3. 36 | workspan march 2016
The Evolution of Say on Pay
In many ways, current executive
compensation practices reflect a
follow-the-pack mentality. Figure 1
shows pay growth has slowed to
4 percent during the past three years.
Base salaries remain stuck around
$1 million, so growth has been with
incentives. The development of exec-
utive compensation plans for public
companies is now largely robotic
because compensation committee
members typically follow Institutional
Shareholder Services (ISS) and Glass,
Lewis & Co. LLC, two firms that
guide institutional shareholders on
how to vote. ISS also articulates how
companies should develop their peer
group and long-term incentive plan.
Because ISS is pushing for long-
term incentives that are based on
performance, stock options are not as
common. The ISS rules have slowed
the growth in executive compensa-
tion somewhat as companies must
now outperform their peers to justify
above-market compensation, which
is a good thing. Say on pay has had
a sobering effect on compensation
committees. In the past, some direc-
tors were more focused on supporting
management pay plans regardless
of the reaction of their shareholders.
Now, most directors ask: Will ISS
support our program?
Say-on-pay votes do not bind the
company or the board of directors.
But even having a shareholders’ vote
“no” on these executive compen-
sation issues often prompts the
company and the board of directors
immediately to revisit the proposed
compensation packages and practices.
ISS and Glass Lewis continue to
influence executive compensation
trends by continually redefining best
practices. These advisory groups typi-
cally update their best practices each
year based on regulatory changes and
provide detailed commentary and
descriptions for member companies.
These groups provide models that
help companies compare their
practices other companies.
With widespread acceptance of
say-on-pay rules, these advisory
groups will become even more
critical to companies in determining
the acceptability of their compensa-
tion packages to shareholders.
During the past few years,
companies have responded to
ISS and changed many long-term
incentive plan design practices.
Those changes include:
❙❙ Shifting to performance-based,
long-term awards versus time-
based vesting, something that many
THE ISS RULES HAVE SLOWED THE GROWTH
IN EXECUTIVE COMPENSATION SOMEWHAT AS
COMPANIES MUST NOW
OUTPERFORM THEIR PEERS
TO JUSTIFY ABOVE-MARKET COMPENSATION,
WHICH IS A GOOD THING.Oneyearpay,inthousands
2009 2010 2011 2012 2013 2014
$12,000
$10,000
$8,000
$6,000
$4,000
$2,000
$0
$6,435
$8,412
$8,930
$10,146
$9,877
9,319
Figure 1 | S&P 500 CEO Median TDC
4. | 37march 2016 workspan
shareholders believe supports a true
pay-for-performance strategy.
❙❙ Reducing performance periods
to three years to help set more
accurate goals during periods of
economic uncertainty.
❙❙ Measuring performance relative to
peer group measures to take into
account the overall movement of the
stock market and a company’s rela-
tive movement to its peers.
❙❙ Using multiple long-term incentive
vehicles versus having only one to
provide greater diversity in goals
and to help manage risky behavior.
❙❙ Using cash-based long-term incen-
tive plans to conserve shares and
target specific long-term financial
goals that might not be reflected
in the stock price.
Long-term incentive plan design
continues to change based on share-
holder alignment, market uncertainty,
pay-for-performance linkage and risk
considerations. Companies should
continue to review their long-term
incentive plans based on their busi-
ness strategy, pay philosophy and
market conditions. Also, ISS voting
recommendations must be consid-
ered. However, it is important for
companies to keep all incentive
programs simple and to communicate
clearly how the plans work. Today’s
long-term incentive plans often have
overlapping performance periods
which can be very hard for executive
to monitor and track.
Today, more than 90 percent of
say-on-pay votes are supported by
shareholders. This support is often
tied to say-on-pay voting recommen-
dations issued by ISS and Glass Lewis.
Looking back a year, companies that
expected to submit an equity plan
for shareholder approval in early 2015
were wondering if ISS’ new Equity
Plan Scorecard (EPSC) methodology
would make their votes (and vote
preparations) more challenging.
With the 2015 proxy season completed,
most shareholders have continued
to vote favorably. The 2015 voting
outcomes suggest that the EPSC
methodology gave companies greater
flexibility to structure key equity plan
provisions and appropriately size their
share requests.
With this added flexibility, however,
came greater accountability as
companies in our experience devoted
much more preparation and analysis
time for 2015 equity plan proposals,
including more outreach to share-
holders to understand individual
voting policies and decision points.
Additionally, and equally as important,
many companies took the opportunity
to enhance their proxy disclosures
to tell a more complete story around
the share request. In short, the equity
plan proposal enhancements we saw
this year somewhat mirror the evolu-
tion of the compensation discussion
and analysis (CD&A) in recent years
as a result of say-on-pay votes.
Proxy statements still report
compensation based on present
value, with the ultimate payment
largely dependent on company
performance and general economic
conditions. Some companies now
report realized pay, which is a form
of W-2 earnings, to show that the
present value is often different from
realized pay. Newport believes many
companies will disclose realized pay
in the years to come.
Bonus Payments Based on
EPS Should Exclude the
Impact of Share Buybacks
Standard & Poor’s report dividends
and stock buybacks in the United
States totaled more than $900 billion
in 2014 — the highest level on record,
and last December, a Conference
Board presentation compiled data
demonstrating that capital invest-
ment by U.S. public companies has
decreased and is less than that of
private companies.
A recent Reuters investigative report
explores the widespread practice of
basing CEO compensation on earn-
ings per share, then boosting those
earnings through share repurchases.
The rise in share repurchases is a
response to shareholder pressure to
increase shareholder value in an age
of easy money, low interest rates
and slow revenue growth. But the
original concept around using EPS as
a performance measure is getting lost
as fewer shares outstanding, through
buybacks, becomes the real perfor-
mance driver. The Reuters analysis
found that more than 50 percent
(255) of the companies in the S&P
500 Index reward executives in part
by using EPS. See Firgure 2 on page
38. A few companies — Johnson &
Johnson, FedEx, Time Warner Inc.
and IBM — strip out the potential
effect of buybacks on performance
metrics to determine pay. Others
should follow their lead.
Activist Investors, Zero-Based
Budgeting May Have an Impact
On Executive Compensation
Activist investors are pushing
underperforming companies to
improve shareholder value, which
is nothing new, but their influence
has increased. Companies have
been pushed by activist investors
to change their cost structure with
zero-based budgeting. This may have
implications for how companies set
goals for their annual and long-term
incentive plans.
Zero-based budgeting is a classic
business process that has gained
new prominence with private equity
investors. Private equity investors use
zero-based budgeting to get compa-
nies to rethink their business model
and existing cost structure.
A March 25, 2015, Wall Street
Journal article described one well-
known zero-based budgeting effort:
A key ingredient in 3G Capital
Partners LP’s recipe for reshaping the
U.S. food industry — reflected in its
roughly $49 billion deal to acquire
Kraft Foods Group Inc — is an
arcane-sounding financial tool (zero-
based budgeting) that slashes costs by
focusing on details such as the use
of photocopies.
No more color copies!
Several reasons exist for zero-based
budgeting’s relevance today. First, the
economy remains volatile, and in
5. 38 | workspan march 2016
times of volatility, profitable compa-
nies with a strong competitive edge
are best positioned to innovate, grow
and beat the competition. Zero-based
budgeting helps companies identify
resources that are not generating an
adequate return and encourages stra-
tegic redeployment of those funds in
order to achieve business objectives
and strengthen companies’ market
positions. And in today’s era of digital
disruption, many use those funds
to invest in new technologies and
capabilities that can help them out-
compete traditional and nontraditional
digitally enabled competitors.
After deals, companies can use
zero-based budgeting to make more
efficient use of resources, funds are
reallocated to help propel the newly
merged business forward.
While finance executives have
applied zero-based budgeting over
the decades, it has generally lacked
the rigor required to maintain cost-
management discipline over the long
term because it was not an ongoing
process. And strategies that drove
cost cutting were not necessarily
connected with strategies for where
and how to reinvest the funds to help
the enterprise grow.
Rather, companies that adopt zero-
based budgeting are investing in it
for the long haul. They are applying
advanced forms of procurement
to change spending behaviors and
negotiate better pricing based on an
enterprise-wide view of spending.
Rather than just whittling away at
costs piecemeal and tackling over-
head, they use zero-based budgeting
to focus resources on core goals,
shifting funds from products or
programs that aren’t productive to
activities that truly drive growth.
Management across the busi-
ness gets involved as expenditures
and programs are evaluated at a
forensic level. Finance and procure-
ment work together as management
examines who spends how much
on what. Is the investment maxi-
mizing the return?
By going through this process,
management across business units,
categories, functions and geographies
S&P 500 companies that use earnings per share as a performance metric that boosted
2014 EPS as net income fell
Net income,
percentage change
Exxon Mobil
Coca-Cola Enterprises
Caterpillar
TeraData
Parker-Hannifin
Starwood
United Health
EPS,
percentage change
Assurant
Activision Blizzard
-15 -10 -15 0 5 10 15 20
Note: Data exclude extraordinary items. Sources: Reuters; company reports
... COMPANIES THAT ADOPT ZERO-BASED BUDGETING
ARE INVESTING IN IT FOR THE LONG HAUL.
THEY ARE APPLYING ADVANCED FORMS OF PROCUREMENT
TO CHANGE SPENDING BEHAVIORS ...
Figure 2 | Down Becomes Up
6. 40 | workspan march 2016
buys into the budget. Wasteful
spending, redundant processes,
bureaucracy and unproductive
products and services are surgically
removed, freeing up resources that
can be used elsewhere to fuel inno-
vation and growth. In the process,
recognizing that there can be differ-
ences from industry to industry, a
company may identify perhaps as
much as one-third of costs that can
be reallocated.
Global consumer goods company
Mondelez International, using zero-
based budgeting, has freed capacity
to fuel growth. The company was
able to save $350 million in selling,
general and administrative expenses
in fiscal 2014, and projected a three-
year savings of $1.1 billion. It now
aims to increase operating margins
from 12 percent in 2013 to 14 percent
to 16 percent by 2016. It enjoyed
three consecutive quarters of adjusted
margin expansion through the third
quarter of 2014, with adjusted oper-
ating income margin up 140 basis
points to 13.6 percent in the third
quarter. These improved margins are
helping Mondelez step up investment
in production facilities, especially in
emerging markets. It is unclear how
far costs can be reduced with zero-
based budgeting.
Is There a Limit to What Can
Be Cut or Reallocated?
From a performance cost-management
perspective, using zero-based
budgeting becomes one of the perfor-
mance goals to encourage teamwork
around budgetary goals. People are
held accountable for categories of
spending, and they are encouraged to
treat the company’s money like their
own so that they question the value
of each expense.
Although zero-based budgeting is
not an easy process and requires
concerted effort, it helps companies
reduce costs and drives growth. It’s a
new classic that drives benefits that
speak for themselves as they help
companies compete and grow.
Retirement and Deferred
Compensation May Get More
Attention from Executive
Compensation Regulators
Retirement and deferred compensa-
tion plans are a significant component
of executive compensation plans.
For example, the CEO of Freeport-
McMoRan will receive $63.3 million
in retirement benefits that have
accrued over his long tenure with
the company, the Wall Street Journal
reported on Dec. 28, 2015.
Deferred compensation and
supplemental retirement plans have
been under the ISS radar for years
but this may change. Presently, ISS
defines egregious pension/supple-
mental executive retirement plan
(SERP) payouts as:
❙❙ Inclusion of additional years of
service not worked that result in
significant benefits provided in
new arrangements.
❙❙ Inclusion of performance-based
equity or other long-term awards in
the pension calculation. The design
of the SERPs can vary significantly
between companies. Defined benefit
plans have largely disappeared from
the corporate landscape, but this is
still used by many SERPs.
Going forward, ISS may look more
closely at SERP design. For example,
SERPs can be designed as a defined
benefit or defined contribution
plan. The defined benefit structure
is generally more attractive, and
design issues like this may be
reviewed by ISS in the future. Plan
design elements such as years of
service, vesting and income replace-
ment targets also could come under
greater scrutiny.
While ISS guidelines and say on pay
have slowed the growth in executive
compensation, there are new issues
that need to be carefully consid-
ered, such as the influence of share
buybacks on EPSs, the impact of
zero-based budgeting on performance
management and the cost of execu-
tive retirement benefits.
Mark Reilly is principal and head of
the executive compensation practice at
Newport Group in Chicago. Contact him
at mark.reilly@newportgroup.com.
FROM A PERFORMANCE COST-MANAGEMENT
PERSPECTIVE, USING ZERO-BASED BUDGETING BECOMES
ONE OF THE PERFORMANCE GOALS TO ENCOURAGE TEAMWORK
AROUND BUDGETARY GOALS.
resources plus
For more information, books and
education related to this topic, log
on to www.worldatwork.org and
use any or all of these keywords:
❙❙ Executive Compensation
❙❙ Shareholders, Budgeting
❙❙ Regulations.
