Responsible executive compensation for a new era of accountability

4197 P-00 1/27/04 9:57 AM Page i Responsible Executive Compensation for a New Era of Accountability Edited by Peter T Chingos and Contributors from Mercer Human Resource Consulting, Inc JOHN WILEY & SONS, INC 4197 P-00 1/27/04 9:57 AM Page i 4197 P-00 1/27/04 9:57 AM Page i Responsible Executive Compensation for a New Era of Accountability Edited by Peter T Chingos and Contributors from Mercer Human Resource Consulting, Inc JOHN WILEY & SONS, INC 4197 P-00 1/27/04 9:57 AM Page ii This book is printed on acid-free paper Copyright © 2004 by John Wiley & Sons, Inc All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written 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appropriate Neither the publisher nor author shall be liable for any loss or profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com Library of Congress Cataloging-in-Publication Data ISBN 0-471-47431-2 (cloth) Printed in the United States of America 10 4197 P-00 1/27/04 9:57 AM Page iii About the Editor PETER T CHINGOS Peter T Chingos is a principal in the New York office of Mercer Human Resource Consulting and a member of the firm’s Worldwide Partners Group For more than 25 years he has consulted with senior management, compensation committees, and boards of directors of leading global corporations on executive compensation and strategic business issues He is a frequent keynote speaker at professional conferences, writes extensively on all aspects of executive compensation, and is often quoted in the national press He has appeared before the Internal Revenue Service and the Securities Exchange Commission on a variety of regulatory issues related to compensation He is a member of the advisory board of the National Association of Stock Plan Professionals and currently teaches basic and advanced courses in executive compensation in the certification program for compensation professionals sponsored by WorldatWork In 1998 he received WorldatWork’s prestigious Keystone Award for outstanding contributions in the areas of compensation and human resource management He is the editor of Paying for Performance: A Guide to Compensation Management (John Wiley & Sons, 2002) iii 4197 P-00 1/27/04 9:57 AM Page iv About the Contributors BEVERLY A BEHAN Beverly A Behan is a partner with Mercer Delta Consulting’s Corporate Governance Practice, based in New York She works with chairs of governance committees and CEOs to enhance the effectiveness of their boards of directors She has worked extensively in the area of board assessment and individual director peer assessment since 1997, when she helped to design and implement a director peer assessment process for an international bank that won international corporate governance awards for innovation in this area She has been quoted as an expert in corporate governance in the leading business journals MELISSA L BUREK Melissa Burek is a principal in Mercer Human Resource Consulting’s New York office She focuses on all aspects of executive compensation and has worked with leading companies and boards of directors on compensation strategy, annual and long-term incentive plan design, tax and accounting issues, and board compensation She has been responsible for Mercer’s “best practices” research among Fortune 100 companies and within the insurance industry She has worked extensively with manufacturing, insurance, and pharmaceutical companies in assessment and redesign of total compensation programs Ms Burek holds BBA and MBA degrees from the University of Michigan K KELLY CREAN Kelly Crean is a principal in Mercer Human Resource Consulting’s Atlanta office He consults with clients on equity-based compensation practices, board of director pay, business analysis, and incentive plan design He is one of the firm’s leading consultants on executive pay from the shareholder and institutional perspective Mr Crean has written numerous articles on executive compensation and equitybased pay practices for various corporate governance publications Prior to joining Mercer, he was a senior compensation specialist with Institutional Shareholder Services, the leading proxy and advisor service to institutional investors He holds BA and MBA degrees from the University of Georgia iv 4197 P-00 1/27/04 9:57 AM Page v About the Contributors v SUSAN EICHEN Susan Eichen is a principal in Mercer Human Resource Consulting’s New York office and a member of Mercer’s Washington Resource Group, which assists Mercer clients and consultants in addressing technical legal and regulatory issues and providing government relations expertise on a wide range of retirement, health, compensation, and other human resource topics Ms Eichen specializes in incentive plan design, option valuation, and accounting for compensation arrangements Her clients include publicly and privately held companies, subsidiaries, and foreign-owned entities in a broad range of industries She has written extensively on issues in incentive plan design and the impact of accounting rules on compensation policies and practices A CPA, Ms Eichen holds an MBA from the Wharton School and a BA from Brown University DIANE L DOUBLEDAY Diane Doubleday is a principal in the San Francisco office of Mercer Human Resource Consulting She specializes in executive compensation and has particular expertise in the design and operation of equity plans She is a frequent speaker and author on equity compensation and emerging issues affecting executive compensation She holds an AB and JD from the University of California, Berkeley WILLIAM H FERGUSON William H Ferguson is a principal in Mercer Human Resource Consulting’s Los Angeles office, the Performance, Measurement, and Rewards Practice leader for Los Angeles, and a member of the U.S Practice Leadership Team He has over 15 years of experience advising executives and boards of directors on creating shareholder value by designing integrated value management, performance measurement, and reward programs His consulting experience covers a broad range of industries, including high tech, software, real estate, chemicals, and financial services, among others He received his BA and MS degrees from Stanford University HOWARD J GOLDEN Howard J Golden, JD, is a principal in Mercer Human Resource Consulting’s New York office He specializes in executive compensation design and compliance, the interrelationship of compensation and benefits programs, corporate governance issues, and regulatory matters Mr Golden has been a contributing editor for many professional journals, a featured speaker at many national forums, and has testified before Congress He is quoted often in the national media 4197 P-00 1/27/04 9:57 AM Page vi vi About the Contributors MICHAEL J HALLORAN Mike Halloran is a principal in Mercer Human Resource Consulting’s Dallas office and a member of the firm’s Worldwide Partners Group He has consulted on executive compensation and benefit issues for over 25 years, focusing on linking executive compensation to business strategy and enhanced performance for shareholders He is a frequent speaker on executive compensation issues for WorldatWork, The Conference Board, and other leading forums He has a bachelor’s degree in mathematics from Northwestern University and an MBA from Northwestern’s Kellogg School, specializing in finance and accounting G STEVEN HARRIS Steven Harris leads Mercer Human Resource Consulting’s executive compensation practice in the southeastern U.S region and is a member of the firm’s Worldwide Partners Group Based in Atlanta, he has more than 15 years of experience consulting in the business-based design and use of executive equity and cash incentive compensation programs He is a frequent speaker at business and professional associations on executive compensation and pay-for-performance issues and has provided briefings on executive pay trends to U.S Senate and House staff as well as to senior officials within the Departments of Treasury and Labor He holds BA and MA degrees in psychology and an MBA degree from Indiana University SHEPARD LONG Shepard Long is a principal in Mercer Human Resource Consulting’s New York office, where he specializes in executive compensation strategy development, payand-performance assessments, and annual and long-term incentive plan design He also coordinates Mercer’s ongoing “best practices” research, which focuses on executive compensation practices at high-performing Fortune 100 companies He holds an MBA from New York University’s Stern School of Business HAIG R NALBANTIAN Haig Nalbantian is a member of the firm’s Worldwide Partners Group, a founding member of Mercer’s Strategy and Metrics group, and co-chair of the company’s global R&D Council He is a labor and organizational economist and has been instrumental in developing Mercer’s unique capabilities to measure the economic impact of human capital management Previously he was on the faculty of economics at New York University and was a research scientist at its C V Starr 4197 P-00 1/27/04 9:57 AM Page vii About the Contributors vii Center for Applied Economics He has written extensively on the subject of incentives and organizational performance and has consulted with leading companies across a wide range of industries Mr Nalbantian has MA and M.Phil degrees in economics from Columbia University RUSSELL MILLER Russell Miller is a principal in Mercer Human Resource Consulting’s New York office He consults with senior management and boards of directors on value management, performance management, and compensation issues The focus of his work is on developing performance measurement systems and compensation programs that are linked to business strategy and drive value creation Mr Miller is a frequent speaker on value management and performance measurement He has a BS degree in finance from the Wharton School of the University of Pennsylvania PETER J OPPERMANN Peter J Oppermann is a principal in Mercer Human Resource Consulting’s New York office He has more than 20 years of consulting experience focusing on executive and board compensation He has developed executive and management compensation programs for national and international clients in the manufacturing, services, e-commerce, and high-technology sectors He is a frequent speaker at national and regional seminars on executive and management compensation LEA L PETERSON Lea Peterson is the global and U.S leader of Mercer's Communication Practice and a member of the firm’s Worldwide Partners Group Her responsibilities include setting strategic direction, as well as leading the growth and development of the communication consulting business worldwide Ms Peterson has over 25 years of experience in organizational communication for major international corporations She works with global clients on communication strategies for organizational change and performance enhancement Her work includes creative problem solving to achieve client business objectives and effective processes to engage internal stakeholders in the execution of complex change The International Association of Business Communicators has awarded her a Gold Quill eight times for excellence in communications Prior to joining Mercer in 1984, Ms Peterson managed employee communication in several major corporations Ms Peterson has a BA degree in English from the University of Maryland and an MA degree in English from the University of New Hampshire 4197 P-00 1/27/04 9:57 AM Page viii viii About the Contributors J CARLOS RIVERO Carlos Rivero is a partner in Mercer Delta Consulting’s New York office He works in the areas of organization diagnosis and change, organization culture, and applied research with emphasis on measurement and feedback Dr Rivero has published several articles and book chapters on executive team effectiveness, strategic human resources, management development, and corporate governance He holds an MA and PhD from New York University in Industrial/Organizational Psychology WEI ZHENG Wei Zheng leads the Performance, Measurement and Rewards Practice in North China He has worked with a wide range of leading Chinese and U.S companies spanning many industries Prior to joining Mercer China, he was with Mercer’s Strategy and Metrics group in New York He is an economist specializing in human capital strategy, performance measures, executive compensation, and financial analysis and was instrumental in developing Mercer’s capability to quantify economic effects of human resources management Mr Zheng received his PhD in economics from New York University 4197 P-14 1/27/04 284 10:05 AM Page 284 Role of the Compensation Consultant In other words, their analysis and recommendations are biased toward the benefit of management despite the existence of contradictory facts and circumstances One component of this criticism hinges on the financial aspect of the consultantclient relationship Compensation consultants may be perceived as beholden to management because they are concerned about collecting fees and providing other services Or the criticism may be more emotional, questioning whether the consultant’s desire to please overrides other considerations Both of these criticisms typically are aimed at vendors as opposed to advisors Vendors may be more susceptible to these financial and emotional concerns because their work is primarily transaction-oriented and immediate financial outcomes are paramount Advisors generally place a higher value on maintaining and growing the relationship itself than on the outcomes of the current transaction, and are more likely to avoid these potential concerns Compensation consultants need to behave and be perceived as business advisors By taking a long-term view and developing a deep understanding of the client organization, they can maintain appropriate distance and objectivity This further enhances the value of the services being provided and increases the likelihood of an ongoing, constructive client relationship (b) Driving an Upward Spiral of Executive Pay A common criticism of the compensation consulting profession is that compensation studies and recommendations automatically result in an upward spiral of executive pay According to this argument, each time a company attempts to position its pay relative to the pay of other organizations, the benchmark is increased For example, if a company desires to pay at the 50th percentile of a peer group, then adjusts its pay upward to achieve the 50th percentile of the peer group, the benchmark (50th percentile) rises for the next company that desires to pay at the 50th percentile of the same peer group Rather than being the cause of spiraling executive pay, keeping informed of prevailing market practices is a critical element in attracting, motivating, and retaining the highest level of talent needed to deliver superior results Companies need to be informed of the market value or replacement value of the key positions within their organizations and then make thoughtful and appropriate decisions with respect to the incumbents in these positions and the overall financial strength of the organization By considering changes in the market rate of compensation for critical positions, the skills and abilities of the incumbents in these positions, and the financial resources of the organization, sound and defensible compensation decisions can be made without artificially inflating pay levels The primary driver of any upward spiral in executive pay is scarcity Just like any other product or service where demand exceeds supply, prices increase In the context of executive compensation, the demand for great CEOs far exceeds the supply of great CEOs And, many believe that the gap between the supply of and 4197 P-14 1/27/04 14.5 10:05 AM Page 285 Establishing a Consulting Foundation 285 demand for CEO talent is only going to increase in the future Under these circumstances, we should not be surprised to find an escalation in executive compensation Criticisms rather should be focused on those situations where compensation consultants and their clients are not evaluating and considering the relative performance of the executive team and the company as a whole For example, a company that consistently performs in the 25th percentile of its peer group in critical areas should not consistently be providing executive compensation at the 75th percentile of its peer group In these situations, not only can the overall benchmark pay levels be unduly impacted, but the alignment between pay and performance can be derailed 14.5 ESTABLISHING A CONSULTING FOUNDATION: CONSTRUCTING THE FACT PATTERN (a) Understanding the Business Strategy and Key Performance Drivers The first step in establishing a consulting foundation is to understand the business strategy and key performance drivers In other words, how has the organization chosen to compete and how will it measure its success? Without this fundamental understanding, it is impossible to provide sound advice and counsel that will drive business results For example, a mature company in a stable industry with few significant competitors will have very different executive compensation needs and challenges compared to an emerging company in a growth industry with limited barriers to entry Similarly, a company focused on operational efficiency and cost optimization would select very different performance measures and compensation program designs compared to a company focused on capturing market share and growing the business These issues are discussed in Chapters and (b) Identifying a Peer Company Group and Pay Practices The next step in the building process is to identify appropriate peer companies and their pay practices Peer companies often reflect organizations within the same industry and of similar size to the client However, it is also important to consider companies that may better represent the true market for talent or companies that are performing at a comparable level For example, a large transportation company may want to evaluate its pay practices against other similar transportation companies (industry peer group) and to a collection of large nationally dispersed organizations that have similar key positions responsible for capital-intensive logistics and related technology infrastructure (talent peer group) Another example would be a life sciences company that may want to evaluate its pay practices relative to 4197 P-14 1/27/04 286 10:05 AM Page 286 Role of the Compensation Consultant an industry peer group as well as a group of companies that have achieved doubledigit revenue growth and earnings per share over the last three years (performance peer group) See Chapter for a detailed discussion of peer group selection Once the peer companies have been identified, pay data and practices can be collected, cleaned, and compiled Compensation data typically are gathered for base salaries, annual incentives, and long-term incentives (including both cash and equity-based incentives) Data also can be gathered for beneficial ownership, stock option overhang (shares granted and reserved for future compensation grants compared to shares outstanding), annual stock option grant rates, and other compensation-related information It is often important to review multiple years of compensation data to smooth any anomalies that may exist from one year to the next with respect to the variable elements of the total compensation package For example, a single-year analysis may be distorted if one of the peer companies has an every-other-year stock option grant strategy or had an isolated year when an extremely large or mega stock option grant was made (c) Establishing the Compensation Philosophy In order to make use of the competitive market compensation data, the company must first agree on a compensation philosophy or strategy In addition to addressing the definition of the relevant labor market (e.g., the selection of peer companies and the rationale for their selection), the compensation philosophy should articulate how the organization desires to position pay relative to the labor market For example, the company may want to target base salaries at the 50th percentile, total cash compensation (salary plus incentive) at the 60th percentile, and total direct compensation (total cash compensation plus the annualized value of longterm incentives) at the 75th percentile This would be considered a leveraged pay strategy because it relies heavily on the variable pay elements to drive the overall competitiveness of the pay package (d) Comparing Current versus Desired Practice Once the pay philosophy has been set or validated, variance analysis can be performed to assess how current pay practices align with the company’s desired positioning For example, based on the fact pattern just described, it may be revealed that actual base salary levels are positioned above the 50th percentile while total cash compensation is below the 60th percentile This suggests that salary increases should be evaluated carefully and that incentive compensation levels are not providing the desired level of total cash compensation There are many elements in a typical total compensation program, and care must be taken to avoid making isolated decisions on individual elements without regard for the impact on the total program For example, since many annual and 4197 P-14 1/27/04 14.6 10:05 AM Page 287 Compensation Consultant as a Trusted Advisor 287 long-term incentive plans have award opportunities tied to participants’ base salaries, changes to base salaries cannot be made without considering the impact on total cash compensation and total direct compensation A major responsibility of the compensation consultant is to bring this holistic perspective to bear on analysis and recommendations (e) Testing Pay and Performance Linkage An often overlooked but critical component of any compensation analysis is an internal and external test of the pay and performance linkage Internally, the targeted compensation mix and variable pay plan designs should be reviewed and modified to ensure an appropriate mix between fixed and variable award opportunities and an appropriate alignment of pay and performance Externally, variable compensation levels should be compared to companies that have performed similarly over the performance period on critical measures For example, absent extenuating circumstances, there should be alignment between the competitiveness of annual incentive awards (e.g., 60th percentile) and the relative performance of the company compared to its peers (60th percentile) 14.6 COMPENSATION CONSULTANT AS A TRUSTED ADVISOR (a) Business Advisor versus Data Provider Compensation consultants typically collect, clean, and compile a significant amount of compensation data in providing their services These data provide a critical reference point from which to review and assess a company’s current compensation arrangements relative to competitive market practices However, the compensation consultant needs to be more than a data provider Highly effective consultants need to function and be perceived as business advisors In the past, many compensation consultants focused exclusively on providing data Today, compensation data often are automated and regarded as a commodity Also, many companies have become dissatisfied with this approach and the quality of the advice it yields Compensation consultants must get beyond the data and provide sound advice and counsel based on a broad understanding of their client business strategy, industry dynamics, competitive positioning, relative performance level, and other facts and circumstances Collecting, cleaning, and compiling compensation data is the beginning, not the end, of the compensation consultant’s responsibilities to the client To become a business advisor, the consultant needs to provide insight in addition to information The ability to develop and provide insight is the by-product of combining the compensation consultant’s expertise and experience with the 4197 P-14 1/27/04 10:05 AM Page 288 288 Role of the Compensation Consultant deep knowledge and continuous learning that comes from lasting consulting relationships In this role, compensation consultants rely more on personal trust than professional certifications and will add the most value by asking pointed and probing questions rather than providing additional pay data (b) Guide to Best Practices Most companies have some firsthand knowledge of best practices, among their board members, their executive team, or their human resource professionals Also, most compensation consultants have access to and knowledge of best practices, and some helpful in-depth research exists on this topic However, in order to be highly effective, the compensation consultant must serve as a guide to best practices The difference between being knowledgeable regarding best practices and serving as a guide to best practices is the ability to filter the vast array of ideas, approaches, and solutions to arrive at the specific best practices that make the most sense for the company and that have the greatest potential for creating sustainable shareholder value This filter is not a tool, a technique, or even a process Instead, it is an ability that a business advisor can obtain only through experience, intellectual curiosity, deep knowledge of the client, and enduring relationships For example, the ability quickly to identify passing fads, myopic thinking, inconsistencies with core strategy, and hidden implementation obstacles can save valuable time and money Being able to map, modify, and apply best practices from other industries and situations can create the greatest opportunity for competitive advantage and is therefore another invaluable competency of a business advisor (c) Shareholder Perspective The hallmark of a true business advisor is the ability to review and analyze information and decisions from multiple perspectives Only through thoughtful and deliberate consideration of all relevant constituencies can a consultant truly provide sound advice and counsel In the executive compensation arena, one of the most critical perspectives to review thoroughly is that of shareholders Much of what is done in executive compensation is focused on shareholders For example, when setting executive compensation strategy, alignment with shareholder interests is of paramount concern When developing restricted stock or stock option grant levels, shareholder dilution is reviewed carefully However, these are simply the direct and tangible areas in which the shareholder perspective needs to be considered; many other components need to be taken into account The significant rise of institutional ownership and shareholder activism has changed dramatically the concerns and considerations of compensation consultants It also has changed the roles, responsibilities, and in some cases attitudes of the compensation consultant’s most visible customer—the board’s compensation 4197 P-14 1/27/04 14.6 10:05 AM Page 289 Compensation Consultant as a Trusted Advisor 289 committee Although these issues are explored more thoroughly in other chapters, the importance of completely understanding the shareholder perspective and acting on this knowledge cannot be overstated In theory, shareholders are most concerned with long-tem value creation as evidenced by increases in total shareholder return Therefore, everything the compensation consultant reviews, analyzes, and recommends needs to be viewed through this lens of long-term value creation Whether it is attracting the right talent to the company, providing the right reward structure to drive high performance, or retaining the organization’s key talent, the impact on shareholder value needs to be understood, analyzed, and documented Finally, in today’s environment, shareholder communications need to be complete, clear, timely, and accurate in order to meet fully the needs of this important constituency 4197 P-14 1/27/04 10:05 AM Page 290 4197 P-15 EM 1/27/04 10:06 AM Page 291 Index A Absolute performance, xx, 64, 65 Accountability, xvii, xx–xxi, 97, 239 Accountants, 81 Accounting, xv, 160–161, 220 Accounting firms, 81 Accounting standards, 136–137 Acquisitions, 90–91 Administrative support, 262 Alignment, 11, 36, 163, 209 Amelio, Gilbert, 97–98 American Stock Exchange, xv Annual grant rates, 121 Annual incentives, xx, 68–73, 206–210 eligibility for, 69 funding of, 69 leverage with, 70, 71 payment methods for, 70, 73 performance measures for, 70 and performance mix, 69 Annual meetings, 119 Annual reports, 72, 83 certification of, 79 corporate governance guidelines disclosure in, 93 Annual share usage, 72–73 Apple Computer, 97 Assessment (generally): of board of directors, see Board assessment of CEO, see CEO evaluation of performance measures, 37–39 Assessment of executive pay programs, 52–96 communication regarding, 75 and current program understanding, 53–56 objectives of, 52–54 pay and performance relationship in, 63–67 and pay levels, 59–62 and pay practices, 67–74 regulatory requirements for, 74–75 validation of compensation strategy in, 56–59 Attitude, CEO, 110 Audit committees, xv, 82, 86–87, 220, 222, 233 Auditors, 81, 82, 220 Award mix, 73–74 B Balance, xvii Base salary, xx, 65–66, 127, 205–206 Behavior: and communication, 256, 257, 264 executive, 110, 264 Benchmarks/benchmarking, xviii, 32, 33 information needed for, 48 of pay levels, 60–62 of pay practices, 58, 68–70, 73, 74 of salaries, 65 Benefit programs, 127–128 Binomial option pricing model, 140–144 Blackout periods, pension, 82 Black-Scholes option pricing model, 142–147, 150–153 Boards of directors, xvi See also Directors; Outside director compensation assessment of, see Board assessment audit committees of, 82 CEO’s relationship with, 105 compensation committee of, 56, 95–96 self-evaluation of, 93 and shareholders, 77 Board assessment, 237–255 for chair/lead director, 252 for committees, 252–253 context of, 239–243 customization of, 251 feedback in, 249–251 importance of, 237 interview approach to, 246–248 management evaluation in, 251–252 291 4197 P-15 EM 1/27/04 10:06 AM Page 292 292 peer review in, 253–255 process of, 244–246 real-time approach to, 248 and review of minutes, 253 risks/opportunities of, 238–239 survey approach to, 246 Bonus programs, 127 Book value of equity (BV), 3–6 Bottom-line impact (of CEO), 102–103 Broad-based stock purchase plans, 157–158, 169 Broker voting, 82n.1, 92–93, 113, 114, 116 Burn rate, 72–73, 121, 125, 167–168 Business design, 21–22 Business outcomes, articulation of, 256 Business press, 117–118 Business risk, 14 BV, see Book value of equity C California Public Employee’s Retirement System (CalPERS), 99, 106, 118, 122, 125, 126 Capital market peers, 185–186 Capital sources, Cash-based appreciation plans, 126 Cash incentives, 213–214 CEOs, see Chief executive officers CEO evaluation, 97–112 clarifying purpose of, 100–101 defining performance dimensions/measures for, 102–105 implementing, 107–110 key questions for, 98 leadership and participation in, 106–107 selecting objectives/specifying measures for, 104, 105 thorough/disciplined, 99–100 year-end assessment, 108 Certification of financial statements, xv, 79, 94, 220 CFOs, see Chief financial officers Chairman of the board, 105, 230, 252 Change agenda (step in Mercer strategy), 267 Charters, 85–88 Chief executive officers (CEOs), 29, 129 evaluation of, see CEO evaluation and inappropriate profits, 82 reports certified by, 79 Chief financial officers (CFOs), 79, 82 Choices, communicating implications of, 262 Clarity (of plan values), 264–265 Index Code of business conduct and ethics, 80–81, 94 Cohesion (of plan components), 265 Commitment, xx Committees, 85–88, 252–253 See also Audit committees; Compensation committees Committee pay, 224–225, 231, 233, 235 Common language, 10 Communication, 256–274 about basics of program, 257 about executive pay assessment, 75 Communication for Impact™ strategy, 257, 266–270 creating value with, 259 with directors, 85 as driver of enterprise success, 264–266 equipping executives for, 273 executives’ need for, 261–264 with investors, 116–117, 130–133 LILI™ Model of, 258 and performance measurement system, 44 personalization in, 270–272 in present business climate, 272–273 to senior management, 259–263 What’s Working™ study, 259–260 Communication for Impact™ strategy (Mercer), 257, 266–270, 274 change agenda (step in), 267 context assessment (step in), 266 implementation (step in), 269–269 measurement (step in), 269 reinforcement (step in), 269 strategy (step in), 267–268 Communication plan, 263–265, 268 Company-specific volatility, 180 Compensation, xx, 95–96, 263, 284–285 Compensation committees, xvi–xvii, 68, 85–86 in assessment of pay programs, 56 and CEO evaluation, 106 and CEO feedback, 108 chair roles, 233 changed structure/operation of, 217 and corporate governance, 95–96 exemptions approved by, 90 independence of, 125 sound practices for, 278–279 Compensation consultants, xvi–xvii, 68, 86, 221, 275–289 criticisms of, 283–285 establishing foundation for, 285–287 importance of, 275–277 independence of, 277–282 selecting, 282–283 4197 P-15 EM 1/27/04 10:06 AM Page 293 Index as trusted advisors, 287–289 Compensation strategy, xix–xx, 56–59, 168 Competitive market, 57–58, 275–276 Competitive position, 20–21, 201–202 Comprehensive project plan, 268–269 Confidentiality, 272 Conflict-of-interest relationships, 125, 277–282 Consultants, see Compensation consultants Context (of plan values), 264 Continuous improvement, communication for, 257 Corporate governance, xv–xvi, 76–96, 160 board and management roles in, 77–78 compensation committee procedures affected by, 95–96 guidelines-listing rule for, 93 and Sarbanes-Oxley Act, 78–82 and stock exchange listing requirements, 82–95 Corporate officers, 79, 82, 94 Correlational weighting, 193 Cost/asset position, 21 Culture, 16, 59 D Debt capital, Deferred compensation programs, 128, 262 Development stages (of company), 39 Differential shareholder return (DSR), 195–196 Differentiation, 21 Dilution, 73, 121, 161 Directors, 106, 108, 221–222 See also Outside director compensation code of business conduct and ethics for, 94 compensation of, 95–96 discretionary grants to, 125 guidelines for, 93 independent, xvi, 83–85 loans to, 79–80 unfit, 82 Disclosure information, 119, 128 Discounted cash flow, 12–13 Discounted employee stock purchase plans, 169 Discounted stock options, 122–123 Discretionary equity grants, 125 Discretionary plans, 89 Dismissal (of CEOs), 97, 129 Dividends, 125, 140, 143–144, 149–150 Dow Chemical, 106, 107 DSR, see Differential shareholder return 293 E Economics, market, 18–20 Economic profit (EP), 5–9 Electronic filing, 78–79 Eligibility, 69, 72, 210–211, 261 Emotion, 249–250, 254 Employees, 9, 10, 94 Employee benefit plans, 77–78 Employee owners, 117 Employee Retirement Income Security Act (ERISA), 77–78, 91 Employee stock ownership plans (ESOPs), 117 Employee stock purchase plans (ESPPs), 91, 169 Employment inducement awards, 90 Enron Corporation, 76, 97, 160, 172 Enterprise guardianship, 105 Environment, boardroom, 250–252 EP, see Economic profit Equity capital, Equity compensation, xvi broad-based, 169 challenges of, 169–170 for directors, 225–228 factors influencing change in, 160–162 new role of, 162–168 role of, 59, 203, 204 shareholder approval of, 88–93 shareholder perspective on, 127 trends in, 159–171 ERISA, see Employee Retirement Income Security Act ESOPs (employee stock ownership plans), 117 ESPPs, see Employee stock purchase plans European Union (EU), 136 Evergreen provisions, 89, 122 Executive compensation positioning, xx Executive compensation programs, xvii, xix Exercise price, 139, 148 Expectations, 7, 14–15, 17, 31–32, 217–218 “Expected life” assumption, 148 Expensing (of stock options), 126, 129, 160–161 External directors, 106, 108 F Fade rate, 12 Fair value, 72, 137, 170 FASB (Financial Accounting Standards Board), 136 Feedback, 249–251 4197 P-15 EM 1/27/04 10:06 AM Page 294 294 to CEOs, 97–98, 101, 108–110 in communication plan, 269 on compensation program, 53–56 criteria for handling, 245–246 in director peer review, 253–255 investor, 131 multisource, 106–107 performance, 257 for senior managers, 260 Fiduciaries, 77–78 Financial Accounting Standards Board (FASB), 136 Financial counselors, 271 Financial experts, 82, 86, 220, 222 “Financial literacy,” 86 Financial statement certification, see Certification of financial statements Fit (of performance measurement system), 37 Focus, communication for, 256 Focus groups, 55–56 Foreign private issuers, 95 Form 8-K (SEC), 80 Form 10-K (SEC), 83, 85 401(k) plans, 91, 117 Full-share reloads, 123 Full-value awards, 235 Funding (of annual incentives), 69 G Generally accepted accounting principles (GAAP), 136 General market volatility, 180 General Motors, 108 Geographic locations, 55, 59, 261 Goal-setting, 47–49, 265 Governance ratings systems, 126–127 Government regulations, 20 H Hidden agendas, 272 Holding periods, 74, 124, 168, 215 Honeywell, 101 Hotlines, 271 Human resources (HR) department, 113–115, 133 I IASB (International Accounting Standards Board), 136 IASC (International Accounting Standards Committee), 136 Index Implementation (step in Mercer strategy), 269–269 Incentive compensation, xix–xx, 261 Incentive plans, 153–158 See also Annual incentives Incentive vehicle mix, 73–74 Income statements, 72 Incremental shareholder return (ISR), 196 n 16 Independence: of auditors, xv, 82 of compensation committee, 125 of compensation consultant, 277–282 independent directors, xvi, 83–85, 90 Indexed exercise prices, 156–157 Indexed stock options, 165 Individual investors, 116–117 Industry risk, 14 Industry volatility, 180 Insider trading, 78 Institutional investors, 117–119, 217 Intangibles, 15–16 Integration: of all components of pay, 256 of performance measurement system, 44, 46–47 Internal controls reports, 82 International Accounting Standards Board (IASB), 136 International Accounting Standards Committee (IASC), 136 Internet, 78, 118 Interviews, 55, 246–248 Intrinsic value, 5–8 Investors, see Shareholders Investor relations, 131 ISR (incremental shareholder return), 196 n 16 K Key messages, developing, 267 Knowledge gaps (about plans), 262 L Labor market peers, 185 Labor unions, 117, 118 Language, common, 10 Lead directors, 84–85, 222–223, 232, 252 Leadership, 104–107 Legal counsel, 131 Leverage, 70, 71, 208–209 LILI™ Model (Mercer), 258 Linkage, 45, 46, 72, 163–164, 287 4197 P-15 EM 1/27/04 10:06 AM Page 295 Index Listing requirements, stock exchange, xv–xvi, 82–95 for code of business conduct and ethics, 94 for corporate governance guidelines, 93 for independent directors, 83–85 for required committees, 85–88 for shareholder approval of equity plans, 88–93 Loans, xv, 79–80, 128 Long-term incentives (LTIs), xvii, xx, 66–65, 72–74, 210–216 “Look-back” provisions, 84, 157–158 LTIs, see Long-term incentives M Macroeconomic factors, 20 Management, 43 board effectiveness evaluation by, 251–252 compensation committee relationship with, 95 and compensation consultants, 278–280, 283–284 and shareholders, 77–78 succession of, 93 Managing for value (MFV), 1, 2, 22–25, 28–30 Market economics, 18–20 Market risk, 14 Market value, 3, Market value added (MVA), 3, Material financial changes, 82 Material revisions of plan, 89–90, 92 Measurement (step in Mercer strategy), 269 Media, 118 Meeting fees, 224, 231, 233 Megagrants (of options), 124 Mercer’s LILI™ Model, 258 Mergers, 90–91 MFV, see Managing for value Microsoft, 154 Midyear review (of CEO), 108 Minutes, board, 253 Monte Carlo simulations, 144–145 Moral hazard, 179 Multisource feedback, 106–107 Mutual funds, 118 MVA, see Market value added N Named Executive Officers, 57, 66, 72, 75, 125 Nasdaq, xv–xvi, 75, 82, 122, 126, 127, 160, 162 295 New executive compensation model, 201–218 annual incentive plan design in, 206–210 base salary in, 205–206 benefits/perquisites in, 216–217 compensation committee’s role in, 217 long-term incentives in, 210–216 program objectives for, 201–205 and shareholder expectations, 217–218 New York Stock Exchange (NYSE), xv–xvi, 75, 82–95, 113, 122, 126, 127, 160, 162 Nominating/corporate governance committee, 87–88 Non-executive chairman, 230 Non-GAAP financial information, 81 Nonmanagement directors, 84–85 Non-shareholder-approved plans, 126 Non-U.S executive compensation, 59 NYSE, see New York Stock Exchange O Objectives, CEO, 104, 105, 107–108 Off-balance sheet arrangements, 82 On-demand information, 262 Online toolkit, 271 Operational impact (of CEO), 103, 104 Option term, 139, 148 Organizational change, communication as driver of, 257 Organizational system, 15–16 Outside director compensation, 95–96, 219–236 current state of, 223–230 developing program for, 234–235 factors influencing changes in, 219–223 trends in, 230–234 Overhang, 73, 167–168 Ownership requirements, 74, 124 and benefits of board assessment, 239 increasing prevalence of, 168 in new executive compensation model, 204 in outside director plan, 227–229, 232, 233, 235 P “Paper gains,” 67 Parallel excess plans, 91 Past performance, 101 Pay and performance relationship, 63–67 aligning, 209, 215–216 communicating, 256, 265 determining, 58–59 Pay disparity, 129 4197 P-15 EM 1/27/04 10:06 AM Page 296 296 Pay for performance, xviii, xix, 174–176, 204–205, 229–230 Pay levels, 59–62, 260 Pay mix, 202–203 Pay practices, 67–74 Peer company groups, xx, 173–174 comparability of, 234 constructing, 184–192 data on, 68 defining, 57–58 identifying, 285–286 trends in use of, 202 Peer review, director, 253–255 Pension plans, 82, 91 Performance-based compensation, 75 Performance contingencies, 154–156 Performance management, 49–51 Performance measurement system, 31–51 barriers to success of, 43–44 building, 45–47 as competitive advantage, 34–35 components of, 35 as decision-making framework, 34 and goal-setting, 47–49 performance management vs., 49–51 pitfalls to avoid with, 41, 43 selecting measures for, 35–44 and value creation objective, 31–33 Performance measures, 63, 65, 70, 206–207, 214 Performance mix, 69 Performance risk, 178–183 Performance Sensitivity Analysis (PSA), 174, 180–183, 187–191, 193–195 Performance shares, 212–213 Perquisites, 216–217 Personalization, 257, 270–272 Plain-vanilla stock options, 123–124 Portfolio approach, 164–167 Positioning, xx, 20–21, 201–202 Proactive companies, 114, 118, 131 Product market peers, 185 Pro forma financial information, 81 Proxy solicitation, 116, 119 Proxy statements, 66, 68, 83, 84–85, 114, 128–129, 132 Proxy votes, xvii, 92 PSA, see Performance Sensitivity Analysis Public companies, 68, 74, 136 Public Law 107-204, see Sarbanes-Oxley Act Published indexes, 57–58 Index Q Qualified plans, 91 Quarterly reports, 79 R Rating measures, 105 Ratings systems, 126–127 Recommunication, 269 Regulation, 20, 74–75 Reinforcement (step in Mercer strategy), 269 Relative cost/asset position, 21 Relative market performance goals, 155–156 Relative performance, xviii, xx, 64, 65 Relative performance evaluation (RPE), 172–200 economic rationale for, 174–178 key questions for implementing, 183–184 peer group construction for, 184–192 and risk, 178–183 risk-adjusted measures for, 192–198 stock-based-incentive plans using, 198–199 Reload options, 123 Repricing of options, 89, 122 Reprimand letters, 95 Research, communication, 267 Responsible pay, xvi Restricted stock, 74, 121, 123, 125, 153–154, 165–166, 212, 215 Retirement plans, 128, 216 Return to risk ratio (RTRR), 196–198 Rewards program, communication of, 256–258, 263–265 Risk, 14, 178–183 Risk-adjusted measures, 192–198 Risk-free interest rate, 140, 149 Role-modeling (of communication), 263 RPE, see Relative performance evaluation RTRR, see Return to risk ratio Run rate, see Annual share usage S Sarbanes-Oxley Act of 2002 (SOA), xv, 75, 77–82, 160 SARs (stock appreciation rights), 166 Search firms, 88 Securities and Exchange Commission (SEC), xvi, xvii, 75, 78–83, 88, 136 4197 P-15 EM 1/27/04 10:06 AM Page 297 Index Securities Exchange Act (1934), 78–80 Self-evaluations, 93, 95, 108, 237, 246–249 Senior management, 43, 259–260, 262–263 Sensitivity analysis, 150–153 SERPs (Supplemental Executive Retirement Plans), 128 Service market peers, 185 Severance arrangements, 128, 129 Shareholders, xvii, 113–134 approval of, 88–93, 113–114, 127, 129 communication with, 130–133 compensation concerns of, 119–128 and consultants, 288–289 employees as, 117 expectations of, 7, 14–15, 17, 31–32, 217–218 external influences on, 117–118 individual, 116–117 influence of, 161–162 institutional, 117 perspective trends of, 114–115 policies of, 118–119 proposals from, 128–130 Shareholder activism, 114 Shareholder value, 1, 10–11 Silence, avoiding, 273 Skepticism, 272 SMART objectives, 267, 269 SOA, see Sarbanes-Oxley Act “Split-dollar” insurance benefits, 128 Spot value, 11–12 Stakeholders, 9–10, 115–118 See also Shareholders Standards, xxi, 136–137 State of Wisconsin Investment Board (SWIB), 118 Stock appreciation rights (SARs), 166 Stock-based incentives, 211–213 Stock exchanges, 77, 82–95 Stock options, xvi, xvii, 211–212 and burn rates, 121 and dilution, 121 discounted, 122–123 eligibility for, 72 evergreen, 122 expensing of, 126, 129, 160–161 grants of, 129 holding periods for, 124 megagrants of, 124 in new executive compensation model, 215 ownership guidelines for, 124 plain-vanilla, 123–124 pricing models for, 66 reload, 123 297 repricing of, 122 valuation of, see Stock option valuation Stock option valuation, 135–158 binomial model of, 140–142 binomial vs Black-Scholes model of, 143–144 Black-Scholes model of, 142–147 for broad-based stock purchase plans, 157–158 disadvantages of Black-Scholes model for, 145–147 indexed exercise prices in, 156–157 for long-term incentives, 66–67 Monte Carlo simulations of, 144–145 old rule of thumb for, 138 performance contingencies in, 154–156 randomness of, 139 reasons for, 138 and restricted stock, 153–154 selecting assumptions for, 147–150 variables of, 139–140 varying the assumptions of, 150–153 Stock price, xvii, 139, 148, 175 Stock volatility, 140 Strategic communication, see Communication for Impact™ strategy Strategic enterprise messages, 265 Strategic leadership, 105 Strategy, compensation, xix–xx, 56–59, 168 Strategy (step in Mercer strategy), 267–268 Supplemental Executive Retirement Plans (SERPs), 128 Supplemental retirement plans, 216 Surveys, 56, 68, 118, 246 Swapped share reloads, 123 SWIB (State of Wisconsin Investment Board), 118 Systematic risk, 178–179 T TAC (total annual cash compensation), 66 Target Corporation, 101 Tax issues, 113, 125, 129 Technical plan documents, 262 Technology, 20, 21, 24 Television, 118 Time commitments, 219–221 Time frame, 45, 46, 65–67, 214–215 Top-five Named Executive Officers, see Named Executive Officers Total annual cash compensation (TAC), 66 4197 P-15 EM 1/27/04 10:06 AM Page 298 298 True-up provisions, 154–156 2.99 limitation, 129 Tyco, 97 U United Kingdom, 173–174 Unsystematic risk, 178, 179 V Validation, xx, 56–59 Value, 1–30 and business strategy, 18–22 case study of managing for, 28–30 communication and creation of, 256, 259 creation of, 7–9, 13–18, 31–33, 256, 259 definitions of, 3–7 drivers of, 25–28 estimating, 11–13 Index forces affecting creation of, 13–18 managing for, 22–25 shareholder, focusing on, 10–11 stakeholder, 9–10 Value creation objective, 31–33 Vanguard, 122 Vendors, 284 Vesting, 168, 215, 225, 227, 232 Volatility, 140, 147–153, 178, 180–182, 229 W Web sites, 78–79, 93, 118, 271 What’s Working™ study (Mercer), 259–260, 270 WorldCom, 97, 172 Y Year-end assessment (of CEO), 108 ... executive reward strategies in light of what is, in fact, a new era of executive compensation A few of the hallmarks characterizing well-designed and responsible executive compensation programs... between making money and not What did value and managing for value mean for this organization? Engagement and understanding that managing for value has personal relevance for everyone in the company... looking for a responsible pay resolution Two things are missing in many executive compensation programs in the United States: balance among elements and accountability for results A hallmark of a responsible