerformance

Prevalence S&P 500 CEO Short-Term Incentive Plan Performance Metrics

• Continuing differentiation between short- and long-term incentive plan metrics.

• Intent is to address institutional investor and proxy advisory firm criticism of duplication

between short- and long-term incentive plan performance measures, which could lead to

“paying twice for the same performance.”

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Long-Term Performance Metrics • Total shareholder return (TSR) has overtaken profit-based metrics (e.g., EBIT, EPS) to

become the most prevalent metric in long-term performance-based plans

• TSR is overwhelmingly measured on relative, rather than absolute, basis in LTI plans.

However, absolute TSR modifiers increasing in prevalence (e.g., maximum payout at 100%

of target for negative absolute TSR performance).

48.0%

29.4%

16.7% 19.0%

11.5% 9.5%

7.5% 9.1%

6.0%

57.7%

26.6%

18.1% 17.5%

11.2% 9.1% 9.1%

7.3% 5.7%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

Relative TSR EPS ROC/ROIC Revenue OperatingIncome / Margin

ROE Cash Flow Net Income Stock Price

Prevalence S&P 500 CEO Long-Term Incentive Plan Performance Metrics

2011

2012

2013

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Selection & Goal Setting

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Incentive Plans

Provide direct link between

corporate strategy and compensation

Drive sustainable company

performance over the long term

Rationalize compensation

costs to shareholders

Satisfy corporate governance concerns of

various constituents

Align employees with business unit

and corporate objectives

● Performance measurement is critical to any short- and long-term incentive design.

● When the appropriate performance metrics are selected and goals are properly

calibrated within executive incentive design they achieve the following:

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Selection Considerations

• The SEC requires companies to disclose executive incentive plan performance measures and either the specific performance goals (e.g., EPS of $1.25), or the degree of difficulty associated with achieving specific goals.

Disclosure Rules

• Companies are also expected to select appropriate metrics and not to deviate from pre-established goals when determining incentive payouts. Altering metrics, or even the definition of a metric, in order to increase payouts is a contentious issue with proxy advisory firms.

Governance Expectations

• In challenging and/or uncertain times marked by volatility within the market, maintaining line-of-sight is critical to ensuring that executives remain engaged and focused on the company’s long-term strategic priorities.

Market Conditions

• Incentive compensation is a material expense item for most companies and, as such, compensation committees want to communicate to shareholders that funds are being expended prudently.

Financial Expense

• Information asymmetry, where one party in a transaction (e.g., management) has more or better information than the other (e.g., board) exists with respect to corporate performance expectations.

Moral Hazard

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Metric Types

Market Measures Operating Measures Financial Measures

Idea ● Reward performance for a

company’s market

performance

● Reward performance for a

company’s operational

performance

● Reward performance for a

company’s financial performance

Performance

Metric

● Relative TSR

● Stock price appreciation or

absolute TSR

● Interest coverage ratio

● Inventory days on hand

● Debt to capital ratio

● Revenue

● ROIC or ROE

● EPS, EBITDA , Cash flow

Disclosure

Example

● Shares/units will vest upon

the relative achievement of

TSR versus peer group over

one 3-year performance

period

● Shares/units will vest upon the

achievement of a pre-established

debt to capital ratio for one 3-

year period

● Share/units will vest upon the

generation of 8%, 10%, or 12%

average ROIC for one 3-year

period

Reasoning ● Market-based measures are

highly prevalent in the market

and regarded to be a

“complete picture” of company

performance

● Operational achievements are

often leading indicators of

financial results

● A comprehensive view of

financial performance would take

into account revenue, profits and

the capital employed to generate

those profits

● Since companies typically “get what they measure,” it is important they measure the right

thing to optimally incentivize executives and achieve alignment between key stakeholders.

● Companies typically select incentive plan metrics from three distinct categories.

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Setting Challenging Goals

Difficulty Assessment

Probability of Attainment Assessment

0-19% Extremely Challenging

20-39% Very Challenging

40-59% Challenging

60-79% Moderately Challenging

80-100% Not Challenging

Goal Difficulty Analysis Inputs

● Ten Years of historical company performance

● Ten years of historical company peer group performance

● Upcoming-year analysts’ estimates for the company

● Upcoming-year analysts’ estimates for the peer group

Slide sourced from Executive Pay at a Turning Point, Chapter Twelve: Debunking Myths of Easy Goals and Tools for Assessing the

Difficulty of Goals, by Aubrey Bout and Brian Lane of Pay Governance.

Additional Questions for the Compensation Committee

● How often have historical annual bonus payouts been paid above target?

● How have payouts historically aligned with the business cycle?

● How was prior-year performance, and did they beat their goals?

● How are this year’s growth goals compared to last year’s?

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Evaluating

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Proxy Advisors “Shareholders would also expect such a company to fully disclose performance metrics and goals,

which should be reasonably challenging in the context of its past performance and goals, guidance the

company has provided to analysts, etc(…)

Results of financial/operational metrics: If a disconnect is driven by cash pay, ISS considers the rigor of

performance goals (if any) that generated the payouts. Recent (GAAP) results on metrics such as return

measures and growth in revenue, profit, cash flow, etc. -- both absolute and relative to peers – may also

be examined to assess the rigor of goals and whether the quantitative analysis may be anomalous (if

other metrics suggest sustained superior performance). As noted above, company disclosure about the

metrics, goals, and adjustments to results, should be clear and fulsome.”

- “Evaluating Pay for Performance Alignment: ISS’ Quantitative and Qualitative Approach (January 2013)

“Performance measures should be carefully selected and should relate to the specific business/industry

in which the company operates and, especially, the key value drivers of the company’s business.

While cognizant of the inherent complexity of certain performance metrics, Glass Lewis generally

believes that measuring a company’s performance with multiple metrics serves to provide a more

complete picture of the company’s performance than a single metric, which may focus too much

attention on a single target and is therefore more susceptible to manipulation. When utilized for relative

measurements, external benchmarks such as sector index or peer group should be disclosed and

transparent. The rationale behind the selection of a specific index or peer group should also be

disclosed. Internal benchmarks should also be disclosed and transparent, unless a cogent case for

confidentiality is made and fully explained.”

- 2014 U.S. Glass Lewis Policy Guidelines

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Shareholders “The compensation committee should establish performance measures for executive compensation that

are agreed to ahead of time and publicly disclosed. Multiple performance measures should be used in an

executive’s incentive program, and the measures should be sufficiently diverse that they do not simply

reward the executive multiple times for the same performance. The measures should be aligned with the

company’s short- and long-term strategic goals, and pay should incorporate company-wide performance

metrics, not just business unit performance criteria.

Performance measures applicable to all performance-based awards (including annual and long-term

incentive compensation) should reward superior performance—based predominantly on measures that

drive long-term value creation—at minimum reasonable cost. Such measures should also reflect

downside risk. The compensation committee should ensure that key performance metrics cannot be

manipulated easily.”

- Council of Institutional Investors Corporate Governance Policies (May 2014)

“Compensation should be objectively linked to appropriate company-specific metrics that drive long-term

sustainable value and reflect operational parameters that are affected by the decisions of the executives

being compensated(…)

Performance metrics, weights and targets should be disclosed, including why they are appropriate given

the company’s business objectives and how they drive long-term sustainable value(…)

TIAA-CREF believes that performance goals for equity grants should be disclosed meaningfully.

Performance hurdles should not be too easily attainable. Disclosure of these metrics should enable

shareholders to assess whether the equity plan will drive long-term value creation.”

- TIAA-CREF Policy Statement of Corporate Governance (6th Editiion)

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Prognostications

Thank You

Setting a High Bar: What Does Incentive Plan Rigor Look Like?

Chris McGoldrick

Research Manager

Equilar

Chad Norton

Vice President

Capital Group

Steve Pakela

Partner

Pay Governance