STATE OF MICHIGAN BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION
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1 STATE OF MICHIGAN BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION In the matter of the application of ) INDIANA MICHIGAN POWER COMPANY ) Case No. U-0 for Authority to Increase Its Rates for the Sale of ) Electric Energy and for Approval of Depreciation ) Accrual Rates and Other Related Matters. ) ) INDIANA MICHIGAN POWER COMPANY TESTIMONY VOLUME II Andy R. Carlin Jeffrey L. Brubaker Michael N. Kelly Robert B. Hevert Franz D. Messner Andrew J. Williamson Teresa A. Caudill Daniel E. High Matthew W. Nollenberger Kurt C. Cooper
2 STATE OF MICHIGAN BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION In the matter of the application of ) INDIANA MICHIGAN POWER COMPANY ) Case No. U-0 for Authority to Increase Its Rates for the Sale of ) Electric Energy and for Approval of Depreciation ) Accrual Rates and Other Related Matters. ) PRE-FILED DIRECT TESTIMONY OF ANDREW R. CARLIN
3 INDEX I. PURPOSE OF TESTIMONY... II. OVERVIEW OF COMPENSATION PRACTICES... III. COMPETITIVENESS OF TOTAL COMPENSATION... IV. INCENTIVE COMPENSATION OFFERED BY THE COMPANIES... A. Annual Incentive Compensation... B. Senior Management Compensation... C. Long-Term Incentive Compensation... V. EXECUTIVE BENEFITS... VI. SUMMARY...
4 PRE-FILED DIRECT TESTIMONY OF ANDREW R. CARLIN ON BEHALF OF INDIANA MICHIGAN POWER COMPANY ANDREW CARLIN 0 0 Q. Please state your name and business address. A. My name is Andrew R. Carlin. My business address is American Electric Power, One Riverside Plaza Columbus, Ohio. Q. By whom are you employed and what is your position? A. I am employed by American Electric Power Service Corporation (AEPSC) as the Director of Compensation & Executive Benefits for the American Electric Power system. AEPSC supplies engineering, financing, accounting, planning, advisory, and other services to the subsidiaries of the American Electric Power (AEP) system, one of which is Indiana Michigan Power Company (I&M or the Company). In this testimony, I refer to I&M and AEPSC collectively as the Companies. Q. Please describe your educational and professional background? A. I received a Bachelor of Arts Degree from Bowdoin College in with majors in Economics and Government. I also received a Master of Business Administration degree from the J. L. Kellogg Graduate School of Management at Northwestern University in, with concentrations in finance, management strategy, and accounting. From to, I worked for Putnam Investor Services as a Shareholder Services Representative. From to 0 and in the summer of, I worked as an Associate Consultant and Research Analyst in the U.S.
5 ANDREW CARLIN 0 0 Compensation Practice for William M. Mercer, a leading international human resource consulting firm. I worked for Bank One Corporation (Bank One), now part of J.P. Morgan Chase, in multiple finance and compensation capacities. From to, I was a participant in Bank One s Financial Officer Development Program. As part of the Financial Officer Development Program I served as a Financial Analyst, Treasury Analyst, and Marketing Analyst. From to, I served as Bank One s Compensation Analysis Manager. From to, I served as Executive Compensation Development Manager. From to, I served as Bank One s Manager of Executive Compensation. From to 000, I served as Compensation Manager for Bank One s Investment Management, Capital Markets and Finance One groups. I joined AEPSC as the Director of Executive Compensation & Benefits in 000. In 00, I took on responsibility for employee compensation, in addition to my executive compensation and benefits responsibilities, and have served the Company as the Director of Compensation and Executive Benefits since then. Q. What are your responsibilities as Director of Compensation and Executive Benefits? A. In my current position, as a member of the AEPSC compensation group, I am responsible for, among other things, developing and maintaining effective and cost efficient compensation programs for I&M and AEP s other regulated subsidiaries.
6 ANDREW CARLIN 0 0 Q. What services does the AEPSC compensation group provide to the Companies? A. The compensation group is a department within Human Resources that is responsible for the design, development, and administration of the employee compensation program and some employee benefit plans for AEP and its subsidiary companies, including I&M. The compensation group conducts ongoing research and recommends changes to compensation programs as necessary to prudently manage employee compensation. The compensation group also develops communications materials and manages compensation plans and programs in compliance with federal and state regulations related to employee pay. The compensation group works to ensure that total compensation for employees, as a whole, is market-competitive. This is done by comparing the compensation offered by AEP and its subsidiaries to that of other employers using information obtained through third-party compensation surveys. The list of compensation surveys the Companies utilize is provided as Exhibit IM- (ARC- ) 0 Survey List. This coordination enables AEP and its subsidiaries to recruit and retain the qualified employees that are required to provide service to customers. Q. Have you previously submitted testimony in any regulatory proceedings? A. Yes. Please see Exhibit IM- (ARC-) Previous Rate Case Proceeding Testimony List for testimony submitted in other regulatory proceedings.
7 ANDREW CARLIN 0 0 I. PURPOSE OF TESTIMONY Q. What is the purpose of your testimony in this proceeding? A. The purpose of my testimony is to show that the compensation I&M is seeking to include in its cost of service is reasonable, customary, prudent, marketcompetitive, and vital for attracting, retaining and directing the efforts of employees with the requisite skills and experience necessary to efficiently and effectively provide the Companies electric service to customers. As such, it should be included in the Companies going level operating expenses. My testimony also will demonstrate that the Companies compensation strategy; which offers employees the basic ability to earn market comparable compensation, including a combination of base pay and incentive compensation, benefits customers through the cost and quality of the work that employees perform on behalf of customers. In addition, I will discuss the steps the Companies have taken, in light of economic conditions and the Companies financial situation, to control compensation costs and total labor expense. I will also show that the Companies executive retirement benefits are reasonable, customary, prudently incurred and market-competitive and a vital component of a total rewards (total compensation and benefits) for the attraction and retention of executives with the requisite skills and experience necessary to efficiently and effectively provide electric service to customers and, therefore, beneficial to customers.
8 ANDREW CARLIN 0 0 Q. What are the compensation terms used in this testimony? A. The Companies compensate all employees with a combination of a fixed compensation (Base Pay) and a variable annual or short-term incentive compensation opportunity. Annual incentive compensation is referred to as short-term incentive compensation or (STI). I refer to the sum of these two types of compensation (Base Pay and + STI) as Total Cash Compensation (TCC). Approximately,00 positions in the AEP system are also provided a long-term incentive (LTI) compensation opportunity. These,00 positions require unique skills and involve roles for which long-term continuity, prudency and vision are required. Total compensation ( total compensation ) is comprised of Base Pay, STI and, for eligible positions, LTI (Base Pay + STI + LTI). Total compensation and TCC are the same for employees who do not have an LTI opportunity. Q. Is the compensation strategy described in this testimony used throughout the AEP system? A. Yes. The compensation strategy described in this testimony for I&M is the same strategy used for all other regulated AEP entities. The utilization of a consistent compensation strategy provides substantial economies of scale and enables employees to work nearly seamlessly in other AEP operating companies, such as for major storm restoration events. The benefits received by I&M customers from this strategy are the result of the application of this strategy both to I&M direct employees and I&M s allocated share of AEPSC employees.
9 ANDREW CARLIN 0 0 Q. Are you sponsoring any exhibits in this proceeding? A. Yes. I am sponsoring the following exhibits: Exhibit IM- (ARC-) 0 Survey List Exhibit IM- (ARC-) Previous Rate Case Proceeding Testimony List Exhibit IM- (ARC-) I&M Total Compensation vs. Market for Technical, Craft and Clerical Positions Exhibit IM-0 (ARC-) Total Compensation vs. Market for Exempt Positions Exhibit IM- (ARC-) Total Compensation vs. Market for Senior Management Positions Exhibit IM- (ARC-) CAHRS, Evaluating the Utility of Performance- Based Pay Exhibit IM- (ARC-) Target Incentive Compensation Summary Exhibit IM- (ARC-) Towers Watson 00 Annual Incentive Plan Design Survey Findings Report Exhibit IM- (ARC-) 0 ICP Goals for I&M Distribution and Staff Exhibit IM- (ARC-0) 0 AEP System Annual Incentive Compensation Funding Measures Exhibit IM- (ARC-) 00 to 0 Safety Comparison Exhibit IM- (ARC-) Michigan Outage Cost Analysis II. OVERVIEW OF COMPENSATION PRACTICES Q. What is the Companies fundamental approach regarding compensation and benefits? A. The Companies compensation and benefit programs are designed to support customers' need for safe and reliable electric service. The Companies accomplish this by focusing performance measures on objectives that ensure
10 ANDREW CARLIN customer value. The Companies take a holistic approach to designing its compensation and benefit programs as a total employee rewards package. The following principles serve as a foundation for the design of our compensation and benefits.. Long-term customer value is created through the use of incentive compensation that recognizes and rewards employees for strong performance. Well-designed incentive compensation does this by 0 0 improving employee engagement and retaining high performing employees, which improves company performance. High levels of employee engagement and better retention of high performing employees are telltale traits of high performing organizations. The Companies organizational performance is improved by retaining high performing employees and by recognizing and awarding the knowledge, skills, and experience that make them successful. The Companies reduce overall customer costs through that approach while also ensuring that customers are served by suitably experienced and knowledgeable employees.. Improving employee health and well-being improves productivity. A healthy workforce reduces absenteeism, sustains employee commitment and top performance, which improves productivity and customer satisfaction.
11 ANDREW CARLIN 0 0. Linking pay to performance efficiently and economically aligns employee and customer interests. Placing a portion of employee compensation at risk based on performance encourages employees to achieve higher levels of performance, customer satisfaction, and productivity to the benefit customers.. Compensation and benefits program competitiveness is critical. I&M must continuously evaluate its programs to ensure they are competitive to attract, engage, and retain employees, and that the programs are effective at a reasonable cost for our customers and shareholders. Q. What is the Companies compensation strategy? A. The Companies use a total compensation strategy to recruit and retain the employees needed to provide our electric service and service support to our customers. The Companies compensation needs to be market competitive and fair to enable the Companies to attract, retain, and motivate employees with the abilities and experience necessary to provide reliable electric service, safely, efficiently, and effectively for I&M customers. Q. What are the basic options with respect to including incentive compensation as a component of the Companies total compensation strategy? A. Realizing that the Companies compensation strategy must allow employees to earn a market competitive wage and that the Companies compensation must be reasonable in order to obtain cost recovery, the basic choices are to use: ()
12 ANDREW CARLIN % fixed base pay to provide market competitive compensation; or () a combination of lower fixed base pay and a variable pay opportunity tied to performance that together bring employee compensation to market competitive levels. Both pay strategies would pay employees the same market competitive level. Q. What is the Companies overall approach to compensating employees? A. The Companies utilize the combination method which uses lower base pay and a variable incentive opportunity that varies based on performance for all levels of positions. The incentive compensation opportunity this approach provides is not a bonus in addition to already market competitive compensation, but rather provides incentives for employees to attain market competitive compensation by personally performing at a high level and contributing to achieving team performance objectives, such as customer benefit benchmarks. The Companies compensation strategy for all levels of positions is also to provide a target total compensation opportunity (base pay plus the target value of all incentive compensation) that is, on average, at the median of that provided for similar positions. Q. Why do the Companies pay employees in this manner? A. The Companies designed its compensation programs and, specifically, its annual and long-term incentive compensation programs prudently and appropriately from a customer-focused and business perspective. The compensation strategy described in this testimony uses base pay and defined
13 ANDREW CARLIN employee goals to foster efficiency, safety, and improvement in the customer experience. This pay strategy motivates employees to lower costs and generate efficiencies that benefit customers while also maintaining employee compensation at reasonable, market-competitive rates. Q. What are the customer benefits driven by employees earning their payroll compensation using this combination method? A. The Companies compensation method creates a culture of high performance and cost consciousness which reduces the cost of service for customers. The continuous improvement this type of culture produces results in lower costs of service benefitting customers through lower rates. Q. How does I&M determine that the Companies compensation levels are reasonable and market competitive? A. The Companies primarily use compensation surveys to compare its compensation rates and practices to those of other similar companies. Changes to the Companies compensation rates and practices are generally made as needed to maintain competitive compensation for each position relative to these survey comparisons of market competitive compensation. The Companies compensation department participates in or purchases numerous third-party compensation surveys each year which aid in ensuring that the Companies compensation levels are reasonable and market competitive. These surveys provide extensive compensation information for statistically significant samples of incumbents in a wide variety of jobs.
14 ANDREW CARLIN 0 0 Specifically, the compensation department matches Company positions to the jobs included in these surveys and compares the compensation levels and practices for these positions with those of similar companies for similar positions with similar responsibilities, size and scope. After accounting for any differences in position scope, the compensation department uses market median total compensation, including the target value of all incentive compensation, as the primary compensation benchmark for each position. Salary is also used as a point of comparison for all positions and TCC is also used as a point of comparison for positions for which the Companies provide a long-term incentive compensation opportunity. This process for assigning and reviewing salary ranges is consistent with the compensation practices of the majority of electric utilities and other large U.S. companies. The surveys completed and used in this process for the historical test year are listed in Exhibit IM- (ARC-) - 0 Survey List. Q. Why do the Companies use total compensation as the primary point of comparison to market compensation rather than base pay levels? A. Total compensation is chosen as the primary point of comparison because it includes all statistically significant types of compensation earned by employees in the market at the market competitively level. Market compensation survey information provided in Exhibits IM- (ARC-), IM-0 (ARC-) and IM- (ARC- ) shows that variable annual incentive compensation is a statistically significant and often a substantial component of market competitive compensation for
15 ANDREW CARLIN 0 0 nearly every position. This survey information also shows that variable long-term incentive compensation is a statistically significant and often a substantial component of market competitive compensation for executives, managers, and certain other positions, which are the same positions to which the Companies provide such compensation. Employees and prospective employees evaluate total compensation in its entirety when evaluating pay opportunities. No understanding or assessment of market competitive employee pay would be complete or valid unless all types of pay are included in the equation. The Companies also consider the value of any incentive compensation that both the market and the Companies provide in assigning a salary grade to each salaried position. Because of this practice, the Companies base pay levels typically are lower than those of companies that provide less or no incentive compensation opportunity. Q. Is it appropriate for I&M to recover through base rates employee target total compensation costs that include the target level of employee incentive expense? A. Yes. The Companies compensation program has been in place for more than 0 years. Customers have and will continue to receive financial benefits from the effective design and operation of the Companies total compensation program through lower cost of service. Lower costs and increased efficiencies are fostered by incentive compensation and are achieved while maintaining employee compensation at market-competitive rates. The Companies
16 ANDREW CARLIN 0 0 compensation strategy has historically provided advantages to customers and produced additional benefits already reflected in I&M s actual expenses for many prior rate cases, including the test year for this case. Because of these benefits, and because the Companies incentive compensation serves only to bring employee compensation to market competitive levels, it is reasonable for the total of these employee expenses to be included in the cost of service. Q. Is the Companies employee total compensation consistent with other competitors for employees in the market? A. Yes. In fact, the Companies employee compensation is consistent with other competitors and within the market competitive range but below the market median for both physical/craft and exempt positions as shown in Exhibits IM- (ARC-) and IM-0 (ARC-). Q. Why must the Companies provide employees with a market competitive total compensation package? A. The Companies must provide a market competitive total compensation opportunity to attract and retain an adequately skilled and experienced workforce in order to provide the greatest possible benefit for customers. Market competitive compensation is defined as a range around the median or middle level of compensation provided by other utilities and non-utility employers with whom the Companies compete for employees. The Companies would be at a competitive disadvantage in attracting, engaging, and retaining employees if it did not offer comparable total compensation opportunities. Attracting and
17 ANDREW CARLIN 0 0 retaining such a workforce is necessary for the safe, efficient and effective provision of service to customers. Q. What would be the implications to I&M and its customers if the Companies reduced its compensation to less than market competitive levels? A. Reducing employee total compensation to less than the market competitive range would have substantial negative implications for I&M and its cost of service to customers. It is likely that the compensation expense saved would be more than offset by increased hiring and training expense due to increased employee turnover, as well as lower employee productivity, because it would take new employees time to learn to perform their jobs safely, efficiently and effectively. This is particularly true for linemen and other craft positions that require lengthy apprenticeships to learn the skills needed to work independently and safely. It requires apprentice Lineman five years to reach the AEP s journey level (Lineman A) in which they are fully proficient in their job. It would not be economical for the Companies and its customers to become a training ground for lineman or other positions for other companies. Q. Are there any studies supporting your testimony that using an incentive compensation strategy benefits customers? A. Yes. Exhibit IM- (ARC-) - CAHRS, Evaluating the Utility of Performance Based Pay is an academic study that shows the substantial financial benefits that can result from linking pay to performance. The financial benefits shown in this
18 ANDREW CARLIN 0 0 study (see page ) are the result of improved employee performance provided by a workforce whose pay was closely linked to their performance. Q. Does the incentive portion of employee compensation contribute to the Companies compensation exceeding a market competitive pay level? A. No. The Companies incentive compensation is not a bonus plan. The target compensation opportunity that the Companies incentive compensation provides is merely a portion of employee total pay that is at risk to the employee. The Companies incentive compensation is designed to motivate employees and provide needed compensation that, when combined with base pay, brings employee total compensation to a reasonable and market-competitive level. The target value of incentive compensation is a critical component of the marketcompetitive total compensation package that the Companies use to attract and retain qualified employees. The Companies only included the target level as the going level amount of incentive compensation expense in its cost of service request in this case. Because I&M is not requesting to recover the cost of above target payouts, the cost of the above target portion of incentive payouts that occurred in the past and that may occur again in the future are borne entirely by AEP shareholders, not customers. Q. Does the use of incentive compensation reduce the Companies base pay expense? A. Yes. The variable incentive compensation component reduces the amount of base wages needed to provide prudent, effective, and market-competitive
19 ANDREW CARLIN 0 0 employee compensation. Conversely, if the Companies eliminated incentive compensation, they would need to increase base pay to continue to attract and retain the suitably skilled and experienced employees it needs to efficiently and effectively provide service to customers. Q. How do the Companies incentive compensation plan targets compare to other companies targets? A. Target 0 short term incentive compensation for all AEP participants was 0. percent of base pay, including overtime, as shown in Exhibit IM- (ARC-) - Target Incentive Compensation Summary. This is less than the percent target typical of broad-based incentive compensation plans, as shown in Exhibit IM- (ARC-) - Towers Watson 00 Annual Incentive Plan Design Survey Findings Report p.. Q. Will the annual incentive program continue to produce incremental benefits? A. While the annual incentive program is expected to produce additional incremental benefits going forward, these benefits are likely to be small compared to the cumulative total of all ongoing benefits incentive compensation produced in past years that have already been captured in rates or will be captured in rates through this proceeding. These ongoing cumulative benefits would likely erode over time if the Companies were to eliminate annual incentive compensation for a portion of their workforce, as would be considered if, for
20 ANDREW CARLIN 0 0 example, I&M were not to receive adequate recovery of annual incentive expense in its rates. Additionally, to the extent that annual incentive compensation produces substantial additional benefits going forward, the added incentive compensation expense associated with any above target portion of the incentive payouts that employees earn would be paid for by the shareholders, not customers. This is reasonable because the financial benefit of this performance improvement would not be captured by customers until the next base rate case. Customers nevertheless would immediately receive the benefits of any operational improvements. Therefore, as it is a portion of customary employee wages, it is just and reasonable to include all of the cost of the target level annual incentive compensation in the Companies cost of service for rate making purposes. Q. What are the trends in incentive compensation and its prevalence in the employment market? A. Incentive compensation withstood the pressures of the Great Recession and the unprecedented challenges of cost, risk, scrutiny, and talent management issues facing employers today. It continues to be used nearly universally by public utilities and other U.S. companies to encourage desired behaviors and provide competitive total compensation opportunities. The compensation analyses discussed above in this testimony [Exhibits IM- (ARC-), IM-0 (ARC-) and IM- (ARC-)] show that market median total compensation includes incentive compensation for percent of the I&M incumbent
21 ANDREW CARLIN 0 employees in of the technical, craft (traditionally hourly skilled labor, such as line servicers and other trades) and clerical positions as well as 00% of the exempt, managerial, and executive positions. To state simply and avoid misinterpretation, the Companies provide both annual and long-term incentive compensation as part of a market-competitive total compensation package; it is not provided as a bonus on top of an already market competitive compensation package. Moreover, the Companies are only seeking recovery of target level of incentive compensation. Any incentive compensation earned in excess of the target amount is funded by shareholders. As a result, incentive compensation does not increase employee payroll costs. In other words, if incentive compensation were not provided, the same dollar value of incentive compensation would need to be added to base pay in order for the Companies to provide a market competitive compensation package to its employees. Paying market competitive compensation enables the Companies to attract, retain, and motivate the suitably knowledgeable and experienced employees it needs to efficiently and effectively provide its electric services to customers. Furthermore, incentive compensation provides many additional and substantial benefits to customers, which are described in detail later in this testimony.
22 ANDREW CARLIN 0 Q. How would excluding all or part of the Companies employee incentive compensation expense affect the competiveness of the Companies employee compensation for physical and craft positions? A. If the Companies annual incentive compensation were to be excluded and doing so prompted the elimination of annual incentive compensation for physical and craft positions without an offsetting increase in base pay, then total compensation for of physical and craft positions (. percent) would fall below the marketcompetitive range and the Companies average employee total compensation would fall 0. percent below the market median, which is also below the market competitive range. Without a corresponding increase in base pay, eliminating the incentive compensation component of the Companies compensation strategy would put the Companies at risk of being unable to attract and retain the skilled and experienced employees necessary to safely and reliably provide its service to customers. This shows that the annual incentive compensation paid by the Companies is necessary to achieve market competitive compensation for these positions and, thus, is a reasonable and appropriate cost of doing business that cannot be eliminated without an offsetting increase in base pay if total compensation is to remain competitive.
23 ANDREW CARLIN Q. Do you believe it would be reasonable to disallow recovery of any portion of the target going level amount of employee incentive compensation expense? A. No. The total compensation the Companies provide to employees is a just, reasonable, and prudent cost of doing business in service to customers. Reducing or eliminating a portion of this employee payroll expense would reduce I&M s cost recovery for this expense to less than that required to maintain total compensation in the market-competitive range for a substantial number of positions as shown in Exhibits IM- (ARC-), IM-0 (ARC-) and IM- (ARC- ). Paying market-competitive compensation enables the Companies to attract, retain, and motivate the suitably knowledgeable, experienced and qualified employees it needs to efficiently and effectively provide services to customers, while minimizing overall expense, which is in the best interests of customers and the Companies. Any compensation expense avoided by reducing employee compensation to less than the market-competitive range would likely be more than offset by additional hiring and training expense due to employee turnover, lower employee productivity while new employees learn to perform their jobs safely, efficiently and effectively, particularly for positions that require lengthy apprenticeships and hard to obtain skillsets, such as reactor operator. Q. How are base salaries determined for salaried employees? A. Base salary offers for salaried positions are made by the Companies management within the salary range for the job grade assigned to each position.
24 ANDREW CARLIN 0 The specific offer within the range is based on the qualifications and experience of the prospective employee relative to the requirements for the position. For jobs with multiple incumbents, the base salaries of other employees in the same position are also a major factor. The Companies also maintains a merit-based salary increase program for all salaried positions. The amount budgeted annually for merit increases is established by senior AEP management based on salary planning surveys, the market-competitiveness of the Companies compensation and the budget dollars available for salary increases. As part of the merit program, each employee s individual performance is evaluated on at least an annual basis. The amount of the merit increase awarded to each employee, if any, is based on a combination of factors, including their individual performance rating, their performance relative to their peers, the position of their salary within the salary range for their job, and the size of the merit budget. Q. How does the Companies overall base salary increase budgets compare to market for the years 00 through 0? A. Figure ARC- below compares median utility industry base salary increase budgets for employees to the Companies salary increase budget for the years 00-0.
25 ANDREW CARLIN Nonexempt Salaried (Industry)* Nonexempt Salaried (Company) Figure ARC- Exempt (Industry)* Exempt (Company) Executive (Industry)* Executive (Company) 00 Actual.0% 0.000%.00% 0.000%.000% 0.000% 00 Actual.00%.000%.000%.000%.0% 0.000% 0 Actual.000%.00%.00%.00%.000%.00% 0 Actual.0%.%.000%.%.000%.% 0 Actual.000%.000%.000%.000%.000%.000% 0 Actual**.000%.0%.000%.0%.000%.0% 0 Actual***.000%.00%.000%.00%.000%.000% 0 Actual***.000%.00%.000%.00%.000%.000% Total.00%.%.00%.%.0%.% Difference -.% -.% -.% *The Conference Board Research Report, U.S. Salary Increase Budgets for 00-0 ** Represents.00% merit budget and a 0.% promotional and equity adjustment budget *** Represents.00% merit budget and a 0.% promotional and equity adjustment budget 0 This table shows that the Companies base pay increase budgets have substantially lagged the market median over these years. While many companies pared back their salary increase budgets in 00 due to economic conditions, the Companies salary freeze was a far more substantial response. While utility companies generally returned to nearly percent increase for 00, the Companies increased base wages by only percent and maintained a salary freeze for executive positions. For 0, the Companies base wage increases basically kept pace with the market median and did not make up a significant portion of the 00 and 00 shortfall. The Companies 0 salary increase budget of. percent again lagged the market before returning to market median levels for 0. For 0, the Companies budgeted a percent merit budget and provided a.% promotional budget for line of progression
26 ANDREW CARLIN 0 promotions, such as Accountant to Accountant Sr. In 0 and 0, the Companies allocated.00 percent and.0 percent promotional budget for a. percent total salary increase budget which was even with the market median of.00 percent. Overall, the Companies total salary increase budgets for nonexempt salaried and exempt positions lagged the market median by. percent and. percent over this period, while the salary increase budget for the Companies executives was a total of. percent less than the utility industry market median. Q. How are base pay increases administered for hourly/craft employees? A. Base pay increases for hourly/craft employees, such as line mechanics and meter readers, are provided as a general increase, expressed as a percentage of current base pay rates. General increases are negotiated with the labor unions that represent the Companies employees. The Companies based its position in these negotiations on survey projections for general wage increases and market median total cash compensation for these types of positions. As shown in the General Wage Increase Figure ARC- below, pay increases for these types of employees have also lagged the market overall.
27 ANDREW CARLIN Figure ARC- Hourly/Craft Employees* Year Utility Industry Market Median* The Company 00.00% 0.000% 00.0%.000% 0.00%.000% 0.000%.000% 0.000%.00% 0.000%.00% 0.000%.00% 0.000%.00% Total Pay Increase.0%.000% Company Employee Pay Increases Compared to Market -.0% * The Conference Board Research Report, U. S. Salary Increase Budgets Survey 0 The Companies total increase budget was. percent less than the market median for hourly/craft employees for the 00 through projected 0 period. Reducing the growth of base wages is one of several difficult steps the Companies has taken to address its financial situation and economic conditions in its service territory and this action directly benefits customers by reducing the cost of the Companies electric service. Q. What other steps have the Companies taken to control compensation expense in light of the great recession and weak recovery? A. In addition to constraining the growth of base pay through lower than market merit increase budgets and general increases, the Companies reduced the growth rate of compensation expense by: Freezing external hiring from November 00 through 00.
28 ANDREW CARLIN 0 0 Freezing line of progression promotional increases, such as Accountant II to Accountant I, from November 00 through 00, other than for physical and craft positions. Substantially reducing the use of external contractors and temporary employees. Substantially reducing the employee workforce through staff reductions and severance programs. Implementing efficiency measures, such as LEAN and other continuous improvement initiatives. Taking measured steps to adjust lagging employee compensation to market over time. Q. How have the steps taken to control compensation expenses affected the competitiveness of the Companies compensation? A. Because base pay increases lagged the market overall, the competitiveness of the Companies compensation declined. Base compensation levels for physical and craft exempt positions are below the market median on average, although the Companies base compensation levels generally remain within the market competitive range (typically considered to be +/- 0 percent of the median for hourly/craft employees and +/- percent for other employees). The Companies target annual incentive compensation has also fallen relative to market because these levels are calculated as a function of base compensation. As a result, the competitiveness of Companies target TCC (total cash compensation) and target total compensation were also negatively affected by the below market base pay increases.
29 ANDREW CARLIN 0 III. COMPETITIVENESS OF TOTAL COMPENSATION Q. How does the Companies target total compensation for physical and craft positions compare with market data? A. As shown in Exhibit IM- (ARC-) I&M Total Comp vs. Market for Nonexempt Positions, I&M s average target total compensation for the physical and craft positions included in the EAP Data Information Solutions, LLC 0 Energy Technical Craft and Clerical (ETC&C) Survey is. percent below the market median. Figure ARC- below illustrates the total compensation for I&M line and substation positions in comparison with this survey for the Central/Midwest Region. Figure ARC- Survey Job Line Mechanic Substation Mechanic/Technician AEP Title Line Mechanic- A Station Electrician A AEP Average Target Total Compensation ETC&C Survey Total Compensation % Difference AEP Target Total Compensation vs. Survey Total Compensation $,0 $,00 -.% $,0 $,00-0.% I&M s average total compensation is within but in the lower half of the market competitive range for these positions (typically +/- 0 percent of the survey median for hourly physical and craft positions). However, if I&M s annual incentive compensation were to be excluded, then total compensation for of physical and craft positions (. percent) would fall below the marketcompetitive range and I&M s average total compensation would fall to 0.
30 ANDREW CARLIN 0 0 percent of market, which is below the market competitive range. This shows that the annual incentive compensation paid by the Companies is necessary to maintain the competitiveness of I&M s compensation for these positions and, thus, is a reasonable and appropriate cost of doing business that cannot be eliminated without an offsetting increase in base pay. Q. How does I&M and AEPSC s target total compensation for non-managerial exempt positions compare with market data? A. Exhibit IM-0 (ARC-) - Total Compensation vs. Market for Exempt Positions compares the Companies compensation for non-executive exempt positions to those of similar companies, based on applicable external survey data. This exhibit indicates that, on average, the Companies target total compensation for these positions was. percent below the market median, which is well within a +/- percent market competitive range, which is typical for exempt positions. However, if the Companies annual incentive compensation were to be excluded, then total compensation for these positions would fall to. percent below the market median. While I&M s and AEPSC s average total compensation would remain within but at the low end of the market competitive range, of individual positions (.0 percent) would fall below the market competitive range. This shows that the annual incentive compensation opportunity the Companies provide to these positions is necessary to maintain the competitiveness of the their compensation package and is a reasonable cost of doing business that,
31 ANDREW CARLIN 0 0 practically speaking, cannot be eliminated without a corresponding increase in base pay. Q. How does I&M s target total compensation for management and leadership positions compare with market data? A. The Human Resources Committee of AEP s Board of Directors annually engages a nationally recognized, independent executive compensation consulting firm (Meridian Compensation Partners, LLC), to conduct a compensation study of AEP s management and executive positions. The peer group used for this study consists of similarly sized utility companies that represent the talent markets from which the Companies must compete to attract and retain management and executive employees. An analysis of this study shows that TCC for the executive positions whose time and expense is generally allocated to I&M were within the +/- percent market competitive range on average as of January, 0. However, AEP s total compensation would be below the marketcompetitive range for 00 percent of these executive positions without either the annual incentive compensation or the long-term compensation portion of total compensation, unless it was replaced with base salary (See Exhibit IM- (ARC- ) - Total Compensation vs Market for Senior Management Positions). Obviously, if both annual incentive compensation and long-term compensation were eliminated, executive total compensation would be far below market-competitive levels. This study shows that the portion of compensation provided by annual and long-term incentive compensation for senior management and executive
32 ANDREW CARLIN 0 0 positions is necessary, both singularly and in combination, to maintain the competitiveness of the Company s total compensation for these positions. As such, the cost of this compensation, irrespective of the form in which it is provided, is a necessary, reasonable and appropriate cost of doing business. Once again, this shows that incentive compensation is necessary to maintain the competitiveness of the total compensation package the Companies provide to employees and that, practically speaking, incentive compensation cannot be eliminated without a corresponding increase in base pay or diminishing the Companies ability to attract and retain the suitably knowledgeable and experienced management and executive employees that the Companies needs to efficiently and effectively provide its services to customers. IV. INCENTIVE COMPENSATION OFFERED BY THE COMPANIES Q. How common are annual incentive compensation plans in the utility industry? A. U.S. industrial and electric utility companies nearly universally utilize annual incentive compensation plans as a reasonable and customary part of the total compensation opportunity they provide employees at all levels. Median actual short-term incentive compensation is at least percent of base salary for percent of all energy services industry positions (Willis Towers Watson Data Services, 0 CDB Energy Services Middle Management, Professional and Support Compensation Survey Report U.S.). This survey includes compensation information from Energy Services Industry employers for more
33 ANDREW CARLIN than,000 of their employees. Furthermore, Exhibit IM- (ARC-) - Towers Watson 00 Annual Incentive Plan Design Survey Findings Report, states that: In today s turbulent economic environment, organizations face a perfect storm of cost, risk, scrutiny and talent management issues. Amid these unprecedented challenges, annual incentive plans continue to play an important role in communicating and reinforcing critical organizational objectives, encouraging desired behaviors and providing competitive total direct compensation opportunities. (p. ) Q. What are the general benefits of annual incentive compensation? A. The Companies provides incentive compensation in lieu of larger base salaries because it improves the Companies performance without increasing overall compensation expense. It encourages cost control and aligns work with the Companies objectives, thereby increasing both employee and the Companies performance. When incentive compensation is provided as a component of a market competitive total compensation package, it has no incremental cost above the cost of providing market competitive compensation using base pay alone. If compensation is not linked to performance, then it would only be dependent on position retention, which would discourage prudent risk taking, such as attempting new methods to improve operations and taking on prudent business investments. Such a compensation structure would be misaligned with the interests of both shareholders and customers, who depend on the Companies continued efficient operations and prudent investment to maintain, upgrade and expand the I&M electric system.
34 ANDREW CARLIN 0 0 The Companies utilize merit-based increases for salaried employees as this does provide a performance incentive. However, the Companies prudently limits these increases to small percentage of employee s salaries, which limits their effectiveness as a performance incentive. Merit increases are limited because they are a one-way street. Once salaries are increased, they almost never are reduced, because employees will often quit before accepting a salary decrease. This limits the usefulness of the merit program for rewarding one-time performance that may or may not be repeated. Similarly, linking compensation for management employees only to shortterm performance is counter to both shareholder and customer interests because it would discourage investment necessary for the long-term investment in I&M s electric system. Paying only base compensation to employees at any level sends a clear signal to them that they need only perform their job well enough to avoid being fired for poor performance. For management employees, the absence of incentive compensation can discourage pursuit of projects that would be prudent investments for shareholders and customers. This is because pursuing major projects requires taking on prudent business risks that puts management s continued employment at risk without providing a commensurate pay opportunity to offset taking on this risk. Similarly, a management compensation package that includes base pay and only short-term incentive compensation generally discourages long-term projects, even projects that would be prudently undertaken from the point of view of both customer and shareholder. This is
35 ANDREW CARLIN 0 0 because most long-term projects require upfront investment that reduces shortterm earnings and often requires management to forego short-term incentive compensation. Q. Why does I&M provide annual incentive compensation in addition to base pay? A. I&M provides annual incentive compensation because it improves Companies performance in a way that meaningfully benefits ratepayers without increasing compensation expense. It improves cost control and aligns work with company objectives thereby increasing both employee and company performance. Utilizing annual incentive compensation is also allows for one-time performance to be recognized and rewarded without increasing fixed base pay expense. When incentive compensation is provided as a component of a market competitive compensation package, it has no incremental cost to the company above the cost of providing market competitive compensation with base pay alone. In addition, the benefits of annual incentive compensation include improved employee engagement and improved organization performance by: Providing a forum for prioritizing goals and objectives. Communicating goals and objectives to employees in a manner that is more effective than otherwise possible, including goals and objectives that are important to customers, employees, the communities we serve, and other stakeholders, such as workforce safety and health, customer
36 ANDREW CARLIN 0 0 satisfaction, system reliability, generating fleet availability, environmental compliance and operating efficiency. Focusing and more closely aligning employee efforts and those of departments throughout the organization with the goals and objectives of the organization and, thereby, better ensuring that everyone is working towards the same objectives. Encouraging and motivating employees to achieve these goals and objectives. Rewarding employees for their individual and team performance. Linking some compensation for all employees to shared measures of success so that all employees understand that a significant part of their compensation is inextricably linked to the organization s performance so that all employees have a personal stake in its success. Shifting a portion of compensation expense from a fixed to a variable expense. This reduces earnings volatility, business risk, borrowing costs and the expense and other concerns associated with more frequent and extensive changes in the size of the Companies work force that might otherwise be necessary to meet shareholder expectations. Creating a high performing employment brand that helps to attract, retain and motivate high performing employees,, who often associate incentive compensation with the types of organizations in which they would like to work.
37 ANDREW CARLIN 0 0 Helping to exit low performing employees from the organization. Creating a culture of high performance and cost consciousness. Controlling and reducing expenses due to productivity increases, expense savings, and operational benefits that the Companies would otherwise need to incur addition expense to achieve. Because the Companies incentive programs are a component of a market competitive target total direct compensation opportunity, they have no incremental cost beyond the cost of providing market-competitive compensation using base pay alone and, therefore, they provide the above benefits without giving rise to any offsetting cost. By providing these many benefits, incentive compensation supports the Companies mission of providing cost-efficient, safe, and reliable electric service by efficiently and effectively attracting, retaining and motivating the suitably skilled and highly engaged employees the Companies needs to efficiently and effectively operate its business. A. Annual Incentive Compensation Q. Describe the annual incentive compensation plans that are applicable to this proceeding. A. The Companies annual incentive plans cover all employees, from hourly positions through executive management, except coop students and interns. The majority of the goals for I&M employees participating in this plan are measured at the I&M (operating company) level. For the historical test year (0) there were separate annual incentive plans for employees in I&M; Customer & Distribution Services; Generation; Transmission; and other smaller groups. The remaining
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