(Hay Group Article) Measuring executive pay in 2010 – the equity compensation challenge

The Executive EditionYour resource on executive compensation 2010 | Issue 1

The Executive Edition™ is Hay Group's executive compensation publication offering real-world examples of howcompanies design and implement executive packages to attract, retain, and motivate key personnel.

Measuring executive pay in 2010 – the equity compensation challenge Recent year-end 2009 changes in proxy disclosure rules will cause a shift in themethod and outcome of executive compensation reporting this year. The reportednumbers that tend to be the focus of media, pay critics, and analysts do not alwayscapture the true story of executive pay, however; 2010 will be especially challenging inthis regard. Understanding reported values of executive pay

The complex structure of executive compensation, dominated by various forms ofequity and cash-based long-term incentives, can lead to significantly differentinterpretations of 'pay.' These differences result from the interaction of varying approaches to data collection, analysis,and reporting. Ensuring that all relevant data is collected for incorporation in the analysis, applying meaningful analyticaltools to construct pay models, and reporting the information in a way that recognizes the complexity of pay practices allare essential for board-level decision support. Increased disclosure requirements, governance pressures, and continuedmedia attention make it imperative that pay values are well understood and clearly communicated – internally andexternally. Potential impact of 2009 compensation actions

In 2009 many companies acted to address the results of a depressed stock market, increased market volatility, poorbusiness results, and the effects of those conditions on executive pay. These special, often one-time, actions hold thepotential for misinterpretation – either because they are deemed part of 'annual' pay or, conversely, because they areexcluded from pay calculations altogether. Such decisions made during the data collection process can lead to a flawedanalysis as true pay levels resulting from these items are not represented properly. A particular executive'scompensation often can only be interpreted properly by understanding pay actions on a 'before and after' basis. For example, companies that implemented stock option exchange programs cancelled many years of stock options andregranted some or all of those at a more favorable price. Merely reporting the Black-Scholes value of the regrant as anelement of 2009 pay oversimplifies the total compensation implications. Some of those companies excluded officersfrom their programs yet took other action – such as skipping or deferring the normal annual grant – that also needs to beconsidered. A company whose compensation peer group consists of several companies that made these types of paydecisions in 2009 may find that their executives' pay is deemed to be 'high' without recognizing these dynamics. These complexities highlight the need this year for heightened attention to a three-faceted approach to executive equitycompensation interpretation – collection, analysis, and reporting. Data collection

Discussions of executive compensation focus primarily on single-year values, forming the root of manymisunderstandings. But executive equity awards often are developed as part of a multi-year plan. SEC proxy disclosurerules recognize this through the required three-year reporting format for the Summary Compensation Table and themulti-year aggregations in other tables. A common example is when an executive receives a large new hire equity grant,often two to four times the size of a typical annual grant, and then receives no equity award the following year. Thesingle-year approach often leads to the conclusion that there has been a 'pay cut' or an 'elimination' of long-termincentive awards when pay in year two is compared to that of year one. Much of the important detail is contained in footnotes and narrative in the proxy statement, without which the tabularfigures may be misinterpreted. In addition, many pay actions not captured in the tables are nevertheless disclosed in theCompensation Discussion and Analysis (CD&A) section or appear in 8-K filings subsequent to the issuance of the proxystatement. Given the dated nature of tabular information (i.e., the 2009 proxy tables report pay for fiscal 2008), theseadditional sources are critical to understanding the true current market for executive pay. The complexities of executive

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equity compensation have long required a multi-year, multi-source perspective and the economic turmoil of 2008-2009certainly has increased the importance of this approach. Data analysis

While the valuation of equity instruments receives much attention, the variations in fair value that may result from volatilityor expected life assumptions are less significant than the effects on deemed value from a series of decisions that guidethe equity compensation calculation. Such analysis is often bypassed and the fair value resulting from the reportingprocess – typically what appears in SEC filings – is accepted as the pay value without any furtherconsideration. Compensation committees and executives need to understand these dynamics to ensure effective paydecisions. The volatile equity markets of 2008 and 2009 resulted in equity grants with an unprecedented variation of values relativeto business fundamentals and significant intra-year variations in relative grant values. For example, assume twocompanies whose share prices directly track the Nasdaq index both granted stock options in 2009, the first in earlyMarch and the other in early September. The first company will report grant date fair values approximately 50percent lower than the second company, but by the end of 2009 will have provided intrinsic value that is 260percent greater. Variations of this magnitude are unprecedented in the history of executive pay and cannot beignored. An unusually large number of companies awarded stock options in February through April of 2009 near themarket low and in many cases those grants have quickly accumulated value far greater than the artificially-low Black-Scholes value that will be reported in SEC filings. Ironically, many of those companies granted a larger number of sharesto offset the lower fair value at the time, exacerbating this effect. These dynamics require that companies understand not only what was granted (stock options, time-vested shares,performance-based shares, cash LTI) and how much was granted, but when it was granted. In addition to understandingaward type and timing, the emergence of performance features requires attention to the impact of performancecontingencies or accelerators, thresholds and targets, absolute versus relative performance measures, and theinteraction of time-based and performance-based conditions. Also, as companies add stock ownership guidelines andshare retention requirements, the risk-reward balance has changed. Thoughtful analysis will be required this year tounderstand the real impact on executive pay value resulting from the interaction of these features. Data reporting

With proper collection and analysis, pay can be reported in ways that provide a meaningful picture of executive paypractices over the past years. A single snapshot of pay will not be adequate for telling the story in this complexenvironment. Merely viewing pay as a single number may lead a compensation committee to reach flawed conclusionsabout the company's competitive position in the market. Scenario-based pay projections – incorporated into tally sheetand wealth accumulation analyses – will provide the compensation committee and the executive team with a point ofview consistent with other business decision processes. Pay granted, earned, and realized

A greater scrutiny of pay values introduces a need for the multi-dimensional view of pay, with at least three possible pay'views' to be considered. This approach requires taking pay analysis beyond a grant-based focus to a dynamic view ofthe life cycle of executive pay – when granted, earned, and realized. A significant change in the revised proxy disclosure rules changes the equity incentive figures in the SummaryCompensation Table from an 'earned' to a 'granted' basis. The fair value of all equity awards made during the reportingyear are deemed to have been what was 'paid' to the executive for that year rather than what was accrued foraccounting purposes. There are lengthy and complex arguments around which of these two methods is preferable, andwhy, but sound pay analysis does not force an either-or decision. It is important to understand what was granted, theincremental amount earned, and – as media organizations often do – the pay realized over a period of time to obtain atrue picture of executive pay. While no single analytical structure will make sense for all companies, compensation committees and executive teamsshould:

think through the three data processes – collection, analysis, and reporting – in the context of three alternativeviews of pay (granted, earned, and realized) andask a series of questions to ensure a comprehensive approach. The matrix below illustrates the types ofquestions that may result to help guide this year's analyses and decisions.


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Granted Earned Realized

Collection

Did we capture all of the grants andactions taken last year? Have weproperly categorized 'annual' pay

actions?

Did many of our peers grant during the marketlows? How is that affecting reported grant value

and fair value?

Were there significant realization events that createdcompensation not captured in the typical proxy and

survey formats? Have we compared vested butunexercised in-the-money option gains?

AnalysisHave we explored the stock price

patterns of our peers and reviewedscenario-based pay values?

Have we analyzed competitors' changes in

vesting schedules, acceleration provisions, andholding requirements to understand changes in

earnings opportunities?

Have we conducted an historical analysis of realizedpay to understand how this may be affecting current

grant patterns?

Reporting

Have we accounted for new hires,promotions, terminations, founders,

and special qualifications ofincumbents?

Are we considering risk-adjusted differences inpay values - options vs. time-vested full-value

awards vs. thresholds and targets onperformance awards?

Do our tally sheet and wealth accumulation toolscapture realized value including post-vesting

accumulation?

Many emerging tools – tally sheets, wealth accumulation models, 'walk away' value calculations, and scenario-basedanalysis – address some of these issues. A methodical approach will help a company understand the tools being usedand the rationale for using a tool to the exclusion of others. It can be helpful to view these alternatives in this three-by-three analytical framework to capture the issues surrounding the collection, analysis, and reporting of equitycompensation data and recognize alternative measurement points of grant, earning, and realization to ensure a clearunderstanding of market pay levels and practices.

Fred Whittlesey is a consultant in Hay Group's executive compensation practice. He can be reached at+1.415.644.3739 or [email protected].

CEO pay: full year 2009 proxy reporting at the largest companies

In April 2009, Hay Group released the key findings from our second annual study forThe Wall Street Journal on CEO pay among the first 200 companies that filed a proxystatement in 2009 and reported annual revenue of at least $5 billion. We now havecompleted our review of CEO pay at all 422 companies in this revenue range that fileda proxy statement between October 1, 2008 and September 30, 2009. What were the findings from the full sample of companies?

CEO pay results at the median were largely consistent with the results of the first 200companies examined. For the full sample of 422 companies we found:

salary increased four percent to $1,080,000

bonuses were down 15.6 percent to $1,186,440

overall cash compensation declined 4.7 percent to $2,295,000

total direct compensation - which includes the value of long-term incentive grants of stock options, restricted

stock, and performance awards - was down two percent to $7,314,948.

Chart one: CEO compensation changes and values

Base salary Annual incentives Total cash comp Total direct comp


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WSJ/Hay Group 422 $1,080,000 $1,186,440 $2,295,000 $7,314,948

Did pay declines follow performance results?

As we have often seen in recent years, annual bonuses track the rise and fall of a company's net income. Annualbonuses for CEOs of the 422 companies were down a median of 15.6 percent as net income fell 15.7 percent. The one-year total shareholder return of all 422 companies was negative, -37.7 percent. Total direct compensation wasdown -2 percent for the full sample. Stock options and performance shares lead the way

According to the results from the full sample, 71 percent of companies awarded stock options to their CEOs while 66percent granted performance-based awards (55 percent granted performance-based equity and 18 percent awardedperformance-based cash, as a number of companies granted both types), and 46 percent of companies grantedrestricted stock awards. In comparison to last year, option grant values for the full sample are down 0.4 percent, performance award values areflat at 0.0 percent change, and restricted stock award values are up 5.2 percent. Is this a subtle indication thatcompanies are changing the long-term incentive pay mix? Or was it just a very bad year and they decided to make fewchanges in 2009? The current long-term incentive pay mix of the full sample does indicate that for CEOs in their position for two or moreyears, the value of their performance award grants exceeds the value of their stock option grants:

Performance awards = 41 percent;Stock options = 39 percent; andRestricted stock = 20 percent.

More companies are granting stock options but more money is being allocated to performance awards. In fact, forCEOs the total direct compensation pay mix confirms the same relationships, as stock options make up 23 percent andperformance awards make up 25 percent of the TDC pay mix. Chart two: CEO total direct compensation pay mix (at 422 companies)

Long-term incentive pay multiples dwarf other elements of CEO pay

In recent years, the Securities and Exchange Commission (SEC) has made it possible to determine 100 percent of whatthe named executive officers receive in annual and long-term incentive compensation. All of the annual and long-termincentives granted in the current fiscal year must be recorded in the proxy statement on the Grants of Plan-Based


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Awards table. Hay Group studied CEO pay at the 422 companies and determined that the typical CEO received a long-term incentivegrant of almost five times salary in 2008.

With a median salary of almost $1.1 million, that means that the CEO received over a $5 million long-termincentive grant in 2008.Long-term incentive pay multiples (based on actual fair market grant values) for 2008 were a median of 1.75times salary for restricted stock grants, 2.28 times salary for stock option grants, and 2.30 times salary forperformance-based awards.

In the group examined, the typical CEO has a current tenure of 5.25 years at the median and stands to make a greatdeal of money from outstanding long-term incentives should he or she continue their employment with the company. Chart three: CEO long-term incentive pay multiples (grant value as a multiple of salary)

Realized pay elements add millions to annual pay

During the 2008 fiscal year the full sample's prototype CEO received a median of $2,295,000 in annual compensation(i.e., salary plus bonus) and also realized substantial amounts in long-term incentive compensation.

These CEOs exercised stock options ranging from a value of $9,399 to $184 million, or a median of $3,938,620.Amounts received during 2008 from the vesting of restricted stock awards or the value of performance-basedequity that was earned in 2008 ranged from $21,047 to $37 million, or a median of $2,150,810.Cash-based long-term performance awards earned in 2008 ranged from $155,741 to $18.6 million, or a medianof $2,011,516.

Even in a bad year, most CEOs still received grants and made substantial money from awards that had been made inprior years. How will the new SEC rules impact CEO pay?

The new SEC rules, approved on December 16, 2009, require changes to the Summary Compensation Table (andDirector Compensation Table) that will eliminate the need for companies to calculate and disclose the compensationcosts of long-term incentives in the tables. In the future, companies will be required to disclose aggregate grant date fairvalues of long-term incentives that are also broken out individually in the Grants of Plan-Based Awards Table in theproxy statement. This will provide investors with a much better and simpler way to arrive at a picture of what companiespay their NEOs in the current year, which is comparable across companies. Companies also will need to restate suchamounts that were disclosed in the prior two years if the individual was an NEO in those years. In the end, the new SEC rules will facilitate more comparisons among companies by investors, shareholder groups,consultants, the press ,and other individuals or companies. Looking at 2009 fiscal year data should be especially


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interesting as all calendar year companies are required to make the necessary changes in their 2010 proxy statements.

Steve Sabow is a consultant in Hay Group's executive compensation practice. He can be reached at+1.201.557.8401 or [email protected].

Risk assessment: initial process and checklist

The Securities and Exchange Commission (SEC) in mid-December 2009 finalizedexpanded disclosure requirements regarding executive pay to address potential risk incompensation programs. The new rules require that every publicly held companydiscuss in its annual proxy statement – although not in the Compensation Discussionand Analysis (CD&A) section – whether any of its compensation plans or practices(for executives and non-executives) create risk-taking incentives that are reasonably

likely to have a material adverse effect on the organization. From a practical

viewpoint, the result is that every public company will need to examine each of itscompensation programs:

to be assured that no such potential risks exist, andto fix or otherwise mitigate any potential risks that may be uncovered.

Since many compensation committees have not historically examined broad-based reward programs, the learning curveon these programs may be substantial. One of the most important and immediate challenges for organizations and compensation committees is developing aprocess to assess – and then manage – the possible risks posed by the compensation programs they maintain oroversee. As part of the initial process, we have found it useful to develop a checklist to guide the analysis. However, anyprocess and checklist needs to be tailored to a company's specific circumstances – real thought and analysis areneeded, not simply a 'check-the-box' compliance mentality. Initial process for assessing risk

Create a project team (which might well include a senior risk officer, inside and outside legal counsel, a senior

HR or compensation officer, and a compensation consultant) to assess the level of risk for each of the distinctcompensation programs to be reviewed against a key set of criteria/checklist. (See the sample checklist providedbelow.)

1.

Collect and review the organization's existing written and unwritten pay policies, practices, and plan

documents, as well as similar items pertaining to the company's enterprise risk management.

2.

Conduct the compensation risk assessment and identify for the compensation committee the risks that the

organization faces that could threaten its value or have a material financial, operational, or reputation impact onthe company. Identify the features of the organization's executive and non-executive compensation policies,practices, and supporting management processes that could induce executives and employees to take thoserisks.

3.

Analyze the results of the risk assessment and discuss how to mitigate and manage any such excessive risks,

and/or establish a process and timetable for revising those compensation and incentive programs that containexcessive risks.

4.

Checklist for risk assessment

Below is a sample checklist that contains generally relevant criteria for use in assessing the risk profile of compensationprograms. To determine the risk exposure of each program, we suggest an organization determine the potential costunder a 'worst case' scenario and the probability of such worst case scenario. In working with companies in these


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analyses, we have found it helpful to characterize (or rank) potential cost and risk on a grid as high, moderate, and low,using a red, yellow, and green 'stoplight gap analysis' (as illustrated below) as a visual means for characterizing andaddressing levels of risk.

Review

The financial industry crisis spawned the current focus on potential risk in compensation programs. Companies,regulators, and advisors all are attempting to address the various factors that contribute to risk in compensationprograms, but many important issues still must be addressed. For instance (and most basically), there is no universaldefinition of what is meant by 'risk.' While the SEC has eased the reporting burden for public companies by limitingrequired disclosure to risks that are 'reasonably likely to have a material adverse effect on the company,' the core issueremains. Ultimately companies will receive more guidance (and hopefully more clarity) from the SEC on their initial complianceefforts. Upon review of a company's proxy statement by the SEC (perhaps as part of the SEC's triennial reviews), afailure to show the company conducted a risk assessment in compliance with these new rules could prompt queries onspecific programs. Aside from any input or feedback from the SEC, ideas will be exchanged among companies and theiradvisors and reasonable approaches developed after considering information disclosed in filings during the upcomingproxy season. In the meantime, the initial process and checklist provide a solid starting framework for a company'scompensation plan risk assessment.

Dana Martin is a consultant in Hay Group's executive compensation practice. He can be reached at+1.312.228.1824 or [email protected].


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Tom McMullen is the leader of Hay Group's US reward practice and can be reached at +1.312.228.1848or [email protected].

New SEC rules enhance disclosure of executive payThe regulation of executive compensation accelerated in 2009 as Congress, theObama Administration, and various regulatory agencies all added their voices to thedebate surrounding sound executive pay practices. As 2009 ended, the Securities andExchange Commission (SEC) adopted final rules enhancing proxy disclosure ofexecutive compensation for public companies. We focus here on an overview of thenew SEC rules and address some of the key compliance issues. Key topics addressed

The relationship of the company's compensation policies and practices to riskThe reporting of equity awards for executives and directorsFee disclosure related to the retention of a compensation consultantAdditional disclosure on the qualifications of directors and nominees for the boardDiscussion of the company's leadership structureAccelerated reporting of shareholder votes

The new rules generally are effective for fiscal years ending after December 19, 2009 for proxy statements and annualreports filed on or after February 28, 2010. Relationship of the company's compensation policies and practices to risk

Under the new rules, public companies must discuss compensation policies and practices for all employees – not justnamed executive officers (NEOs) – to the extent that risks arising from them are 'reasonably likely to have a materialadverse effect' on the company. Companies will need to identify and then review all compensation arrangements todetermine whether there are potential risks that might trigger disclosure. Any problems discovered in the review processthen can be fixed or appropriately mitigated. The SEC furnished examples of situations that could potentially trigger discussion and analysis:

If a business unit of the company carries a significant portion of the company's risk profileIf a business unit has a significantly different compensation structure than other unitsIf a business unit is significantly more profitable than others within the companyIf compensation expense at a business unit represents a significant percentage of the unit's revenuesIf the compensation policies and practices vary significantly from the overall risk and reward structure of thecompany

In assessing the degree of risk, companies can consider any compensation policies and practices designed to alleviaterisk or balance incentives (e.g., clawbacks and recoupment policies; bonus banking; stock ownership requirements). The type of disclosure is determined on a case-by-case basis, but may include:

the general design philosophy of compensation policies for employees whose behavior would be most influencedby the incentive programsthe company's risk assessment or considerations in structuring its incentive compensation policiesthe ways in which the company's compensation policies relate to the realization of risks resulting from the actionsof employees (e.g., through the use of clawbacks or holding periods)the company's policies regarding adjustments to its compensation practices to address changes in its risk profilematerial adjustments the registrant has made to its compensation policies or practices as a result of changes in


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its risk profilethe extent to which the registrant monitors its compensation policies to determine whether risk managementobjectives are being met.

Risk-related disclosure will have its own section and will not be included in the Compensation Discussion and Analysis(CD&A). Importantly, as stated in the final rules, the SEC does 'not require a company to make an affirmative statementthat it has determined that the risks arising from its compensation policies and practices are not likely to have a materialadverse effect on the company.' In view of this limitation on the disclosure that is required, it will be interesting to seewhether many companies voluntarily make such an affirmative statement as part of demonstrating that they haveundertaken the appropriate risk assessment. Reporting of equity awards to executives and directors

The full grant date fair value of stock option and share awards will be reported in both the Summary CompensationTable and Director Compensation Table. Existing rules under FASB ASC Topic 718 (formerly FAS 123(R)) required thatcompensation expense be recognized for financial reporting purposes. This change impacts the calculation of totalcompensation used to determine a company's named executive officers. Companies will need to update values shown inthe stock award, option award, and total compensation columns for prior years for each NEO. Disclosure of grant datefair values of individual equity awards will continue in the Grant of Plan-Based Awards Table. Additional disclosure regarding fees affecting independence of compensation consultants

The new disclosure rules require a company to disclose the fees paid to a compensation consultant if the consultantfurnishes consulting services related to executive or director compensation and also provides other services to thecompany. However, fee disclosure is not required if the fees paid to the consultant for additional services did not exceed$120,000 during the company's fiscal year. Where disclosure is required, it must include:

aggregate fees paid for executive and director compensation consulting servicesaggregate fees paid for non-executive compensation consulting serviceswhether the decision to engage the consultant for non-executive compensation consulting services was made orrecommended by management and whether the committee or board approved the other services, if theconsultant was engaged by the compensation committee.

Additional disclosure on the qualifications of directors and nominees

Under the expanded disclosure requirements, a company must discuss the particular experience, qualifications,attributes, or skills that qualify an individual to serve as a director for the company based on the company's business andstructure at the time the disclosure is being made. However, the final rules do not require disclosure regarding thespecifics that qualify the individual to serve as a committee member. Disclosure is required for all directors, even if theyare not standing for reelection in the applicable year, and should include:

any directorships at public companies held by each director at any time during the past five years (instead of onlydisclosing currently-held directorships)certain legal proceedings involving any director or executive officer during the last ten years (instead of five years)disclosure of whether and how diversity is considered when identifying director candidates.

The SEC has not defined 'diversity'; rather, each company is allowed to define it as it determines to be appropriate forits particular circumstances (e.g., experience, skills, education, race, gender, etc.). If a policy on diversity exists, thecompany must disclose how the policy is implemented and how its effectiveness is assessed. Discussion of company leadership structure

A company is required to disclose whether and why it has chosen to combine or separate the CEO and board chairmanpositions, along with the reasons why the company believes that this board leadership structure is the most appropriatefor it at the time of the filing. If the same person serves as CEO and chairman, the company needs to disclose whetherand why the company has a lead independent director and the role of the lead independent director in the leadership ofthe board. In addition, the new rules require companies to describe the board's role in the oversight of risk (which may includecredit risk, liquidity risk, and operational risk). For example, a company may describe whether the entire board reviewsrisk or if there is a separate committee. Further, a company may find it helpful to discuss how risk information iscommunicated to the board or relevant committee members. Expedited reporting of results of shareholder votes


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Traditionally, final results of shareholder votes have been reported in a 10-Q or Form 10-K. Under the new rules,reporting will be required on a Form 8-K within four business days of the meeting. The continuing challenge of appropriate disclosure

The new rules (i) respond to some criticisms of the 2006 overhaul of the SEC disclosure rules relating to executivecompensation, (ii) address various executive compensation issues that have become important in recent years, and (iii)generally expand the scope of required disclosures. Companies are faced with the challenge of accurately explainingtheir programs and policies in a way that is sufficiently detailed yet understandable and meaningful to investors and otherinterested parties. We await guidance, comments, and feedback from the SEC as it reviews filings under these newrules.

Cory Morrow is a consultant in Hay Group's retail sector executive compensation practice. He can bereached at +1.469.232.3826 or [email protected]. Bill Gerek is the US executive compensation regulatory expertise leader for Hay Group. He can bereached at +1.312.228.1814 or [email protected].

Debate, disclosures and direction: a look at Not-for-Profit executive pay issues

Like their for-profit brethren, not-for-profit (NFP) organizations today operate in anenvironment of heightened awareness of executive compensation levels. The debateabout the magnitude of compensation, whether for a Wall Street executive or a localhospital CEO, has caused a palpable shift in attitudes and raised the sensitivity of keystakeholders. This change has found its way into boardrooms, executive suites, andincreasingly, the legislatures of both state and federal government.

Background

In 2008 the global financial crisis spawned the Troubled Asset Relief Program (TARP) which imposed significantrestrictions on executive pay for participating financial institutions. Earlier versions of the legislation contained broadreferences to limiting executive pay levels for organizations receiving federal subsidies. Some thought tax-exemptorganizations – with their particular designation, reimbursement structure, and/or federal grantee status – might besubjected to limitations on executive pay. While the federal government has been the most vocal on this matter, we have seen state legislatures proposing specificlimitations on executive compensation and changes to not-for-profit corporate governance requirements. Although thegenesis for legislative action often has come in response to a specific issue (e.g., concern about the level of pay for alocal hospital CEO or potential conflict of a board member), compensation levels continue to be an incendiary forleveraging by public officials. In light of this background, we begin with a review of recent changes to the disclosure rules regarding executivecompensation for tax-exempt organizations. We then address those areas of executive compensation that we believe,due to today's focus on similar issues in the private sector, will soon have the attention of – and provide direction to –key stakeholders in the tax-exempt not-for-profit world. Experience has shown that organizations would be well-advisedto get ahead of the curve and proactively address any excesses or governance deficiencies.

Disclosures

Much has been written about the revisions to the annual Form 990 disclosures applicable to most tax-exempt


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organizations. When the revised form was introduced, the Internal Revenue Service (IRS) outlined its guiding principles interms of enhancing transparency, promoting tax compliance, and minimizing the burden on the filing organization. We canargue whether the third principle has been met, but do believe that substantial progress has been made in clarifying boththe disclosure and governance expectations of these organizations. Audit findings

An IRS report of March 1, 2007, detailed the key findings from the audit of tax-exempt organizations, providing an earlyindication that changes were likely; the IRS built a clear business case for enhancing the Form 990 filing requirements.This review specifically focused on reasonable compensation standards applicable to tax-exempt employers and alsoaddressed some procedural questions around governance/decision making. The initiative examined Form 990compliance, intermediate sanctions imposed under Internal Revenue Code Section 4958, and private foundationself-dealing. While its findings were lengthy, the essence of the study suggested that:

disclosures of remunerative arrangements were inconsistent and the existing reporting requirements needed to bemodified to provide complete and clear disclosurecompensation levels, while high, could generally be defended with comparability studies, thus reducing thelikelihood of an excess benefit transaction (based upon current standards)the disclosure of governance processes, business relationships, and decision-making should be refined to shedlight on the business practices of these organizations.

Interestingly, the study suggested that only 51 percent of audited organizations attempted to satisfy the three elementsfor obtaining the benefit of the 'rebuttable presumption of reasonableness' under the intermediate sanctions rules. Giventhe value of meeting these standards (i.e., shifting the burden of proof to the IRS in a claim of excessive compensation),it is worth highlighting here the basic requirements for establishing the rebuttable presumption:

The compensation arrangement must be approved in advance by an authorized body of the applicable tax-exemptorganization, which body is composed of individuals who do not have a conflict of interest concerning thetransaction.Prior to making its determination, the authorized body obtained and relied upon appropriate data as tocomparability.The authorized body adequately and timely documented the basis for its determination concurrently with makingthat determination.

The needed documentation must include (1) the terms of the transaction and the date of its approval, (2) the memberspresent during the debate and vote on the transaction, (3) the comparability data obtained and relied upon, (4) theactions of any members having a conflict of interest, and (5) documentation of the basis for the determination.

Direction

Most large tax-exempt organizations should be particularly interested in the restrictions and governance initiativesaffecting executive pay at public companies. In fact, these employers now share an important similarity with TARPcompanies in that US taxpayers are key stakeholders in their organizations. Several of the executive pay restrictionsimposed on the TARP companies are potentially relevant to tax-exempt NFP organizations; when combined with variousgovernance initiatives and compensation trends, executive pay design in the NFP sector promises to be particularlychallenging this year.

Limitations on severance. TARP prohibitions on severance compensation were crafted in response to several former

high profile CEOs of poor-performing companies who received significant severance payments from their damagedorganizations. As more tax-exempt organizations reach into the for-profit ranks for their top talent, severancearrangements have become more generous and could become a target. Restrictions here could pose a challenge to theattraction and retention of key executives because they would not have the significant equity appreciation opportunitiesavailable to executives at for-profit companies. To the extent that supplemental retirement and/or deferred compensationarrangements may be used to augment the trade-offs made by these leaders, the programs need to be coordinated in away that meets both the business and retentive interests of the organization and the recruitment requirements of theleader.

Risk orientation of compensation. Many investment banks came under fire for compensation programs that weighted


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annual performance too heavily at the expense of long-term results. This practice caused many executives to focus onhaving a great year, rather than on achieving sustainable long-term results. Not-for-profit organizations have generallymaintained low leverage on their compensation structure and, in particular, the use of long-term incentive programs isnot prevalent in the NFP arena. While annual incentive plans generally utilize a balanced portfolio of performancemeasures, there has not been as great an emphasis on defining, measuring and rewarding for longer-term expectations.While we may never see the magnitude of performance-based pay utilized by the for-profit sector, expanding thedialogue to consider changing the mix of pay and aligning remuneration with performance expectations is a positive.

Policy on luxury expenditures. This provision, which forces TARP companies to adopt a policy on excessive or luxury

expenditures – such as entertainment, office renovations, aviation and other transportation services, special offsitemeetings, and the like – is designed to address some of the higher profile items that have attracted unfavorableshareholder reaction. While these practices are more limited at NFP organizations, we have seen boards adopt specificpolicies addressing executive expenses, perquisite utilization, and outside organization activities. Understanding thebusiness purpose of a perquisite and adopting a policy regarding its use can be critical.

Compensation committee independence. For many not-for-profits, advisement on executive pay should not work any

differently than it does in the for-profit world. Both the compensation committee and its consultant should be independentand should have adopted policies addressing the definition of each. In situations where an organization is served by aconsultant that may be obtaining significant revenues from other areas like actuarial services, brokering, or benefitsoutsourcing, it is important to understand and disclose them to the board and assess each for potential conflict. Overall,requirements applicable to public companies will be critical for NFP organizations to consider and address, including theindependence of compensation committee members.

Say on pay. This provision, which refers to offering a company's shareholders a non-binding, advisory vote on the

compensation decisions made for named executive officers (NEOs), would be difficult to replicate in a not-for-profitenvironment. That said, we do expect that NFPs will face greater regulation of their executive compensation levels andprograms, with the potential for more stringent standards by the IRS around 'reasonableness of compensation' thanwhat is currently provided for by the intermediate sanctions under section 4958 of the Internal Revenue Code.

Continuing to learn from the private sector. The Securities and Exchange Commission continues to establish and

expand the rules governing the disclosure requirements for the compensation of NEOs at public companies. Central tothese efforts is the required narrative in a Compensation Discussion and Analysis (CD&A) regarding named executiveofficers for each year's proxy statement. Within the CD&A, organizations are required to describe, in plain English, whyreward decisions were made, and to explain the interplay between the different elements of compensation, thecompany, and individual results. NFP organizations would be well served to consider:

what the compensation program is designed to reward

what each element of the compensation program is

why the organization pays each element of compensation

how the organization determines the amount (and where applicable, the formula) for each element

how each element, and the organization's decisions on the element, fit into the organization's overall objectives.

As our government officials contemplate the nature and structure of healthcare reform, we should expect the levels ofcompensation for executives and physicians to enter the debate. Increasing criticism of remuneration and expandeddisclosure requirements imposed by the government will make this activity increasingly important to the organization.

Ron Seifert is a consultant in Hay Group's executive compensation practice. He can be reached at+1.215.861.2583 or [email protected].

James Otto is a consultant in Hay Group's executive compensation practice. He can be reached at+1.404.575.8740 or [email protected].


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Top North American energy organizations' pay and performance – navigating

economic volatility

For energy companies recent times have veered from one end of the businessspectrum to the other. Record profits earned in 2008 on the back of record high oilprices at $150 a barrel were followed by the collapse to $40 a barrel, resulting in cutsin capital expenditure as the full impact of the global slowdown hit home. The creditcrunch started in the US and evolved into a global economic crisis – e.g., stockmarket devaluation, financial market meltdown, mining production cutbacks, automanufacturer's production suspension, layoffs, and more. Organizational strategy andmanagement's ability to navigate volatile commodity prices were put to the test andexecutive compensation plan designs followed suit. The unstable economy providedan opportunity for Hay Group to stress test the calibration of pay and performance of 75 top North American energyorganizations. While each of these issues present their own important and unique challenges, we focused on the outcome of the topNorth American energy organizations through the year, specifically as it relates to the capital markets and shareholderreturns as measured by the alignment of pay and performance of the five named executive officers (NEOs) applying Hay

Group's Performance Index (Hay GroupPI

).

Hay Group's Performance Index (Hay GroupPI) – methodology

Hay GroupPI is a composite index based on an equal weighting of four indicators and is intended to provide a balancedview of an organization's overall performance. The four performance metrics are:

1. Total shareholder return (TSR) A measure of the return (capital gain + dividends) to shareholders.

2. Return on equity (ROE) A measure of how efficiently an organization generates profit on share capital.

3. Earnings per share growth (EPSG) A measure of profitability growth year over year.

4. Corporate governance rating A measure of corporate governance and transparency.

Each organization's four-metric composite performance is ranked by percentile against the peer group and plotted alongthe horizontal axis ranging from zero percent to 100 percent. Similarly, the sum of the NEOs' Expected Total Incentives(the sum of short-term incentives and mid/long-term incentives, expressed as a percentage of salary) is ranked bypercentile against the peer group and plotted along the vertical axis, again ranging from zero percent to 100 percent.The result of the two relative percentiles is plotted in one of four quadrants as illustrated in the following diagram. A45-degree diagonal line is drawn through the origin of the graph and theoretically represents a perfect alignmentbetween performance and compensation:

Quadrant one: The company's performance is below median, incentive compensation is above median. The executive is receiving a higher incentivecompensation level despite failing to deliver superior results relative to competitors


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Quadrant two: The company's performance is below median, incentive compensation is below median. The executive is receiving a lower incentivecompensation level while delivering poorer results relative to competitors. There would appear to be an alignment between pay and performance.

Quadrant three: The company's performance is above median, incentive compensation is below median. The executive is receiving a lower incentivecompensation level while delivering superior results relative to competitors.

Quadrant four: The company's performance is above median, incentive compensation is above median. The executive is receiving a higher incentivecompensation level while delivering superior results relative to competitors. There would appear to be an alignment between pay and performance.

Profile of top North American energy organizations

The median characteristics of the top North American energy organizations are presented in the following table bygeography. Our research identified the top 25 Canadian, top 50 US and top 75 (i.e., aggregate sample) energycompanies within the exploration and production (E&P), storage and transportation (S&T), integrated oil and gas andrefining and marketing (R&M), oil and gas drilling and oil and gas equipment and services market sectors as defined byGICS sub-industry code for fiscal 2008. The US market included the top 50 energy organizations to help narrow thesignificant gap between the median market cap of the Canadian and the higher US market. Median North American energy organizations by geographic market

Geographic market Market cap ($mm) Revenue ($mm) TSR

ROE EPS growth Governance rating (GMI) Expected total incentives as % of salary

Canadian Top 25* $4,084 $3,148 -31% 25% 58% 7.50 368%

US Top 50** $7,872 $7,411 -52% 18% 4% 8.00 643%

Canadian & US Top 75** $5,585 $5,363 -38% 19% 19% 8.00 554%

* Canadian dollars** In US$, Canadian currency converted to US$ by an exchange rate of CDN$1 = US$0.9346

Hay Group's Performance Index (Hay GroupPI) — findings

The following graph illustrates the pay and performance findings for the Top 75 North American energy organizations.Note: the Top 50 US companies are denoted with a blue triangle on the graph and the Top 25 Canadian companies aredenoted with a red triangle. In the analysis less than half the sample fall into quadrants two (Q2) and four (Q4),indicating there is still much work to be done in terms of aligning pay and performance. The issue is further compoundedwhen looking at those organizations falling into quadrants one (Q1) and three (Q3), indicating that boards may wish toreview their incentive designs. Top 75 North American energy organizations

(click the chart to see a larger version)


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In the Top 75 analysis, the companies with the highest pay and performance correlation were Occidental Petroleum(Q4), Williams Companies (Q4), Cimarex Energy Co (Q2), Crescent Point Energy (Q4), Cameron International (Q2),Canadian Natural Resources (Q4) and Baker Hughes (Q4). Occidental Petroleum (Q4) had the fifth highest pay for top

quartile Hay GroupPI

performance. Enbridge (Q3), followed closely by Nexen Inc (Q3) and Enerplus Resources (Q3) hadthe highest performance of the peer group and compensated the executive team below the peer group median. An interesting geographic observation is the fact that 75 percent of Q4 organizations are US based – top pay for topperformance. That said, 95 percent of organizations falling in Q1 are also US based – top pay for below medianperformance. In comparison, 73 percent of Q3 organizations are Canadian – below median pay for top quartileperformance. That aside, a solid 80 percent (i.e., 20 of 25) of the Top 25 Canadian organizations, when compared tothe US peers have above median performance, but only four of the 16 organizations lie in Q4. Therefore, one mightconclude that Canadian shareholders received better value for performance. In general, Top 50 US organizations continue to compensate executives at the highest cross-border levels in the energyindustry, which is not a surprise. However, the results do show that pay is not necessarily aligned to performance,indicating that much work can still be done in the area of calibrating pay to performance that provides value toshareholders.

Gainers and decliners

The following tables set out the top five gainers and bottom five decliners over last year's results for the Hay GroupPI

(horizontal axis on charts) for both the Canadian and US organizations studied over the past two years. The neworganizations added to this year's analysis are omitted.

Canadian top and bottom five gainers and decliners by Hay GroupPI

Top five One-year Hay GroupPI % change Bottom five One-year Hay Group

PI % change

Penn West Energy Trust 500% Suncor Energy -95%

Enerplus Resources 233% Pengrowth Energy -75%

Crescent Point Energy 188% Petrobank Energy -61%

Harvest Energy Trust 150% Husky Energy Inc -56%

Talisman Energy 118% Imperial Oil -33%

US top and bottom five gainers and decliners by Hay GroupPI

Top five One-year Hay GroupPI % change Bottom five One-year Hay Group

PI % change

Newfield Exploration 232%

Valero Energy -94%

ONEOK Inc 73% Chesapeake Energy -72%

Devon Energy 22% Anadarko Petroleum -54%

Murphy Oil 21% Marathon Oil -16%

Chevron Corp 21% Hess Corp -13%

The bottom five decliners in both the Canadian and US peer group showed relatively similar results. However, theCanadian top five gainers illustrated significantly larger year over year change in comparison to the US top five gainers.This observation is likely due to the Canadian capital markets sustaining more value through the financial crisis than theUS markets.


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The road ahead

The financial crisis has put incentive plans, specifically pay for performance, to the test. The findings in this year'sanalysis further supported the fact that there is still much room for improvement when it comes to aligning and calibratingpay to performance. More importantly, it helped to raise important issues such as sustainable growth, risk management,and aligning pay to the risk time horizon of capital investments. We expect some interesting results in our 2010 energypay and performance analysis as our peer companies begin to report FY2009 financial and compensation results.

Paul Gryglewicz is a consultant in Hay Group's Canadian executive compensation practice. He can bereached at +1.416.815.6426 or [email protected].

Bob Dill is a consultant in Hay Group's executive compensation practice. He can be reached at469.212.4344 or [email protected].

2010 Hay Group. All Rights Reserved. Contact us | [email protected]


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(Hay Group Article) Measuring executive pay in 2010 – the equity compensation challenge

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