Introduction

In this chapter, we will explore leading practices of compensation governance and leading trends in performance-based executive compensation. It is important to start looking at effective compensation governance and performance-based executive compensation. We will explore the latter topic in the second half of this chapter once we have laid the groundwork for the compensation subcommittee of the board.

Typical Responsibilities Found Within the Charter of the Compensation Committee

The Compensation Committee's Charter is generally structured with a few key pillars of responsibility. The pillars of responsibility include compensation strategy and philosophy, executive and director compensation, variable incentive plan designs, CEO succession planning perquisites, benefits, and pension, and lastly compensation policy development, executive employment agreements, and regulatory compliance.

• Compensation strategy and philosophy: The Compensation Committee is responsible for setting the tone of the organization and establishing the foundation for aligning the organization's strategy with that of the compensation philosophy. The compensation philosophy will define the principals and objectives of the compensation program as well as the peer group the board will use to establish a degree of fairness in the executive compensation program.
• Executive and director compensation: The Compensation Committee will typically review annually (sometimes more frequently for high-growth organizations and sometimes less frequently with smaller organizations) the competitiveness of both the executive and director compensation program. The review will generally look at both pay levels and pay structure. We will be exploring this is more detail in what follows.
• Variable incentive plan designs: The Compensation Committee will approve the structure of the annual and long-term incentive plans. This will include the magnitude of compensation opportunity as well as the performance criteria needed to be achieved in order for the executive to realize the payment.
• CEO succession planning: The Compensation Committee will allocate time annually to the CEO succession plan. This will include establishing the interim successor for emergency situations and the accuracy of the role description and current executive talent qualifications.
• Perquisites, pension, and benefits: The Compensation Committee will examine the executive benefits (health care, vision, etc.), perquisites (car allowance, memberships, etc.), and pension entitlement. While some pension plans have been on the decline, there remain enough defined benefit and defined contribution pension arrangements in the market that the Compensation Committee needs to keep a pulse on the competitiveness and long-term affordability of the retirement arrangements.
• Compensation policy development: Compensation policy includes such areas as the company adopting say on pay (in North America and many other parts of the world, this is primarily a nonbinding advisory vote conducted annually by shareholders. In some countries this is a binding vote). Other policy development includes defining share ownership guidelines for executives and directors.
• Executive employment agreements: With CEOs turning over on average twice per decade, executive employment agreements are an important item to remain current on. The key areas that have undergone material change recently due to influence from shareholders are the severance entitlement for CEOs and other named executive officers for areas related to change of control and termination with or without cause.
• Regulatory compliance: The Compensation Committee must maintain an annual understanding of the exchange reporting requirements, as well as have an appreciation for the key shareholder advisory firm guidelines.

Compensation Governance Background

Two critical roles of the board of directors are establishing CEO succession plans and establishing executive compensation plans that both attract and retain executive talent and deliver the outcomes that align with the goals set by the board. While the board may act in good faith, there are times there is shareholder pushback. How can the leading boards of directors develop executive compensation plans that are shareholder friendly? Let's take a deeper look at how executive compensation should be established in order to better align executive pay with shareholder returns. The data from CEO compensation research continues to illustrate that the top-paid CEOs have many layers of executive compensation. When a board's Compensation Committee finally agrees on how executive compensation is determined, it must ensure that it is market defensible and will pass the seemingly infinite views on “appropriate compensation.”

Compensation Governance Process

There are four steps a board should follow when determining executive compensation:

1. Establish the compensation philosophy and peer group.
2. Review current executive compensation against market practice.
3. Assess the business impact before making final approvals.
4. Report the process and compensation results to the executives and shareholders via the annual Proxy (DEF 14A).

Performance-Based Executive Compensation

The first half of this chapter focused on the primary steps the Compensation Committee should follow to establish a strong compensation governance approach to reviewing and approving executive compensation and touched on the need for the Compensation Committee to understand the results of an appropriate stress test and to examine the market prevalence of the use and design of both an annual bonus and a long-term equity grant.

In performance-based compensation there are generally two time horizons to consider: annual and multiyear (mid- or long-) term performance. Market practice over the years has established the precedent that most annual performance-based compensation is settled in cash, upon achieving a set of criteria. Multiyear performance helps to align realized compensation with longer-term shareholder returns. It may settle in cash, equity, or a combination of the two. The settlement of cash or equity will lie in the hands of the board at the time of vesting.

Governance Process to Review and Design the Annual Bonus

Annual incentives generally are rewarded in cash at the end of the fiscal year. The incentive award is designed in one of a few methodologies that are widely accepted by shareholders, and one method, discretionary and/or a “special” out-of-plan award, which is not widely accepted by shareholders today. The two most prominent designs in the market are (i) balanced scorecard and (ii) profit-sharing plans. In both cases a properly designed incentive plan will achieve the following:

1. Be aligned with the compensation philosophy and business strategy.
2. Incorporate predefined performance objectives that, if not met, result in no payment.
3. Be risk adjusted and capped at a maximum value when superior performance is achieved.
4. Allow the board to apply upward or downward discretion on the final bonus amount.

Disclosure standards today for public companies require organizations to include in the disclosure three key pieces of information: (i) How (structurally) did the executive get compensated? (ii) How much did the executive receive?, and (iii) Why did the executive get compensated the amount they received? It is this last point that shareholders have begun seeking greater clarity around.

A well-governed process the Compensation Committee should follow surrounding setting and approving the annual bonus is shared between the fourth and first quarter of the fiscal year. Table 38.1 highlights a few agenda items that should be reviewed related to the closing fiscal year and the upcoming new fiscal year. You will notice that there is work related to both closing and new fiscal years in both the fourth- and first-quarter Compensation Committee meetings.

Governance Process to Review and Design the Long-Term Incentive Plans

Performance-based long-term incentives have advanced since 2010. Prior to 2010 many organizations relied heavily on granting stock options and restricted share units. More prevalence surrounding long-term incentives was related to time-based vesting, and performance was factored in based on share price appreciation/depreciation over the vesting period. While vesting periods surrounding long-term incentive compensation have remained a key structural element of long-term incentives, the shareholder community has begun influencing more performance vesting over a time horizon. The introduction of performance-based vesting has generated two key components as to how an executive is compensated. The first is the probability the executive receives the long-term incentive grant is modified, as there is a higher forfeiture component, that should the performance not be met by the company, the executive will not receive the full amount of equity that was originally granted. The second is the greater alignment with realized compensation with longer-term shareholder return, as greater accountability is incorporated into the earning of the executive's long-term incentive grant.

Types of Long-Term Incentives

There are a finite number of ways today to align long-term pay with performance.

Long-Term Cash For a private or publicly traded organization the long-term cash-based plan will be used to reward executives for achieving a set of performance criteria over a specified time horizon, which tends to be in a range of two to four years, contingent on the performance criteria and local tax laws surrounding salary deferral arrangements. A long-term cash plan will be taxed at the executive's marginal rate, and since it is settled in cash, the organization will have a financing component to award the cash payment. Most of these structures use a set cash amount so that the organization is not liable for a cash-based award that it cannot afford. The cash award will also be set to a threshold to not overly dilute shareholders.

Stock Options/Share Appreciation Rights Stock options, despite having a poor reputation in the past, have remained the most common form of long-term incentive to grant to executives. Private and public companies alike can rely on stock options to align executive compensation with future share appreciation. In most geographic areas, they remain the most tax efficient form of compensation and also can align compensation with the longest time horizon, which can be set up to 10 years until expiry. This provides a significant time-value-of-money period above the other means of long-term incentives while stock options tend to be performance based as they only have value when the future share price is above the exercise/strike price the executive may purchase the stock options for (see Figure 38.1).

Some organizations will also tie the vesting of stock options to the achievement of additional performance of the company. For example, if at the grant date the company share price is $10/share, the exercise price will be set on par or at a premium to the $10/share price. A premium exercise stock option will have performance naturally embedded, as it is underwater at the time of grant, so in order for the executive to receive value from the premium priced option in the future, they will need to increase the share price from $10 to the premium and beyond to then have realizable value in the future. The other means of designing performance-based stock options is to determine how they will vest in the future.

All stock options will be associated with some vesting schedule. For example, the options granted today may vest in thirds or quarters on each anniversary date from the date of grant. This is referred to as time-based vesting. A performance-vesting stock option would add a second criterion, such as hitting future share prices or achieving certain future performance in addition to time in order to vest the options. If the performance criteria are not met over the defined time horizon, that portion of the stock options would be forfeit.

Restricted Share Units (RSUs) A restricted share unit may be used in private or public companies, and it will assume the “full value” of the company's unit price. It is different from the stock option, as the RSU will always be valued at the organization's full share price, regardless of whether the share price is higher or lower at the time of vesting. Also, there is no requirement to purchase the RSU once vested, so the executive earns value from the award at the time of vesting.

From a good governance practice, when RSUs are used by the organization, the RSU plan text will define that it is the board's discretion to determine if the RSU vests in cash or equity (net of tax). This mechanism helps the board manage the financial health of the organization. When the RSU is allowed to settle in cash or equity, there is typically a limit on the vesting time horizon to three years; this is due to salary deferral arrangements in some jurisdictions. Some RSU plans will only permit settling in equity, in which market practice will show that the RSUs may vest over longer time horizons such as four or five years. Since the RSU maintains the full value of the share, the units support the executive with additional shareholder alignment, as fluctuations in share price impact the overall value of the award and in turn this alignment supports a correlation with the shareholders' return over that time period.

Performance Share Units (PSUs) Performance share units are identical to RSUs in their value and taxation. The main difference is that, as the word performance implies, the award will vest based on the organization achieving various performance metrics. The early adopters of PSUs typically used a three-year time horizon to look back at performance to determine how much of the PSUs granted would vest. Performance was typically one metric, which was most widely adopted as relative share price performance. Relative share price performance was calculated based on looking at the organization's share price against a share index (i.e., S&P 500). If the company's share price was better than the index's performance over the time horizon, this would deem the units to vest.

The early plan designs were exposed for the mathematical shortcomings of the downward market, as in a downward market where the index and the company share price was negative, meaning the shareholders lost absolute returns, the simplicity of calculating a smaller loss against a larger loss of the index resulted in many executives sill receiving much of their granted PSUs. After these scenarios came to light, organizations began modifying the PSUs' designs to include an absolute share price consideration so that if the share price was down over the performance period, the executives might still receive some of the PSUs granted, but not necessarily the entire grant.

More recently, with the influence of the shareholder advisory firm Glass Lewis, the PSU designs continued to evolve to begin using a scorecard type of approach, where more than just relative and absolute share performance was considered. The scorecard design of PSUs is a similar concept to that used in the balanced scorecard of the annual bonus plan; however, the performance criteria tends to be a mix of share performance and financial performance. Some industries, such as mining and/or oil and gas, that have longer-term construction/asset development plans will from time to time use a project milestone.

Deferred Share Units (DSUs) Deferred share units assume the full value of the share when vested. Vesting is contingent on the recipient departing from the company. In the case of a DSU's use in rewarding executives, they traditionally are only effective in rewarding a “founder” executive or an executive with substantial equity ownership in the company. DSUs effectively can provide the unintended consequence of enticing an executive to leave the organization prematurely in order to extract the value of the DSU's awards in the executive's hands. As such, DSUs are not typically used to reward executives. DSUs, however, are primarily used in compensating nonexecutive directors, as a DSU provides full shareholder alignment and rewards the executive for the time and effort over the duration of their time serving on the board.

Governance Process to Design Performance-Based Incentives

As part of the executive compensation review that is referenced in the first half of this chapter, the board should examine the type of equity being granted among its peers as well as the type of equity deemed market acceptable by the shareholder community. We have witnessed the shareholder appetite on the type of equity shift over time. Today, in 2019 and the foreseeable future, the shareholder community's appetite is to see performance vesting equity; however, there is also much evidence in the say-on-pay vote support that the makeup of the executive's equity grant may be in a portion of both time and performance vesting. This acceptable trend has led to many publicly traded organizations now granting a few types of equity to the executives. Taking a look at Pepsico Inc. (“Pepsi”) in its 2018 DEF 14A filings, the excerpt in Figure 38.1 references how the executive team receive performance-based long-term incentive compensation.

The takeaway is that Pepsi has granted two types of equity to its executives:

1. PepsiCo Equity Performance Units
2. Long-Term Cash Awards

Both types of equity grants are vesting based on a scorecard approach to measuring performance. Pepsi is demonstrating a balance of keeping the executives earning the long-term incentive accountable to shareholders by achieving multiyear share growth, relative share price performance above the S&P 500 index, growing its earnings per share (EPS), and also improving its core net return on invested capital (ROIC).

Pepsi is not alone. Another example where multiple forms of equity are used to reward executives can be seen at Motorola Solutions Inc. (Motorola). The excerpt from Motorola's 2018 DEF 14A in Figure 38.2 illustrates that Motorola executives receive three forms of long-term incentive grants.

We can see from Figure 38.2 that:

1. Long Range Incentive Plan (LRIP) is made up of cash and options and delivered upon the achievement of Motorola share price beating the S&P 500.
2. Market Stock Units are shares that are time vesting.

In both Pepsi and Motorola, each organization has followed market precedence in splitting up the form of long-term incentive between equity and cash future payments, and the future vesting of the awards has the majority contingent on achieving one or multiple performance metrics and the minority of the granted value simply time vesting.

When determining the grant for the executive's next equity long-term incentive award, the board must first determine the defensible fair value to grant the executive. Once the value is determined, the board will need to determine the form of equity to use within the grant itself (i.e., stock options, RSUs, PSUs), and then understand the weight each equity type will make up the total granted fair value. When the board isolates the amount of equity that will be performance based, the next step is to define performance by selecting one or multiple performance criteria (i.e., relative share price performance to an index, absolute share price, EPS growth, improvement in ROIC, etc.). These performance metrics must be specific to the business and business strategy and be deemed to be aligning with longer-term shareholder returns. The performance should not just focus solely on share price, and performance should factor in other non-share-price-related metrics.

Finally, the board will need to define the vesting parameters surrounding each form of equity grant. For time vesting equity only, this might be a graded vesting schedule with a fraction of the equity being vested on the anniversary dates for three to five years into the future, and for the performance vesting equity, this is typically in a cliff vesting format (although some plans will also use a graded performance vesting schedule), over a performance period (i.e., three-year performance period). At the end of the performance period the performance will be determined based on the criteria set at the time of grant, and the number of units that will vest will be linked to the performance achievement. The value of the award will assume the future share price at time of vesting.

Final Thoughts

The Compensation Committee today faces as much work as the most demanding board subcommittees, as getting executive compensation right in today's environment takes time and due diligence. The process the Compensation Committee must follow is one of engagement between executives, fellow board members, independent advisors, and to a degree shareholders. The compensation philosophy is key to allowing the board to make justified approvals on the compensation program and when setting compensation annually. When the necessary steps as outlined within this chapter are taken, the board is in a strong position to inform shareholders through the annual Proxy Circular (DEF 14A) document and answer the three key pillars of (1) How did the executive get compensated?, (2) How much did the executive receive? and (3) Why/what performance was achieved for the executive to receive what the board granted? Providing great clarity in these key areas helps to garner the desired shareholder support surrounding the executive's compensation.

About the Author

Paul Gryglewicz is senior partner, Global Governance Advisors.

As a key member of Global Governance Advisors' senior leadership team, Paul's work incorporates leading-edge governance practices, mitigates risk, and educates key stakeholders on sophisticated compensation systems. He engages with boards and senior management, advising them in the areas of executive compensation, human resource strategy, and corporate governance. Paul advises many TSX, NYSE, and Nasdaq-listed organizations as well as works with privately held organizations and family offices. In addition to his work with for-profit organizations, he also supports and advises government and quasi-government organizations on compensation and corporate governance matters.

Previously he was an executive compensation associate consultant with one of Canada's largest independent compensation advisory firms, focused on strategic compensation review and design for a variety of organizations across Canada.

As an instructor at York University, Paul co-designed and teaches the graduate-level course “Governance of Executive Compensation and Shareholder Accountability.” He is also an active speaker for professional associations presenting on a wide array of executive compensation and governance-related topics and appears on major TV and newspaper media outlets.