21- Compensation for Business Leaders

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"Census" Data Example ERI has leveraged publicly disclosed Executive data to make it available as a 100% census-like compensation research database rather than a salary survey (where surveys have a sample of a population). Two examples are: ERI's Executive Compensation Assessor & Survey ERI's Compensation Comparables Assessor & Tax Exempt Survey Subscribers to ERI's Executive Compensation Assessor® & Survey (XA), include: publicly-traded and privately-held corporations, forensic accountants, various United States government agencies, accountants, attorneys, and other professionals. ERI has been a provider of executive data since 1986 and its databases have grown to include over 14,000 publicly traded corporations in the US and Canada, as well as all presently reporting UK and Euro publicly-traded companies (approximately 1,200), plus available executive compensation survey data. Data for Canada is provided in information circulars, while data from UK and European organizations is provided in annual reports, all manually or digitally extracted. XA offers subscribers the largest available database of executive salary, incentive and benefit data for for-profit organizations. Its companion product, ERI's Nonprofit Comparables Assessor & Tax-Exempt Survey is also the largest database for nonprofit organizations. Together, they allow subscribers to analyze and review source documents on over 20 million job incumbents. Additional applications of executive compensation analyses occur in areas relating to corporate valuations (where owner/manager compensation affects stock value), estate planning, appraisals (S2000), charitable gifts (S170), buy/sells (S2073), ESOP feasibility studies, reasonable compensation, accumulated earnings, dissolution proceedings and other litigation, and insurance funding. XA provides subscribers with the ability to analyze precise valuations of market pay. This application is the only source of its kind that analyzes data compiled from all publicly available executive compensation surveys and all available US SEC DEF 14A "proxy" statements. (Annual reports and information circulars for the UK/Europe and Canada respectively.) The XA application assists with the assessment of an organization's executive compensation competitiveness, customized by geographic area, industry, organizational size and date. The Nonprofit Comparables Assessor has a focus on nonprofits' "comparables" and "reasonable compensation" as contrasted to the Executive Compensation Assessor's for-profit salary and total compensation planning focus. The Nonprofit Comparables Assessor applications are designed to mirror the IRS requirements for selecting comparable organizations and creating the rebuttable presumption found in US IRC 4958's Intermediate Sanctions. The program creates an easy method of establishing defensible compensation levels for the executives (and the organization managers who are "knowing" and who have joint and personal liability). The Nonprofit Comparables Assessor also allows the use of compensation for for-profit companies when relevant, as permitted by IRS rules. ERI is reading the publicly available Form 990s/PFs/EZs and extracting the reported compensation paid by hundreds of thousands of organizations to create evergreen executive compensation surveys. Intermediate Sanctions allow for the creation of a "rebuttable presumption" using data from both taxable and tax-exempt organizations, easily and quickly accomplished via ERI's Nonprofit Comparables Assessor. As required by the Intermediate Sanctions Code (IRC 4958), it reports "compensation levels paid by similarly situated organizations for functionally comparable positions and reveals where there are similar services in the geographic area of the applicable tax-exempt organization." Survey Data To perform market pricing, one needs reliable survey data, and sampling surveys have traditionally filled this role. This data can be obtained from both general national executive and managerial salary surveys or industry-specific surveys. Examples of firms that offer compensation data products: ERI Economic Research Institute Korn Ferry Aon Culpepper Sibson and Co. Willis Towers Watson Mercer Specialized Survey Data and its Advantages Many professional and industry associations conduct and distribute managerial salary surveys. The advantage of these industry surveys is that they provide information on jobs commonly found in organizations within a specific industry or profession. For instance, banking surveys provide information on jobs such as loan officer and branch manager. Also, these surveys may provide information on salaries for the overall sample. Plus, they use major breakdowns, such as geographical regions and organization size. Disadvantage of Survey Data A problem with some data is the sample size. If the sample is subdivided, the number of positions included can become quite small. This makes the data of limited use. Sample size and the reported rate of error (if it is reported) are key to judging the potential validity of the data reported. Peer Groups When relying on surveys, organizations need to make sure that their supporting data contains enterprises and jobs that are comparable. Courts have held that peer groups must be comparable. For example, in Eberl's Claim Service v. Commissioner, 249 F.3d 994 (10th Cir. 2001) the Tenth Circuit rejected a comparison between the companies listed in the Forbes survey, the largest companies in the country, and a taxpayer's relatively small nonpublic company. For executive market pricing, companies use "comparables" data with the exact payments of a peer organization. Surveys often list their participants, but they often do not specifically identify who pays what. In executive benchmarking, the comparable companies are listed with the data being transparent versus the standard survey where the data is "disguised." A peer group of 15-20 companies is typically considered to be an ideal number for executive compensation. A peer group is commonly selected based on similar industry, competition for talent, revenue or market capitalization. Executive compensation can be inflated if companies in the peer group used for top management compensation decisions are too large.

Executive pay levels differ for the same job because of variances caused by:

B) date of analysis, industry, geographic location, and size of organization

Option pricing techniques are used to:

B) Value stock options before they are vested

backdating of stock options:

C) all of the above

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Compensation Anchored to Stock Performance In some circumstances it is impossible or undesirable to grant managers equity compensation. This perspective is common when the organization is closely held or does not want ownership dilution. Some plans are designed where the underlying value of the compensation is based on stock performance, yet the company is not giving managers any company stock. Companies rely on these compensation plans that "act like equity plans," and are the basis of long-term incentive plans. Privately owned companies may offer these types of plans and document/communicate the valuation methodology to the plan participants. Examples are: phantom stock plans stock appreciation rights (SARs) performance unit plans Phantom stock plans. In these cases, "mirror" plans can be created, hence the "Phantom" stock plan. Under a phantom stock plan, an employee receives units that represent shares of stock with a specified vesting period. Once the units vest, the employee is paid the then-current cash value of the stock or the difference between the original value and current value like full-value awards or appreciation awards covered earlier. Taxation: The income received from the phantom stock options is taxed as ordinary income. This income is the same as a cash incentive. Valuation: Determining the current value of the stock is complex. Stocks not widely traded may have no readily ascertainable market value. Sometimes, a number of other financial measures are used as surrogates of the stock value, and their movement directly impacts the phantom stock valuation. Other times, organizations will have an appraiser make annual valuations. New Federal Income Tax rules for deferred compensation exist in the U.S. and should the employee enjoy "constructive receipt," the employer may be required to withhold income taxes. Two important points: 1) many companies using these types of plans have gone to having their enterprises appraised on a Quarterly basis and 2) this is a complex and changing area of tax law. SARs. Top management is paid cash incentives (or sometimes in stock which is outside the scope of this course) based upon the appreciation of the corporate stock. A SAR grants managers the right to receive a cash payment equal to the appreciation in company stock over a period of time. Managers benefit from an increase in stock price, as they would with stock options. However, they are not required to pay the exercise price; they receive the proceeds without purchasing anything. How SARs work: For example, assume a manager is given 100 SARs when the grant date fair market value of the stock is $12 and, over the next three years, the stock price increases $50 per share. As a result, the manager gets $3,800. Performance Unit Plans In these types of plans, the final reward is not related to the value of the stock at the end of the time period. Instead, a value is often fixed for the performance unit when the grant is made. Actual payouts may be in cash or stock. If a grant were for 100 units at $100 with a vesting period of five years, then the employee may receive cash or stock valued at $10,000 in five years provided the performance goals were met. Summary Alternative, equity-based compensation plans allow for capital accumulation without the necessity to actually involve the use of shares of stock themselves. Much like regular stock options, however, there are considerations to review regarding: accounting treatment under American Institute of CPAs (AICPA) rules IRS income tax, including deferred compensation rules the potential need for appraisals

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Golden Parachutes Another form of deferred compensation is a "golden parachute," which provides pay and benefits to an executive after termination of employment that is due to a change of control resulting from a merger or acquisition. Golden parachutes are also used as a defensive measure to avoid a hostile takeover due to the increased costs associated with the golden parachutes. A golden parachute is an Excess Payment in a Severance Agreement. If the total payment equals or exceeds 3 times the five-year average of covered compensation reported in a W-2, the individual's "base amount", the excess "parachute" payment is outside a "safe harbor" and subject to Section 280G which denies a deduction to the employer of the excess amount. If 280G is triggered, the executive is subject to Section 4999, a nondeductible 20% excise tax. Payments may be "grossed up" to cover the 20% excise tax but the gross up is also considered to be a parachute payment. If the executive has unvested options that vest due to a change of control, a portion of the options value is included in determining the 3 times benefits payable. Some Compensation Committees retain discretion to adjust severance payments amounts to avoid 280G and 4999 being triggered. Disclosure of golden parachute compensation arrangements and vote requirements relating to covered proxy statements, schedules, and forms filed with the SEC took effect on or after April 25, 2011. Golden parachutes extend pay and benefits for a limited period of time, usually 1-3 years. There are two reasons for doing this: Ensures top management stay focused on and carry out their responsibilities in the interest of the organization in the event of a merger or hostile takeover. They are attractive to organizations, as these payments can be treated as business expenses (unless they are deemed excessive). Change of Control Typically, when a company is acquired, there is a subsequent change in management that can leave many key executives without a job. With a change of control, it used to be that top management only received a severance package after being ousted in a takeover to safeguard them from mergers and acquisitions that could potentially threaten their post-transaction employment. Now, change of control arrangements are structured to be either single-trigger, requiring only a change-in-control to take place, or double trigger, which requires a change of control and a resulting termination. Single trigger change of control provisions are heavily criticized for providing top management the benefit of a payment for the change of control without termination of employment. As long as the change of control payment meets the Internal Revenue Code 409A definition that states that the payment needs to be made without the six-month delay for payments triggered by a termination of employment, the real advantage is that the CEO can negotiate in good faith without worrying about losing his position. Double-trigger change of control agreements are more prevalent than single-trigger and favored by shareholders. They require both a change of control, as well as a resulting qualified termination of employment. Double-trigger change of control arrangements lend protection to top management following a change of control. For a specified period of time, the executive will receive payment if not terminated for cause, or if the executive leaves for a qualified reason such as a compensation decrease, title change, required relocation, etc. Also, as this structure necessitates a resulting termination, the six-month payment delay required under 409A takes effect, unless the termination is involuntary or the CEO is terminated with good reason, which negates the need for the change of control payment to be 409A compliant. Termination CEO severance payments in excess of $150 million are newsworthy headlines. More and more frequently, we hear of these substantial payouts for the top executive officer from major U.S. corporations. The common termination clauses in severance agreements include: Involuntary Termination without Cause. Termination by the employer without cause is a "separation from service." Severance payments will be triggered. Termination with Good Reason. The meaning of the circumstances to be treated as an involuntary termination. It will be treated the same as a termination by the employer without cause; the result of material changes to the role and responsibilities of the current job. Involuntary Termination for Cause. The executive does not receive severance payments in the event of a termination for cause. The compensation and benefits that are received customarily are limited to those already earned and vested under applicable plans and other arrangements of the employer. Voluntary Termination other than Death or Disability. Ordinarily, a voluntary termination without good reason does not give rise to severance benefits in reviewing an employment agreement. Termination due to Death, Disability or Retirement. Payments upon termination of employment for disability or death are subject to any other form of "separation from service" (i.e., lump-sum versus installments). However, this type of termination may occasionally trigger vesting of some benefits, or short- and long-term incentive plans.

Which type of stock option plan offers the best tax advantages?

ISO

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Incentives While business leaders receive 20% - 90% of their compensation in the form of base pay, incentives make up the difference. These incentives may be: short term OR long term Non-Equity Incentives. This compensation component typically reflects variable cash-based incentive plan payouts tied to performance factors that are important to the continued success of business units, and the company overall. In SEC-filed proxy statements, the summary compensation table discloses cash incentive awards typically in the non-equity incentive plan column. These cash payouts could have both short-term and long-term time frames and the overall plan provisions could be specific to the executive group or broad-based for all management employees. The values reported in the disclosure are the amounts earned during the year and indicates the performance criteria was satisfied. Short-term Incentives Plans (STIPs) STIPs typically come in the form of cash bonuses and the manager receives a lump sum for meeting a target during the stipulated measurement period, typically one year for first-line managers. In PFP, this target may be defined as: job-related organizational OR a combination Job-related Targets. Typically related to goals and objectives or performance. Organizational Targets. These are common for most managerial bonuses and even organization-wide bonus plans. Financial metrics used to measure performance may be any of the following: Revenue: this is the total amount of money received by the company for goods or services sold during a performance period. Revenue is calculated before any expenses are calculated and includes net sales, exchange of assets, interest, and increase in owner's equity. EBITDA: earnings before interest, taxes, depreciation and amortization. Revenue minus expenses (excluding interest, taxes, depreciation and amortization) Earnings per Share: the organization's net income divided by the average number of shares of common stock outstanding. Operating Income: also called operating profit or EBIT. Revenue minus expenses (excluding interest and taxes). Net Income: this is revenue minus (cost of doing business, depreciation, interest, taxes, and other expenses). Common non-financial metrics include: Management by objectives (MBOs) Performance Customer satisfaction Operational efficiency The motivational value of organizational objectives depends in large part on whether the manager's actions have an impact on these measures, thereby improving the "line of sight" to overall business results. Top management: Members of this group can significantly impact organization-wide measures making them appropriate criteria for determining their incentive pay. Middle management: Members of this group can significantly impact the shorter term (quarterly, semi-annual, and annual) organization-wide measures that focus on execution. If they are successful, they can earn a substantial amount over base pay, an incentive to keep their attention focused on the organization's goals. Front-line management: Members of this group can significantly impact department or business unit-wide measures that may be used to determine incentives at this level. Combination Plans. Organizations may choose to focus managers on a number of measures (including a combination of financial and non-financial measures) that they feel are important to business success. Weighting each measure is necessary when using multiple criteria. Avoid those that overlap or cannibalize each other. Advice often quoted regarding an incentive plan:Keep the incentive plan simple, ideally including two or three measures. In order to be effective, your executives must know how they're being rewarded and why.

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Let's Compare Similar Positions Not all executive positions are equal and not all similar positions are paid the same. Comparisons of executive pay should take into account: location, industry, size and the effective date of reported compensation data. Comparisons should also assure that similar skills, effort, and responsibilities exist. Similar Jobs, Similar Functions Data regarding executive pay is commonly sourced from publicly-available documents. Organizations today are reluctant to share their pay practices and levels for competitive intelligence reasons. The consequence is that compensation data companies (like ERI) use simple benchmark job description title matches. If one assumes that organizations' functions are essentially the same (finance, lead management, HR, risk management, etc.) based on job title/function, comparisons can be easily made. In smaller organizations, this logic is more difficult in that 1, 2, 3 or 4 business leaders divide up all the functions between themselves in various ways. Reliability Statistics - A U.S. Perspective In 1993, the Supreme Court issued an opinion in Daubert v. Merrill-Dow Pharmaceuticals, 509 U.S. 579, 113 S. Ct. 2786, 125 L.Ed.2d 469 that has become the standard for "general acceptance" of expert witness testimony. The admittance of expert witness testimony and evidence requires the evidence be relevant, and reliable. "Relevance" is easily demonstrated with salary survey data for use in lost wage analyses, proxy compensation data for use in maximum reasonable compensation cases, etc. For "reliability", the Supreme Court defined tests for data evidence: 1) it can be illustrated that the theory or technique can be tested, 2) the data has been subjected to peer review and publication, 3) there is a known or potential rate of error, and (4) there is a level of general acceptance in that particular discipline's community. In March of 1999 the United States Supreme Court issued a ruling in the Carmichael vs. Kumho Tire Co. case that further defined when a Daubert reliability challenge applies. The Supreme Court ruled that reliability must be established in all types of expert testimony, both scientific and non-scientific or technical. The Court stated that the Daubert case was not intended to be limited to scientific cases only. Instead, it should apply to all fields of expert testimony. Providers of expert witness testimony must be prepared to describe why an analysis was utilized and why the analysis and data can be considered reliably sufficient. It appears that simple job title matching for executive jobs is acceptable. The IRS and other agencies sometimes forgo the use of titles and simply rank executive positions based upon the compensation received. Statistics of Income (SOI) data available from the IRS on organization pay is typically described in terms of "Highest Paid," "2nd Highest Paid," etc. The listing below illustrates this approach, the rationale being that no matter what the title is of an executive position, the compensation should be equivalent across organizations of similar size, location, and industry.

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MANAGEMENT COMPENSATION Management compensation plans are commonly aligned with short-term and long-term business objectives. Some of the plans provide favorable tax treatment for either the employee and/or the entity they manage. Laws exist (such as ERISA in the United States) that identify "key," "highly-compensated," or "executive" positions which limit the amount of tax benefit that can be derived from the plans. Another definition of management can be based on the U.S. EEO-1 (Equal Employment Opportunity - Job Classification) reporting with two categories 1) Executive/Senior Level Officials 2) First/Mid-Level Managers. The leadership talent may be hierarchically segmented as "strategic management" at the top and "operational or tactical management" at the middle. Segmentation of Business Leadership Roles Terminology varies, but typically one analyzes compensation pay for: top management (executives and directors) middle management (managers) first-line management (supervisors and managers) Revenue and profit will typically determine how much an organization can afford to pay its management team. Top Management These are the leaders at the top of the organizational hierarchy. Also known as the executives, they are responsible for the strategic direction of the organization and the development of short- and long-term goals and objectives to ensure the success and long-term sustainability of the organization. Shareholders, through the Board of Directors, often view these executives as the trustees of their resources and they will generally be considered "insiders" with respect to policy making roles in the organization as well as having access to material business information. Within this group are representative position titles beginning with: Top Chief President Executive Vice President Senior Vice President Vice President (except in financial institutions) Non-Profit Director (when synonymous with CEO) Managing Director (international when synonymous with CEO) Ordinarily, top management positions are responsible for: The total operation of the organization (the Chief Executive Officer, Chief Operating Officer, or President) A major function or a significant segment of the organization such as a group or division (Executive Vice President, Senior Vice President, Vice President, Division President, Chief Revenue Officer) OR The total operation of a non-profit organization (Director performing a role synonymous with a Chief Executive Officer) A major organizational function such as finance (in the United States, the associated title may be, Director). The operations of a significant business in a country or region. In international locations, a Managing Director job title is commonly equivalent to that of chief executive officer. OR Significant portions of the organization's budget, have a significant amount of discretion to hire/fire employees, and have a significant amount of control and input surrounding organization policy. Top management often have an external role in: developing relationships with key stakeholders gathering and analyzing business intelligence and other critical information deciding where the organization is going or how to get there Compensation for top management should closely align with the goals, mission, and success of the enterprise as well as the long-term sustainability of the organization. Middle Management This is the layer of management whose primary job responsibility is to oversee the tactical management of specific departments or business units, making sure that top management's strategic goals and objectives are implemented and managed. Middle managers have an in-depth knowledge of their field (or function), and spend their time ensuring operational efficiency of their function. Middle managers work with other groups within the enterprise to ensure operational success, and they have acquired effective interpersonal and problem-solving skills. Middle managers often direct other managers, supervisors/first-line managers, and individual contributors. They act as an information channel to top management and supervisors. The most typical job titles are Manager or Director. Occasionally, large companies will use Senior Manager and Senior Director as well. A great number of contacts in this group are lateral and cross-functional, so they get work done through means other than the use of authority. Often, they must establish cross-functional relationships in a matrix-type organization structure which can create considerable ambiguity and middle managers report feeling responsible but not having the necessary control. Note: As organizations right-sized and eliminated management levels to reduce bureaucracy and costs, this group has dropped in number dramatically over the past 30 years as reported by salary surveys and demographic studies. Technology and the ease of communications between top and lower management has also contributed to the shrinking number of middle managers. Front-line Management The first-line of the management hierarchy is the supervisors. They are first-line managers, supervising or managing the work of individual contributor employees, both, exempt and non-exempt, depending on the industry. A supervisor is intimately concerned with a small group of workers and the output of that unit. The pressures of the first-line manager are immediate and influence today's results. This contrasts with the pressures of a top manager, who is concerned with problems extending years into the future. Because first-line managers work closely with the employees they oversee, their compensation tends to be set formally through a salary structure based on market practices or informally as a percentage over their workers. A 10-20% differential between workers' pay and supervisors' pay is typical.

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Pay for Performance Managers are well-suited for pay-for-performance compensation strategies, since their efforts can clearly impact the overall performance of the organization. If there is a difference between pay-for-performance systems for managers and those for other groups, it lies in defining manager performance in both financial AND operational terms at the organization level and individual level. But as in most pay-for-performance systems, the correct performance standards must be the focus. In pay for performance, top management pay is often based on long-term objectives coupled with the short-term goals of the enterprise. Merit salary increase matrices, which companies use, are often modeled to provide larger merit increases for higher performance ratings. Companies also use other tools to align pay with performance: Balanced Scorecard and Competency Models. Balanced Scorecard Using the balanced scorecard (BSC) assists in evaluating managers' performance and measures results based on impact to the bottom-line. BSC involves measuring a company's success using Key Performance Indicators (KPIs). This approach is used to define performance in terms of a firm's productivity, efficiency and organization with new types of measurements. The four perspectives of BSC: Financial. Encourages the identification of a few relevant high-level financial measures, explaining how shareholders view the company. Customer. Encourages the identification of measures that explain how customers view the company. Internal Business Processes. Aids in identifying what goals must be achieved. Learning and Growth. Helps to decide how and if the company can continue to improve and create value. Issues: There are two main issues often found with using BSC for determining executive pay. Requires resources and management commitment to establish, support, and maintain a balanced scorecard Requires cascading the scorecard to all levels and evaluating the appropriateness of performance metrics With technology introductions of business analytics and business dashboards, many of the BSC issues are being addressed with reliable and real-time data accessible for these and many other purposes. Competencies There is no common definition found in business today regarding competency modeling. Individuals, including executives, are expected to possess certain traits, knowledge, skills, and abilities and apply them to essential responsibilities, goals and objectives that further the strategies and missions of their organization. Many companies include competencies in their performance evaluations. Results of competencies evaluations serve as inputs to an organization's succession plans. Here's how Competency Models work: Establish a list. The manager and his or her supervisors jointly develop a list of the knowledge, skills, abilities, tasks and understanding required. Evaluate their attainment. Underlying this approach is the assumption that executives who possess certain competencies can facilitate the attainment of organization goals and objectives. Evaluate their application. Competencies prove their value with the illustration of achievements. Competency modeling is the approach found in many larger organizations and has replaced job analysis and job evaluation. In some organizations, the comparison of an individual's achievement is based on this "vocabulary" and replaces even the traditional performance appraisal common to military and governmental organizations.

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Risk and Compensation Practices Incentive compensation can promote excessive risk-taking behavior, which was a dominant force of the 2008 financial crisis. Companies are being more diligent in identifying individuals in the position to expose the company to significant risk and are aligning pay programs for those individuals to discourage unnecessary or excessive risk-taking. Looking at compensation through a lens that focuses on risk-taking raises important issues about compensation plans. Shareholders are concerned with pay for performance (PFP), balanced between reasonable performance goals and risk-taking. Companies are putting greater emphasis on long-term sustainable value rather than short-term goal achievement. Long-term incentive plans that pay with equity are more effective when the plan requires top management to hold the equity through retirement. Annual cash incentives will continue to play a role in executive compensation, but may constitute a smaller component of pay depending on the business requirements. Dodd-Frank Clawback Extension The Dodd-Frank Act has several executive compensation rules related to clawbacks, CEO Employee pay ratio and other disclosures. Clawbacks. Pay recovery policies, or "clawbacks", came to the forefront with the Sarbanes-Oxley Act in 2002, requiring that in the event of any accounting restatement based on misconduct, incentives paid to the CEO and CFO within 12 months preceding the restatement must be recovered. Dodd-Frank proposes to expand the use of clawbacks to require all listed companies on stock exchanges to have a policy for clawbacks of excess incentive-based compensation for all current or former executive officers (not only the CEO and CFO) after financial statements are restated for any reason, not just misconduct. The Securities and Exchange Commission has still not approved this rule so Sarbanes-Oxley continues to be the applicable rule for clawbacks. Pay Ratio Disclosure. The Dodd-Frank rule requiring public companies to report a CEO pay ratio relative to employee pay requires public companies to disclose their CEO pay ratio based on compensation paid for a company's first full fiscal year that began on or after January 1, 2017. Companies on a January 1 to December 31 calendar year were first required to include the new disclosures in their submissions in 2018. The CEO pay ratio rules will require U.S. public companies to disclose the following: annual total compensation (median) of all employees excluding the CEO; annual total compensation of the CEO; and the ratio of these two numbers. It is important to refer to the SEC.gov website for details on compliance with this important ruling. Company exemptions are those covered by the JOBS Act, i.e. emerging growth, foreign private issuers, and small reporting companies. Why is Executive Pay So High? Key executives are so well compensated for a variety of reasons: Labor Market: The labor market recognizes the market value of the top executives. As equity compensation grows, the market value influences the total direct compensation of these jobs among competitor companies as well. Skill: The people in these jobs are highly skilled, must have vision, leadership, and creativity, and their replacement can be difficult. Training: Ordinarily, managers have worked for the organization a number of years, and the organization may have spent a considerable amount of money in training them as they move up the managerial ranks. These individuals' knowledge bases are assets to the enterprise. Commitment: Managers spend a great deal of time at their work, usually 60 hours a week or more. Even if they are not formally working, they often take their jobs home with them. Because of this heavy responsibility, they must find the rewards worth their efforts. Small supply: There is an undersupply of candidates due to baby boomers retiring and subsequent generations are much smaller in number. High Turnover: Any group that is as important and visible as top management will have to be paid competitively in order to minimize unwanted turnover. Economic Growth: In good times, the economy and companies expand, increasing the need for executives.

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SUMMARY Total Compensation Compensation programs for business leaders are a combination of base pay, incentive pay, and equity awards. Given the importance of business leaders, their high visibility, and their easy movement to other organizations, it is usual to pay above market average. All organizations have a keen interest in the rewards earned by similar individuals in similar positions. Salary surveys are often used to find this information. In today's world, these comparisons also use products like ERI's Assessor Series which include publicly reported data for traded and nonprofit entities. ERI has been a provider of executive data since 1986 and its databases have grown to include over 14,000 publicly traded corporations in the US and Canada, as well as all presently reporting UK and Euro publicly-traded companies (approximately 1,200), plus available executive compensation survey data. Incentives & Stock Option, Equity Awards Business leaders' incentives programs are divided into short- and long-term plans. Short-term incentives are typically lump sum cash rewards for a one-year or less performance period. They may use a measure of overall organizational performance or job-related goals. Long-term incentives are intended to retain the organization's business leaders, keeping them loyal and continuing to perform. These plans may pay in cash or equity. They are a variation of a stock awards or option awards plan and are given to the executive over a 2- to 5-year period. Perquisites Business leaders are also granted a variety of perquisites that may not be available to other employee groups. These perquisites and short- and long-term incentive plans are golden handcuffs designed to tie business leaders to the organization. Golden parachutes are also used to attract and retain executive talent to provide security in the event of change of control resulting from a merger, acquisition, or a hostile takeover. Conclusion Business leaders represent a small percentage of workers, yet they represent a major portion of the cost of compensation. It is vital to develop a compensation program for this group that both obtains the most from these employees and keeps the within reason. Shareholder groups are indicating that companies receiving less than 70 percent approval in say-on-pay votes will need to make meaningful changes to their pay practices. Corporate boards are more vigilant that incentive results are measured over a one- to five-year time horizon. Business leaders' compensation is designed to engender the success of the organization. They are responsible for the operation of the organization and so it makes sense to relate pay to how well the organization does. Since good business leaders are in short supply and they have knowledge of the market, it is usually necessary to pay above average market rates. Salary structures for business leaders typically have very wide ranges, reflecting the variations in performance and responsibilities that are possible in managerial jobs. Short-term incentives are typically annual bonuses payable upon attainment of individual and organizational performance goals. Long-term incentives are associated with long-term organizational performance measured over 2 to 5 years. These incentives may be paid in equity, which is the most common, or cash. Top management pay has been spiraling upward in recent years. While base pay may be reduced in bad economic times, top managers are still being offered lucrative equity packages. This trend in top management pay levels only changes when shareholders and the Board of Directors hold business leaders responsible for specific goals and evaluate the business leadership's performance based upon these targets. Incentives should be long-term and should not be paid unless the company and the top management meet target goals. We expect to see business leadership pay continue to be in the spotlight. We end with the observation that a competitive and legal compensation package for a strong management team with high standards of performance will drive a high-performance culture influencing top business results and shareholder returns.

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Salary Structures When designing a salary structure for top management compensation, a recurring challenge has been whether to use: one salary structure for the whole organization OR separate structures for different employee or functional groups Many organizations segment their employee population and develop flexible salary structure(s) to effectively manage them. Segmenting the executive structure from the professional/management structure typically will ensure both are paid appropriately relative to the desired competitive marketplace. Pay strategies include establishing the desired competitive position relative to the corresponding desired marketplace such as the mean, 50th, 60th, or 75th percentile. When designing a salary structure, common pay strategy decisions include: Lead the market Lag the market Lead-lag the market In a lead the market structure strategy, salary structures are set to be at the market rates by the end of the compensation planning year so at the beginning of the year the pay rates will be leading the market. In a lag the market structure strategy, salary structures are set to be at the market rates by the beginning of the compensation planning year so at by the end of the year the pay rates will be lagging the market. In a lead-lag the market structure strategy, salary structures are set to be at the market rates for the middle of the compensation planning year so at the beginning of the year the pay rates will be leading the market until the middle of the year, then lagging the market the second half of the year. Pay Policy Line A market trend line is developed based on the desired pay strategy of the company. Market pricing is the most prevalent practice to create a pay policy line. The first step is to identify the market rates for various benchmark jobs that cover the entire pay spectrum from the highest to lowest rates of pay. The most credible approach for identifying the trend line is calculating the slope and intercept of the least-squares which can be calculated from the plotted market rate points on a graph using regression statistical methods. The salary structure may be developed based on a straight line or a curved line. Pay-policy lines are used in salary structures to chart a smooth progression between pay grades. (To learn more about establishing wage structures and pay policy lines, see DLC Course 82: Creating a Market Competitive Salary Structure.) Salary Ranges Salary ranges typically describe acceptable levels of compensation for a group of similarly valued jobs. If an organization does use a separate salary structure for top management, one often finds wide salary ranges, sometimes known as "spread." Salary RangesThe distance between the lower and upper earnings limits of a position (or grouping of positions). Having a large spread in salary ranges is useful because of market practice, the length of time an incumbent will be in a top role, and the wide variation in the performance of managerial jobs. The use of broader ranges lets organizations recognize this variation by paying top performers significantly above average performers. The use of pure market pricing is increasing where each job is paid at its specific market value rather than overpaying some jobs and underpaying others. Pure market pricing is also known as ranges within grades. Salary grades are optional for pure market pricing. Broadbands Broadband-type compensation structures evolved between 1990 and 2000 because businesses flattened their organizations and decentralized the decision-making to be more responsive to customers. In flatter organizations, "vertical" promotional opportunities continue to be available but lateral career growth based on skill acquisition, job enrichment, and job enlargement is increasingly more prevalent. Broadbanding no longer enjoys the popularity it did 20 years ago. Although broadbands foster learning, employee development and flexibility, they require extensive use of market compensation data, have a lack of structure and control, and require greater Human Resource guidance. Salary ranges exist so that organizations do not overpay or underpay for the functions/tasks being performed and to provide cost control. More than any other factor, legal considerations drive management toward more generalized, broader base salary applications. When used, large U.S. organizations today use as few as five or six broadbands with very large ranges of pay. Federal contractors using broadbands will likely have greater compliance requirements.

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THE TOTAL COMPENSATION PACKAGE Now that we've looked at types of management jobs, we'll examine their compensation packages. These packages have a number of components: Benefits (statutory and non-statutory) and perquisites should also be considered when designing the overall Total Rewards program. Key constructs to effectively design and manage the total compensation package are: Compensation mixFixed pay vs. variable payShort-term pay components vs. long-term pay components LeverageLevel of up-side potential in variable pay and long-term pay components Base Salary The percent of total compensation that base salary, or fixed pay, represents depends on the level of the job in the organization's hierarchy. Generally, the percentage is negatively correlated with the progression in the career path. First-line managers' base salary typically represents 80%-90% of their total compensation, middle managers' base salaries are 40-80% of their total compensation, and top-level managers' base salaries are 20%-40% of their total compensation, respectively. The higher the management level, the lower the percentage of total pay is represented by base salary. Base salaries are determined by both internal and external factors. These factors include: compensation strategy job content job evaluation market pricingorganization sizegeographyindustry/competitors salary structure organizational performance employee performance culture Industry and revenue are the most common components used to measure jobs in external salary surveys. Compensation strategy. A compensation strategy will determine the overall compensation direction for an organization or an employee group as compared to the external labor market. Job content. Job analysis and job documentation are considered to be the foundation of every compensation plan. Accurate job documentation is critical to ensure a fair and equitable hierarchy of jobs as well as appropriate market pricing to develop a competitive compensation program. Job evaluation. Jobs may be evaluated based on internal equity or through external market pricing. Job ranking, job classification, factor comparison, point factor and external market pricing are common types of job evaluation plans for both management and non-management jobs, Some pay equity laws require job evaluations based on skill, effort, responsibilities, and working conditions, suggesting a point factor methodology be used for job evaluation. The Hay job evaluation program and Aon Hewitt's Job Link are examples of point factor job evaluation programs. The vast majority of companies will use external market pricing to evaluate their jobs. Market pricing. Market pricing is the process by which the value of each benchmark job in an organization is determined through the analysis of the external marketplace as typically reported through salary surveys. This is the most common of all job evaluation methodologies. Of the companies that market price their jobs, 60% design their programs with one range per grade, but the other 40% use multiple ranges within grades or "pure market pricing." This can be a valuable methodology for pricing management jobs. Organization size. The basis for determining top management pay is frequently defined by annual revenue. Other factors include market capitalization, the asset size of the enterprise, budget, or the number of employees. These define the "scope" of the position. Geography. The question being, "Is there a national, regional or local market for management talent?" The answer is that typically, the more senior the position, the broader the definition of the geography. Industry practices. Industry differentials have long been utilized to assist in explaining executive compensation. Higher margin firms typically need less revenue to generate higher compensation values for their management. Low margin enterprises (grocery stores, for example) need larger revenue amounts. Salary structure. First-line and middle-management pay criteria are more likely to be influenced by internal organizational factors. The top management's pay is a ceiling in the organization and all other managerial positions can be compared in terms of their percentage of that position's pay. Larger organizations tend to have more levels of middle management, as do those where professionals or unions are empowered and involved in management. Organizational performance. Specific organizational measures are most often incorporated within incentive pay programs than within base pay programs. Some common measures for organization performance include: Revenue/Revenue Growth Operating Income, Net Income Cash Flow, Expenses New Sales, Strategic Goals EBIT, EBITDA Absolute or Relative TSR EPS Turnover of assets, capital, inventory ROC,ROE,ROIC, ROI, ROS, ROA Margins: Net Profit, Operating Profit, Gross Profit, Profit per Employee Economic Profit/Economic Value Added Customer Service/Satisfaction Product Development/R&D Quality/Continuous Improvement Employee Engagement Leadership Development/Retention Employee performance/merit. How a base salary gets adjusted for current employees is typically determined by individual results/effort. Culture. Is innovation and risk taking valued? Does the company have a "Pay-for-Performance" culture? The company's compensation program must support the corporate culture and it has to be driven by the top management in order to drive the objectives of the organization. Compensation is interwoven into the core of a company's culture and has many touch points across the enterprise. The best compensation plan will not make up for a lack of leadership support, a poorly executed business strategy, a lack of integrity, or any number of other more important corporate characteristics and values.

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Say-On-Pay In 2011 the SEC approved the non-binding Say-On-Pay rule as one component of the executive compensation provision of the Dodd-Frank Act, comprehensive financial regulatory reform legislation enacted due to the collapse of industry giants Lehman Brothers and AIG, and the near demise of many others. The executive compensation provision restricts executive pay in order to discourage companies from awarding lucrative packages that encourage risky behavior. Other components of the executive compensation provision include clawbacks (e.g., recouping executive compensation in the event of an accounting restatement), compensation committee and adviser independence, enhanced compensation disclosures, and corporate governance. Shareholders can now vote on executive compensation packages, at minimum, once every three years. They also have separate nonbinding votes on golden parachutes (covered earlier) in connection with merger transactions. The new rule was implemented starting with 2011 annual meetings for public companies with public investors owning greater than $75 million worth of shares. Smaller companies had to be compliant with this requirement effective 2013. Although the Say-On-Pay rule is nonbinding, companies must disclose in public filings whether they followed the shareholder vote. If the Board does not make adjustments to executive compensation based on the shareholder vote, it may face several negative repercussions: dissension between the Board and shareholders, the negative recommendations of major shareholder advisory firms, lowered investor confidence, and directors may not get re-elected. In the UK, a similar rule has been in place since 2002 and, as a result, has more effectively linked pay to performance, improved communication among boards, management, and institutional investors, and aligned shareholders and management. How should companies manage the Say-On-Pay process? Establish formal communication plans Proactively identify potential executive pay issues and concerns in advance Make transparent the rationale behind their executive pay programs in the proxies' compensation discussion and analysis section Partner with proxy advisors Work with key institutional shareholders Work closely with Legal and Finance teams to ensure compliance

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Types of Equity Compensation There are two common types of equity compensation plans: Options AwardsIncentive Stock Options (ISOs), which are qualified plansNon-Statutory Stock Options (NSOs), which are non-qualified plans Stock AwardsRestricted Stock PlansPerformance Share Plans Option Awards Option Awards usually involve granting an employee the right to purchase a specified number of shares of company stock at a set price subject to a vesting schedule and term limit of the option. If the company does well in the future, the stock options may gain significant value over the life of the award. How stock options work: Judy, COO of ABC Corporation, is offered 5,000 options to purchase company stock at a price of $5 a share (the closing stock price on the date of grant). She may purchase that stock according to the vesting schedule specified by the plan. Upon 100% vesting, the stock price is $15 per share. Judy exercises the options, buying the shares for $25,000 and then selling them for $75,000. She makes a profit of $50,000 (less taxes). (This example is shown to illustrate the economic dynamics of an option where real shares are used, which could result in different tax scenarios.) ISOs. Incentive Stock Options is a tax-favored plan in the U.S. that does not result in taxable income to employees (non-employees cannot receive ISOs) at the date of grant or their time of exercise if certain conditions are met. One limitation is a $100,000 cap on the annual value of ISOs that vest. Any options that exceed this cap do not have tax-favored treatment. ISOs are found in large, publicly traded organizations as their value is readily ascertainable applying an option pricing model. In privately-held organizations, the value of closely-held shares is not readily ascertainable because the stock is not traded and hence their use is less prevalent. How ISOs work: The exercise of an ISO does not require income to be reported on a tax return, but it may give rise to the alternative minimum tax (AMT). The AMT is equal to the amount by which the fair market value of the stock exceeds the amount you paid for it. All the taxes paid can be on capital gains when the stock is sold as long as the holding period is satisfied (e.g. sold more than two years after the date the option was granted and more than one year after the ISO was exercised). John Smith on June 30, 2016 received ISOs with a right to purchase 100 shares of employer stock for $10 a share. On July 2, 2017, when the market price is $16, he exercised the ISOs at the stated $10 exercise price. He then sold on Aug. 2, 2018, for $25 a share. The sale date was more than two years after the June 30, 2016 grant date and more than 12 months after the July 2, 2017, exercise date. Therefore, the entire $1,500 profit was taxed at the long-term capital gains tax rate. NQSOs. The NQSO is a popular form of stock option for those organizations with a readily ascertainable stock price. They are also popular due to the flexibility they allow companies in plan design and can be granted to anyone, whether they are an employee or not. This can include outside consultants and non-employee directors, etc. However, they do not satisfy the IRS requirements for preferential tax treatment. The person receiving the options does not pay any income tax on them when they are granted. When the option is exercised, the employee will pay ordinary income tax on the difference between the value of the stock and the exercise price. The company receives a tax deduction on the same amount. When the stock obtained from the exercise is sold, a capital gain or loss will be incurred on the difference between what the stock is sold for and the fair market value at the time of the exercise of the option. The type of capital gain (long term or short term) would depend on the length of time the shares were held after exercise. Here's generally how NQSOs work: Ethan is granted 100,000 options to purchase your company's stock at $1 per share (which is the fair market value of the stock on grant date). When the stock rises to $15 per share, he exercises, buying the stock for $100,000. Taxation: On exercise, he must pay taxes at the ordinary income rate on the difference between the exercise price and the current market value, even if he doesn't sell the stock right away. So even if Ethan doesn't sell his stock immediately for $1.5 million, he owes taxes on the $1,400,000 gain. (Note, tax rules change and both federal and state income taxation exist so any exercising plan participant should seek advice from a tax accountant or lawyer.)

Top management pay is most often based on:

A) an enterprise's success

If a company goes bankrupt, rabbi trust funds go to which party first?:

A) creditors and plan beneficiaries

In pay for performance, it's best to base pay on:

A) defined organization goals and measured performance

Golden parachutes protect key executives:

A) in hostile takeovers

Which type of variable pay plan will best motivate managers?

A) incentive plans

Your organization's Compensation Committee should most likely include:

A) outside directors

Specialized industry surveys are good to rely on because of:

A) the jobs they survey

If one were to use the BSC approach to evaluate a Chief Operating Officer, Mr. Fred McClure, what type of goals would be included?

B) Financial and Customer

Matching executive jobs by job title is _________ for expert witness testimony?

B) Most likely acceptable, but one needs to be aware of variations for smaller firms

Appropriate data for compensation comparisons in the US for nonprofit organizations includes:

B) a similar or comparable employer

Top management are often paid base salaries that are ____ than their incentives and other pay.

B) lower

Most organizations use what approach to set executive pay?

B) market pricing

The size of the baby boomer generation means the pool of top management candidates is:

B) shrinking

The disadvantage of incentive plans that use combination standards is that:

B) the more standards used, the harder the incentive plan is to understand

Top management salary structures typically have ___ salary ranges.

B) wide

Phantom stock plans

C) don't require the manager to put up any money.

Who is likely to participate in company LTIPs?

C) executive team, which may include key management and occasionally, critical top professionals

Additional incentives and perquisites for key executives are often called:

C) golden handcuffs

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Comparing Similar Organizations There are several key factors to consider regarding the selection of comparable organizations: date of an appraisal geographic location organization size industry Date of an appraisal. With the fast movement and growth of management compensation, care must be taken to find comparable data from the same time period. Geographic location. ERI's example of this feature in the Assessor series shows clear geographic differentials explainable only by location. The question being, "Is there a national or a local market for management talent?" Country practices also reflect the variance of compensation for similar functions in organizations of like size, but this could be caused by tax laws, cost of living, cost of labor, legal requirements, and cultural differences, rather than geographic differences. Organization size. Organization size has proven to be a major criterion in determining top management pay. It is often defined by annual revenue, the asset size of the enterprise, fiscal budget, or the number of employees. Surveys vary their reporting of management compensation by these dimensions. Most utilize revenue, but financial institutions have long used "assets." Nonprofits and consulting firms may use the number of employees working or their fiscal budget. The End Game - a Comparable Peer Analysis The key today (under new IRS rules) is to create peer analyses to justify the payment of "competitive pay." The end game is a peer analysis that takes into account all the elements of pay providing a "picture worth 1,000 words."

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DETERMINING AND APPROVING BUSINESS LEADERS' PAY The administration of business leaders' compensation differs from other pay programs when it comes to one major question: Who sets business leaders' pay? For all other groups, the answer would be the executives. Sarbanes-Oxley and tax codes (such as IRC 4958 in the U.S.) call for oversight. In privately-held companies with a single owner-manager, an executive may well set his/her own pay. In U.S. publicly traded companies, SEC and IRS rules call for oversight by a Board of Directors, which may form a "Compensation Committee" composed of some of the Board members. Even so, the rise of CEO compensation levels is a concern for board members, especially when it can affect a corporation's earnings. The Role of the Board of Directors In publicly traded companies and many privately held corporations, a special committee of the Board of Directors known as the "Compensation Committee" sets executive pay. This committee typically consists of 3-5 members who need to pass an independence test; typically, they are "outside directors," as opposed to "inside directors." That is, they are not members of the management team affected by the compensation decisions. These outside members may include: CEOs and COOs from other companies former government officials retired executives academicians investors bankers thought leaders in their area of expertise "Outside director" Compensation Committee Board members are defined as: Not a current employee; not a former employee who received compensation for prior services in the current year, and has not been an officer of the corporation; Not directly or indirectly receiving remuneration from the corporation during the current year, other than director fees, or Not receiving more than de minimis remuneration from the corporation during the prior year, other than director fees. The legal "independence" guidance that exists regarding Compensation Committees include: Parts of IRC 4958 Regulation S-K Item 407 on Corporate Governance, outside Director, as previously mentioned. The Committee assures that the shareholders, creditors, and other stakeholder groups are not unfairly taken advantage of by the management group in terms of their potential to strip funds from the organization or become unnecessarily rewarded. They meet independently of the management group, often with consultants, to ascertain the level and effectiveness of the organization's compensation plans. The independence requirements are further governed by the stock exchange(s) where the company's stock is listed. Tap the link for more information on Compensation Committee independence regulations www.law.cornell.edu/cfr/text/17/229.407.

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Deferred Compensation We have already discussed several forms of deferred compensation using equity-related plans. Other forms of long-term deferred compensation exist, with the most popular being those tied to retirement or severance benefits, and many are non-qualified plans for top management, meaning they are exempt from participation requirements. Nonqualified deferred compensation plans provide executives and sometimes key management the opportunity to defer a portion of their compensation and related taxes until the deferred compensation is paid. Plans are relatively common among large, publicly held corporations, but less common among private corporations. Typically, plans are established to provide a deferral opportunity for executive compensation or benefits. They may be used to provide a retirement vehicle to executives or an opportunity to defer employee-earned compensation (typically short- and long-term incentives) and related taxes while earning interest on the deferral. With the U.S. IRC 409A ruling, the complexity and limitations of deferred compensation plans are more restrictive and complicated. U.S. - IRC 409A U.S. IRC 409A covers any plan that provides for an employee or consultant to have a legally binding right in a taxable year to compensation that has not been actually or constructively received in that year, but will be paid in a later taxable year. IRC 409A affects nonqualified deferred compensation plans (NQDC), certain trusts or similar arrangements. This code covers most salary and bonus deferrals under nonqualified plans, supplemental executive retirement plans, below market stock options, stock appreciation rights, other non-stock approaches, excess retirement plans, and excess benefit plans. We discuss these plans further in DLC Course 74: Trends in Retirement Plans and Course 42: Accumulated Earnings and Deferred Compensation. Under the tax code 409A, the participant is allowed an election, no later than the close of the preceding taxable year (or in some cases no later than six months into the performance year), during which the amount, time, and form of distribution are decided. Almost all plans existing before 2006 have had to be revisited and revised (the Code allows "safe harbor" protections similar to tax exempt organizations). Under IRC 409A, the IRS has the right to collect withholding taxes on income deemed earned although not paid out. Non-compliance penalties payable by the plan participant (not the employer) include interest, 20% tax penalty, and ordinary income taxes. The allowable distributions of NQDC plan benefits include a severance payout having a mandatory 6 months wait period, specific dates documented per schedule or fixed in the plan, and specific events like disability, death, change in control, or unforeseen emergency. Payouts may also be accelerated in the event of specific triggers like a domestic relations order, 409A violation resulting in plan termination, certain conflicts of interest, and lump sum cash out if the value of the deferral is below an amount stipulated in the plan document. The rule that allows for exceptions for unforeseeable emergencies includes the following: Illness or accident of the participant or beneficiary, spouse, or dependent Loss of the participant's or beneficiary's property due to casualty (not otherwise covered by homeowner's insurance) Other events beyond the control of the participant or the beneficiary such as medical expenses, imminent foreclosure or eviction from primary residence, and funeral expenses of a spouse or dependent.

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Does Pay for Performance Really Work? Pay for Performance (PFP) is a priority for businesses. The majority of U.S. organizations look to align compensation decisions to performance measures but they fall short in the execution. With the advent of analytics software and performance dashboards, the measurement infrastructure to effectively execute such pay programs have been greatly enhanced. Companies are also being more transparent about the PFP programs and results so they showcase the impact of such programs. They are openly communicating about the PFP programs clearly differentiating high performance and low performance. The strategic objective of such programs is to achieve and sustain long-term competitive advantage by retaining, motivating and rewarding their best people. Still, it can be difficult for managers to see the performance-reward connection for the following reasons: Timeliness. Many of the rewards are deferred, so that the time frame is too long. Managers don't experience the connection between performance and reward. Vague goals. The goals are not always clearly expressed, so the manager does not know what needs to be achieved. When some organizations do not have explicit PFP programs, they will measure performance through annual appraisals and assign performance ratings that tie into pay decisions. For each employee, a common practice is setting three to five goals that align with and support organization or department goals. Best goals are SMART goals, which is a branded goal setting methodology that means: Specific Measurable Attainable Relevant Time specific Examples of SMART Business Goals: Reduce overall budget costs by 10% by year end 2019 Increase market share by 5% by year end 2019 Increase revenues by 20% by year end 2019 Increase customer satisfaction by 5 pts by year end 2019 A more recent expansion of this goal setting approach is SMARTER goals (Evaluate, Re-evaluate). This broader use incorporates the need to review the SMART goals on an on-going basis to make sure they are still relevant in light of unexpected shifts in business plans. Some organizations incorporate SMART goals concepts to how KPIs are defined for BSCs. Measuring performance is essential to differentiating pay and aligning organizational resources to business objectives. It is easy to argue that Pay for Performance does work. The difficult part is determining the optimal level of pay that fosters the best performance. There is no definitive answer to this question except that when an organization's goal is to be a high-performance organization, a PFP process should be adopted that has on-going reviews to ensure alignment of goals and measures.

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Interactive Exercise The most comprehensive database of executive survey data can be found in ERI's Executive Compensation Assessor®. Unlike traditional salary surveys, which provide a snapshot of the past for a limited number of positions in limited industries, ERI's Executive Compensation Assessor reports competitive salaries, cash incentives, and equity awards for adjustable salary planning dates. The tool provides this total cash compensation for more than 700 top management positions within multiple industries and allows the retrieval of source documents such as 10-Ks, annual reports, information circulars, proxies or Form 990s. Data may be adjusted for: organization size (revenue, market capitalization, assets, number of employees) industry geographic location compensation valuation date These adjustments can be made by clicking on the "Comparables" tab at the top of the Executive Assessor and then clicking on the "Choose Columns" tab also at the top which allows you to select from a broad number of criteria to identify companies of similar scope and size."

pg 17

Loans for Stock Options Before Congress passed the Sarbanes-Oxley Act in July 2002, many companies set up loan programs specifically for business leaders so they could exercise and sell company stock options. Loans typically were for specified purposes and might have had favorable interest rates. Because they have been so widespread, the tax services of all countries have accumulated complicated and confusing rules for "below-market" loans. Due to today's highly regulated legal environment, companies no longer provide executive loans. Today, major stock brokerage firms offer extensive programs to support companies and their employees in the management of equity programs. Backdating or Discounted Stock Options In 2006, the United States Securities and Exchange Commission reported studying firms that "backdated" options previously granted. (Their review began after academic research reported the suspicious timing of option grants, often right before a rise in the share prices.) In order to deliver immediate stock option value, many companies used to backdate the options by changing the grant date of option shares already allocated to a date when the option would be "in-the-money" or simply issue the option at a lower exercise price than the fair market value on grant date thereby discounting the option. This can be a fraudulent practice with criminal prosecution and significant tax penalties so legal guidance is critical. There are some exceptions so legal counsel is required.

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Long-term Incentive Plans (LTIPs) The purpose of long-term incentives is to motivate, reward and tie leadership to the long-term success of the organization. In contrast to STIPs, which are ordinarily paid in cash and tied to short-term goals, 1 year or less in duration, LTIPs more often relate to strategic, long-term related goals, normally 2-5 years in duration, and may be paid out in cash or equity compensation. When business performance is not sustainable, top management is often criticized for a focus on short-term results. As a result, these LTIPs take on added importance. In the past, the traditional vehicle for providing long term-incentives was stock options where the value of shares could be readily ascertainable using an option pricing model. The use of stock options has come under attack because of: huge grants made to Executive Officers trading in or re-granting options that are "under water" in a stock market downturn (back dating) keeping the stock price high by any means (re-pricing) The most common LTIPs are stock options and restricted stock. Well over half of the companies utilize performance awards, also known as performance shares or performance units, where eligibility for a restricted stock award is based on the attainment of defined performance goals and objectives. Traditionally, participation in LTIPs was reserved for top management, the 5% percent at the top of the organization. LTIPs increasingly spread to lower levels of employees in the 1990s but have subsequently been curtailed by changes to accounting rules that require their expensing against corporate profits at the time of grant or exercise. Today, LTIPs grants are typically allocated to the executive team, may include other levels of key management, and occasionally may include critical top professionals. Insider trading. Top management may not be able to take advantage of increases in the price of the stock, since they may not use insider information when selling or purchasing the stock. If they were to do so, this would be known as "insider trading." Organizations must use care in designing and administering plans that utilize company shares to avoid insider trading practices. Insider trading is a fraudulent practice with criminal convictions in a court of law. It is important to contact your legal counsel to avoid insider trading practices, even unsuspected, within your business. To understand the complexity of executive compensation, shown below is the "all industry" screen shot for a Chief Executive Officer in the U.S. as taken from ERI's Executive Compensation Assessor & Survey displaying data for stock related and long-term incentive income paid to executives, which can be 100% or more of the sum of both salaries and bonuses earned.

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Non-Profit Executive Compensation In addition to maximum reasonable compensation that applies to both non-profit and for-profit organizations, there are specific regulations pertaining to executive compensation in non-profit, tax-exempt organizations. Intermediate Sanctions For non-profit organizations, employee compensation, which may exceed the standard of what is considered maximum reasonable compensation, is one area that can be subject to IRC 4958 Intermediate Sanctions. Intermediate sanctions are the penalty excise taxes imposed by the Internal Revenue Service when individuals associated with a tax-exempt organization are potentially overpaid. Intermediate sanctions may be applied to "disqualified persons" who receive excess benefits and to the organization managers who approve the transaction. A disqualified person is someone who is "in a position to exercise substantial influence over the affairs of the organization." This definition includes a nonprofit's board members, substantial contributors, and executive officers. It also includes the family members of disqualified persons. To protect parties involved in setting compensation levels, there are Safe Harbor provisions. The Safe Harbor provision protects the organization decision makers who are involved in the design and administration of these plans by excusing liability if the attempt to comply in good faith can be demonstrated. For example, safe harbor provisions would protect the decision makers from liability under Securities and Exchange Commission rules for financial projections made in good faith. Rebuttable Presumption Rebuttable presumption is a legal term used in a variety of ways. Under IRC 4958, generally, it means that if certain steps are taken, then it will be presumed that the person taking those steps acted in a certain way (fairly, reasonably, without negligence, etc.). It is an assumption considered true until proven false. The advantage of a rebuttable presumption in compensation cases is that the burden of proof shifts to the IRS. Having a presumption in your favor can often be a major advantage in a dispute or in litigation. If the rebuttable presumption steps are followed, there is a presumption that the compensation is reasonable. However, the IRS may rebut the presumption of reasonableness if it finds the comparable compensation data that was relied on to determine the reasonable compensation to be of questionable validity. Under most circumstances, when the IRS challenges the reasonableness of compensation, a facts and circumstances approach will be followed with the burden on the organization and the person being compensated to prove the amount is reasonable.

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Option Pricing Technique Placing a value on options or grants based upon future stock performance and economic variables requires an option pricing technique. These techniques are complex mathematical models, but there are many calculators on the Internet that will perform the calculation, if you provide the information requested. ERI has a Black-Scholes calculator on its website. These techniques have become important because organizations must calculate the stock option value each period they are awarded to participants. The Securities and Exchange Commission requires that stock options amounts be recorded in the yearly filing of the corporation's 10-K and proxy statements. Since the advent of accounting regulations FAS 123R in 2005 and its subsequent replacement, ASC 718, in 2009, companies have reported the fair market value (FMV) of all equity-based compensation which becomes an expense that directly affects the income statement. The Binomial (Lattice) and Black-Scholes methods are the most common option pricing techniques. Understanding the fundamental design of these models can aid the total rewards practitioner to manage the information requirements for disclosure, to assess effective equity plan designs, and to enhance employee communications. The Black-Scholes and Binomial models have improved valuation results since they take into consideration plan design characteristics, allow for sensitivity analysis with volatility assumptions, and reflect exercise behavior realities. The standard inputs to both models include: Current stock price Exercise price Risk free interest rate Expected dividends on stock Expected stock price volatility Expected term of option Determining the value for the expected option term relies on the behavior of the employees who hold options and is less predictable. For private firms (who tend to use Black-Scholes), the expected volatility of their stock is also less predictable since they have no trading history like public firms. The stock price, exercise price, risk free interest rate, and expected dividends tend to be more stable inputs to the models. Becton Dickinson adopted the binomial model in 2004 and a recent Form 10-K Report disclosed sets of 3-years of assumptions and inputs used in the valuing of its stock appreciation rights (SARs):

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Perquisites Business leaders (particularly key executives) often receive special benefits, called perquisites, which promote key employee retention. In the U.S., perquisites have come under great scrutiny and various new regulations appear focused on these executive compensation practices. Perquisites are reported in the "All Other Compensation" for U.S. SEC compensation disclosures and the current threshold for disclosing perquisites is for amounts exceeding $10,000. ERI collects U.S. Proxy Statements, Europe & Asia Annual Reports, and Canada Information Circulars as well as conducts salary surveys to include these sources in the Executive Compensation Assessor & Survey. Insurance Group life insurance coverage for business leaders is inexpensive, although as a multiple of salary, it does create a greater cost. Key executives often receive additional life insurance and special types of insurance, such as travel insurance. Long-term disability insurance is another element and one of the few where U.S. organizations can discriminate. Another type of life insurance policy is company-owned life insurance, which is taken out by a company on the lives of business leaders considered to be vital to its operation. Under this type of plan, the company in question pays the premium on the insurance but is also the plan's primary beneficiary. Each of these types of insurance has its own tax rules that vary by province/state and country. Time Off Although their time-off provisions are the same or higher than for other employees, business leaders tend to not take advantage of vacation time as readily as other groups. It is sometimes necessary to insist they take time off since a large financial liability can arise for the organization if a category such as vacations is allowed to accumulate or accrue over time. (Special work rules, tax and HR codes may exist by province/state or country regarding carry-over and caps related to paid time off.)

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Profit Sharing Another type of STIP is profit sharing, where the company sets aside a percent of total profits in a fund. Each manager's share of this fund is determined by his or her base pay. Profit-sharing plans focus managers on the company's bottom line. Managers are more aware of the profit margin, since they receive a piece of the pie. These plans also allow the company's compensation bill to rise in good times and shrink in bad. Unfortunately, profit-sharing plans have drawbacks. Profitability may be achieved at the expense of quality. In addition, profits are influenced by so many variables that it may be difficult for an individual manager to feel that his or her contributions really impacted the organization's results. Discretionary Bonuses It is possible to establish a discretionary plan where the Board of Directors determines each year if a bonus will be distributed for the past year's performance. The board may also determine the payout amount. The undefined nature of this procedure reduces the motivational value of the plan and is not considered an "incentive" plan per se.

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Reasonable Compensation In long-term compensation plans, there are four common themes: Provide a market competitive compensation plan to ensure the ability to attract, motivate, and retain key executives. Motivate and reward business leaders for long-term organizational success. Establish performance goals for executives that reflect this success. Provide tax effective compensation. The last goal is constantly changing and requires complex and complicated application of tax laws. It is best to seek legal and tax counsel. In 2004 that advice was supplemented by a U.S. Tax Code IRC 4958 that describes the safe harbor afforded to "organizational managers" who document compensation decisions. What is "reasonable compensation"? The IRS defines reasonable compensation as "the value that would ordinarily be paid for like services by like enterprises under like circumstances." Maximum reasonable compensation is a standard used by the IRS for the total compensation package, including bonuses and benefits. Closely held corporations are the typical target of IRS reasonable compensation challenges. Although it depends on the type of corporation involved, some companies draw unreasonably low or unreasonably high compensation in order to minimize taxes. This has led the IRS to develop and define the concept of reasonable compensation. Tax regulations exist to examine unreasonable executive compensation for a: Stockholder who is an employee Person who owns all or most of the corporation's stock Other members of the primary stock holder's family To learn how these analyses are made, see DLC Course 12: IRS Reasonable Executive Compensation. Valuation Maximum reasonable compensation would be the highest amount of the total compensation package, including salary, bonuses and benefits, which would be an allowable IRS deductible business expense for services rendered by comparable employers. What is considered "appropriate data"? As an example, small organizations with gross receipts of less than $1 million, the compensation for similar positions paid by three comparable organizations is considered appropriate data. All other organizations must undertake a more detailed analysis of comparable compensation. It's also acceptable to obtain a compensation study from a qualified third party. Payments under a compensation arrangement are presumed to be reasonable if the following conditions are satisfied: Arrangement is approved in advance by an authorized body The authorized body used appropriate comparability data The authorized body documented the basis for its determination

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Retirement Plans Since business leaders pay levels are generally higher than non-managerial employees , there is a disproportionate participation of these highly compensated employees in qualified retirement plans which, under the U.S. ERISA, can result in them losing their tax qualified status so various types of non-qualified supplemental executive retirement plans (SERPs) are offered. Rabbi Trusts To partially offset the risk inherent in deferred plans, rabbi trusts were created. Here, a quasi-trust partially protects business leaders from creditors (and a hostile management takeover). The funds are highly regulated and employers are unable to access the money once it is placed in the rabbi trust. The first IRS letter ruling that pertained to this type of trust involved a religious congregation that contributed money to a trust for its rabbi, hence the name. A rabbi trust has to be: unfunded so assets have to stay unsecured for a certain management group or group of top-paid employees Not well understood by many practitioners, we discuss these plans further in DLC Course 74: Trends in Retirement Plans and Course 42: Accumulated Earnings and Deferred Compensation. Many of these plans are or have been informally funded using life insurance products and the variations are many. Much like a race, the challenge has been to have the financial planners stay one step ahead of the Tax Code and the enforcement agencies. Under ERISA, these plans are also known as nonqualified plans. Employers must wait for the year in which the employee recognizes compensation before taking a deduction. The employee is provided with some tax deferral opportunities. The principal issue is the lack of security because, unlike qualified retirement benefits that are held in trust, nonqualified participants are only creditors of the company should it go bankrupt.

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Setting Base Salaries Traditionally, base salaries for managers have been set by 1 of 3 methods: Job evaluation Market pricing Hybrid (combining job evaluation and market pricing) Job evaluation. The process of job evaluation relies on job analysis where information is collected on each job in order to find out what the job incumbent must do to perform the work successfully. Through competency-based evaluation, managerial jobs have become easier to define, evaluate, and value, particularly if one focuses on a Job Description. At the top management level, organizations often have one job incumbent in most functions, and the impact of the executive on the organization can be great. Management Job DescriptionsNon-Management Job Descriptions Managerial job descriptions are typically written in terms of: broad functions essential responsibilities scope and impact of assignments degree of accountability the extent and nature of supervision and influence involved In contrast, standard job descriptions focus on: basic function AND essential responsibilities (See DLC Course 33: Job Analysis and Job Descriptions.) Market pricing. Today, most organizations utilize market pricing. Jobs within the organization are compared with one or more compensation surveys to determine if there is a good match. It is the marketplace that is the main determinant of pay received as compared to an internally equitable job evaluation approach. Salaries or compensation will be described in terms of "ranges" and the individual's pay will be discussed in terms of its relationship to the mid-point of that range, referred to as the compa-ratio. An individual's pay compared to the market value of the job is referred to as the market index. Executive positions are described in terms of their competitive market price found in peer (selected) organizations. Hybrid. Setting base salaries can also be done using a hybrid method of combining internal job evaluation and market pricing. Companies may define the salary structures by distinct grades and then market price the benchmark jobs to set the pay ranges. The non-benchmark jobs may then be slotted or ranked based on internal equity into the salary structure by assigning them to the grade containing other jobs that are internally equitable within the organization. Understanding the different levels of management roles in an organization helps compensation practitioners or consultants effectively design and propose a viable compensation solution to address the business's objectives. Many organization, cultural, industry, legal, taxation, and economic factors need to be considered when aligning compensation programs to business strategies. The first step to align a compensation program with the business strategy is to establish a compensation strategy. The second is to understand the advantages and disadvantages of the type of salary structure the organization will use. The third is to select the structure that best supports the business needs. The fourth is to determine if job evaluation, market pricing, or hybrid methods will be used to design salary structures. Finally, it's important to work closely with Boards of Directors to review and approve compensation plans for top management.

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Stock Awards Stock awards are also referred to as full value awards meaning these awards deliver the full face value of stock at the time of vesting to the grantee (or employee) and it is generally awarded at "no cost" to the employee. Restricted Stock Plans (RSPs): The organization grants the manager a certain number of shares of stock, with time-based (also referred to as service or tenure vesting) vesting. There are typically two types of restricted stock plans: Restricted Stock Awards (RSAs) Restricted Stock Units (RSUs) Employers offer these plans to align the business leadership with long-term objectives of the company. RSAs differ from stock options in that, after vesting, ownership of the stock is automatically transferred to the employee and the employee has taken no action. Also, unlike stock options, RSAs always retain the face value of the stock when the award is vested. For RSAs, at the time of grant, the company's shares are issued to an employee with vesting requirements over a period of time (e.g. 3 to 5 years). Dividends are paid and the grantee has voting rights for RSAs. Let's take a look at a restricted stock award plan: Roger, CEO of XYZ company is granted 500,000 RSAs. He may not sell the shares until he meets certain conditions: These conditions might include: holding the stock for a period of 5 years remaining employed with the organization during that period If the employee does not meet the requirements for restrictions to lapse, the shares are forfeited. RSUs differ from RSAs in that the grantee does not receive dividends or have voting rights until the award is vested. For both plans, the company distributes shares or the cash equivalent of the number of shares used to value the unit after the vesting requirement. Performance Share Plans (PSP). In this type of plan, managers receive a grant of stock that is contingent upon how well the stock performs over some time period, such as three to five years, plus meeting established performance goals. These goals may be either internal organization goals or external goals. How performance share plans work: Thomas is granted 1,000 performance shares of stock that have a grant date fair market value of $50 per share. If the value of the stock triples in five years, then he would be granted the 1,000 shares which have a value of $150,000 provided he had accomplished the performance goals. If he had not achieved the required performance goals, he would receive no stock grant, and if the value of the stock was lower than the current $50, the grant would not have near as much worth. In this type of plan, payouts may either be made in stock or in cash. There are many variations in the design of performance share plans.