How to Optimize Company Performance Shane Dikolli, Associate Dean, Duke University (US) Dan Kapinos, Director, Radford / Aon Hewitt (US) Stacey Petrey, VP – Total Rewards, Mylan (US) Carl Stegman, SVP Product Mgmt, Fidelity Stock Plan Services (US) WHY IS PERFORMANCE EQUITY HERE TO STAY IN PLAN DESIGN? The Say-on-Pay Web Proxy/CD&A Disclosure 2013 Say-onPay Results Proxy Advisory Firms SEC Rule Making 2014 Say-on-Pay Votes Institutional Shareholders Performance (TSR) The Media Dodd-Frank Clawbacks & CEO Pay Ratios Consultant Independence Committee Conflicts Hedging & Pledging Policies Broad-based Equity Granting Trends: 2005-2013 Proportion of Participants by Award Type Options 2005 2006 2007 Restricted 2008 2009 Proportion of Grant Value by Award Type Performance 2010 2011 Source: Fidelity Stock Plan Services Administration data, 2005-2013 2012 Options 2013 2005 2006 2007 Restricted 2008 2009 Performance 2010 2011 2012 2013 Research Highlights • • Payouts continue to be in directional alignment with relative performance High-performing companies tend to demonstrate stronger alignment between performance and award payouts than low-performing companies – – • Performance award cycles ending in the last two years (2011 and 2012) have paid out better than cycles ending in earlier years – • Significant economic uncertainty at the time performance goals were set may be contributing to this outcome Across most data sets, TSR has risen to the top as the most prevalent performance measure, although earnings measures continue to be widely used – • This is particularly true when comparing payouts for awards based on one year of performance vs. three years Raises questions as to whether companies are setting a “floor” when setting performance goals Awards based on an earnings measure resulted in above target payouts more often than TSR-based awards Using absolute or relative measures do not result in any materially different payout, but using both resulted in max payouts a vast majority of the time Past performance is no guarantee of future results. Source: Fidelity Stock Plan Services and ClearBridge Compensation Group Performance Plan Study, 2013 Performance Plans Align Pay with TSR Performance TSR Performance Versus S&P 500 (n=155) Max Overall, payouts aligned with TSR Performance High Performance High Pay (n= 67) 66% of the time Performance Share Payout Low Performance High Pay (n= 31) R² = 0.1248 Key Conclusions:  Among high performing companies, 76% of payouts were aligned with performance Target Low Performance Low Pay (n= 36) 0% Past performance is no guarantee of future results. Source: Fidelity Stock Plan Services and ClearBridge Compensation Group Performance Plan Study, 2013  In contrast, payouts among low performers were directionally aligned only 54% of the time High Performance Low Pay (n= 21) 25% 50% 75% TSR Percentile Rank Relative to the S&P 500 100% Performance Plans Align Pay with EPS Growth EPS Growth Performance Versus S&P 500 (n=130) Payouts aligned with EPS Performance Max Performance Share Payout Low Performance High Pay (n= 30) High Performance High Pay (n= 52) 68% of the time Key Conclusions: R² = 0.2954  EPS has a stronger statistical correlation to performance compared to TSR, with fewer significant outliers Target Low Performance Low Pay (n= 36) 0% Source: Fidelity Stock Plan Services and ClearBridge Compensation Group Performance Plan Study, 2013 High Performance Low Pay (n= 12) 25% 50% 75% EPS Growth Percentile Rank Relative to the S&P 500 Past performance is no guarantee of future results.  High Performance Low Pay outliers are almost entirely removed 100% What Influence Does the Performance Measure Selected Have on Payouts?  Performance award payouts tend to be best aligned with plans based on TSR or earnings performance, producing alignment two-thirds of the time  Metrics such as revenue growth and returns (ROC and ROE), when also measured on a relative basis, did not result in as strong a correlation between performance and pay Past performance is no guarantee of future results. Source: Fidelity Stock Plan Services and ClearBridge Compensation Group Performance Plan Study, 2013 What Influence Does the Performance Measure Selected Have on Payouts? (Con’t) There is little difference in how plans pay out when comparing absolute vs. relative plans   Plans that are based on a combination of absolute and relative measures, however, paid between Target and Max 83% of the time. This may indicate that when both measures are combined together in the same plan design, they provide a “Check” or “Hedge” against each other. Performance Plan Payouts Absolute vs. Relative Plans Relative 23% Absolu te 14% Both 15% 26% 62% 2% 38% 17% 0% Past performance is no guarantee of future results. Source: Fidelity Stock Plan Services and ClearBridge Compensation Group Performance Plan Study, 2013 19% 83% 25% 50% 75% 100% WHAT IS THE ACADEMIC EVIDENCE ON OPTIMAL EXECUTIVE COMPENSATION? Table 2, Core and Guay (2010)* Insights from Table 2, Core and Guay (2010)* • Annual pay appears as if it is not related to stock returns – Need to consider portfolio-based effects • • Portfolio-based effects tied to stock returns “punishes” poor performance & “rewards” good performance in ways that cashbased plans do not do. Pay = CEO ability + cost of effort + incentive risk premium + excess pay. Portfolio holdings tied to stock returns appears to be the yardstick for measuring the optimality of compensation. *Core, J. E., & Guay, W. R. (2010). Is CEO Pay Too High and Are Incentives Too Low? A Wealth-Based Contracting Framework. Academy Of Management Perspectives, 24(1), 5-19. doi:10.5465/AMP.2010.50304413 WHAT ROLE DOES LEADERSHIP GOVERNANCE, EDUCATION AND EXECUTIVE COMPENSATION DESIGN HAVE IN DETERMINING COMPANY PERFORMANCE Economic theories of efficient compensation predict a positive relationship between executive pay and company performance, yet successful efforts to document this relationship are few. My research finds company performance can be optimized through executive leadership backgrounds and compensation design. Specifically, my results show the following: 1.Undergraduate and graduate training, and undergraduate degrees from best-inclass institutions, were significantly related to better company performance. 2.The use of performance-dependent compensation and the use of financial measures in performance compensation are notably related to better company performance. Study Parameters: Company Performance, Founder Status, Chief Executive Officers and Named executive officers Leadership Experience CEO (Founder and nonFounder) & NEOs % Prior Affiliated Roles % Prior BOD Experience % Current BOD & BOD Education CEO (Founder and non-Founder) & NEOs % Graduate Degrees % Best in Class Institution % Related Field Agency Theory: Non-Founder CEO 1. Compensation Mix: Larger % of total compensation paid in cash v. stock, larger % of benefits & perks 2. Performance Design: Lower utilization of nonfinancial measures Leadership Role Governance CEO (Founder and non-Founder) & NEOs % of Combined Roles Stewardship Theory: Founder CEO 1. Compensation Mix: Smaller % of total compensation paid in cash v. stock, smaller % of benefits & perks 2. Performance Design: Higher utilization of financial measures The quality and performance of an organization’s top management is often the single most important determinant of both the success and survival of the organization (Drucker, 1954). What differentiates leaders? Executive Leadership Governance Conceptual Framework How top management teams are constructed from an incumbent selection, role scope and collective experience and background will influence their ability to work together effectively (Eisenhardt, Kahwajy, & Bourgeois, 1997) Founding executives influence the structures and processes of their developing organization (Mintzberg, 1989; Mintzberg & Waters, 1982) Further, Hambrick and Mason’s (1984) ‘upper echelons perspective’ states that organizational outcomes, such as strategic choices and performance levels, are partially predicated by managerial background characteristics Leadership Experience Education CEO (Founder and non-Founder) & NEOs % Prior Affiliated Roles % Prior BOD Experience % Current BOD & BOD Leadership CEO (Founder and nonFounder) & NEOs % Graduate Degrees % Best in Class Institution % Related Field Role Governance CEO (Founder and nonFounder) & NEOs % of Combined Roles Compensation Design: Does it Differentiate? Compensation design Conceptual Framework To formalize the relationship between owners of and managers, Jensen and Meckling (1976) developed an agency framework where owners of a firm (the principal) delegate decision making to management (the agent) Both agency and stewardship theory are concerned with how principals can increase the likelihood that agents will act to maximize shareholder wealth (Tosi, Brownless, Silva, & Katz, 2003) As such, the goal of the compensation contract is to increase the likelihood that leadership agents will act to maximize shareholder wealth while taking into account founder status through the design of key compensation indicators identified in this study Agency Theory: Non-Founder CEO 1. Compensation Mix: Larger % of total compensation paid in cash v. stock, larger % of benefits & perks 2. Performance Design: Lower utilization of nonfinancial measures Stewardship Theory: Founder CEO 1. Compensation Mix: Smaller % of total compensation paid in cash v. stock, smaller % of benefits & perks 2. Performance Design: Higher utilization of financial measures Executive Summary: what differentiates? Total shareholder return findings Executive Leadership Governance Leadership Education: •Strong Relationships between Percentage of NEOs with UG or GR degrees in related field and 1YR TSR •Positive Relationships between with Percentage of NEOs with UG degrees, GR degrees and total education disclosure Leadership Experience: •Positive Relationship between All NEOs (including CEO) having current board affiliations and 1YR Leadership Governance: •Negative Relationship between CEO-only combined role and 1YR TSR Executive Compensation Design Performance Dependent Compensation •Strong Relationships with Percentage of CEO performance dependent compensation and 1YR/3YR TSRs Financial Measure Utilization •Strong Relationships between CEO utilization of more than one financial measure and 3YR TSR •Positive Relationships between NEO utilization of more than one financial measure and 3YR TSR * After controlling for two-digit SIC grouping HOW DO MANAGER TRAITS MATTER? The Consequences of Manager Traits • Manager traits seem to matter for: – Investment Policy, Financial Policy, Firm Strategy (Bertrand & Schoar, 2003 QJE) • Fee, Hadlock and Pierce cast doubt on these results (2013, RFS) – – – – – • Performance (Chang, Dasgupta, & Hilary, 2010 MSc) Voluntary Disclosure (Bamber, Jiang & Wang 2010, TAR) Financial Reporting (Ge, Matsumoto, & Zhang 2011, CAR) Tax Avoidance (Dyreng, Hanlon & Maydew 2010, TAR) Compensation (Graham, Li & Qiu, 2012 RFS) But traits do not help us understand why managers matter What Manager Traits? • Professional characteristics – Tenure, MBA education, Honors/Awards, Career concerns, Ability, Reputation • Physical characteristics – Height, Facial characteristics, Voice pitch, Voice Dissonance • Life experiences – Military experience, Growing up during the Great Depression. • Cognitive biases – Overconfidence, Optimism • Innate preferences – Risk aversion (e.g., measured by religious affiliation of location), Ethics, Integrity WHAT ABOUT OPTIMIZING PERFORMANCE WITH BROAD-BASED EMPLOYEES? 2013 Aon Hewitt Engagement Study • • Aon Hewitt’s Engagement Practice conducts annual survey and study on employee engagement across hundreds of companies around the globe. How does one measure employee engagement? Say Stay Strive Employees speak positively about organization to coworkers, clients and potential employees Employees have an intense sense of belonging and desire to be part of the organization Employees are motivated and exert effort toward success in their job and for the company Engagement & Performance • Companies with high levels of employee engagement perform at higher levels, and companies with low levels of employee engagement perform at lower levels. 50% Co’s in Top Quartile of Engagement yield TSRs 50% higher than average TSR Co’s in Bottom Quartile of Engagement yield TSRs 50% lower than average TSR 50% Investing in Engagement • Strong correlations exist between investments in engagement and future performance • • Example – Strong Positive Correlation between 2010 Engagement and 2011 Sales Growth 1% increase in engagement predicted 0.6% increase in sales What’s Your Company’s Engagement Level? • • For the most part, about 60% of organizations are highly or moderately engaged That leaves approximately 40% that are passively engaged or actively disengaged • • Passively Engaged – could become engaged in right work environment and could be disengaged if the wrong conditions are present Actively Disengaged – negative about the company, no desire to stay or go above and beyond with jobs (destroying value) Highly Engaged 20% 40% 23% 17% Moderately Engaged Passive Actively Disengaged What Drives Employee Engagement? Key Driver Globally Europe North America Career Opportunities 1 1 1 Organization Reputation 2 2 3 Pay 3 3 Recognition 4 5 Communication 5 4 Managing Performance 2 Innovation 5 Work Processes 4 Other Engagement Driver Views: Job Function Job Level Employee’s Generation Priorities for Improved Engagement • • Leadership – if leaders do not drive engagement efforts, who will? • 54% of global employees view senior leadership favorably • Employees want to see and hear from leadership – to hear about the business, know its direction, to know they care, and to be inspired Reputation – what does your company want to be famous for in the job market? • #2 engagement driver but only 52% of employees can answer question positively • Function of business performance, social responsibility and general impressions • Examples – Amazon, Apple, Disney, Google and Johnson & Johnson Priorities for Improved Engagement • • • Total Rewards • Career Opportunities - #1 driver but only 47% of employees think they have good advancement opportunities • Pay – 44% of employees believe they are paid fairly and a lower amount of job loyalty present in today’s marketplace • Recognition – 48% of employees believe they receive proper recognition Communication – Only 49% of employees believe their company is effective at communication Enabling Performance – Only 55% of employees believe they have the resources to be productive Mylan, Duke University, and Radford/Aon Hewitt are not affiliate with Fidelity Stock Plan Services Fidelity Stock Plan Services, LLC. 682773.1.0 Thank You Shane Dikolli Duke University [email protected] Dan Kapinos Radford, an Aon Hewitt Company [email protected] Stacey Petrey Mylan Pharmaceuticals [email protected] Carl Stegman Fidelity Stock Plan Services [email protected]