Compensation of Executive Board Members in European Health Care Companies. HCM Health Care

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1 Compensation of Executive Board Members in European Health Care Companies HCM Health Care

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3 CONTENTS 4 EXECUTIVE SUMMARY 5 DATA SAMPLE 6 MARKET DATA OVERVIEW 6 Compensation level 10 Compensation structure 14 Variable compensation design 22 Equity ownership guidelines 24 OVERALL VIEW ON EXECUTIVE COMPENSATION 26 TERMINOLOGY 28 ABOUT THE AUTHORS 29 ABOUT HCM HCM Health Care Study 3

4 EXECUTIVE SUMMARY Total direct compensation The median total direct compensation levels in the HCM Health Care companies reached CHF 4.3 million for Chief Executive Officer and CHF 1.7 million for other Executive Board members in Compensation level for Chief Executive Officer was slightly higher than in 2014 mostly due to pay increases in pharmaceutical firms. The median total direct compensation for CEOs in largesized pharmaceutical firms was CHF 9.0 million in contrast to CHF 2.2 million in health care equipment and services firms. Average compensation level for other Executive Board members varied from CHF 0.9 million in health care equipment and services providers to CHF 4.2 million in pharmaceutical companies. Compensation structure The structure of compensation packages for Executive Board members was mainly influenced by the firm s size and industry-specific compensation practices. The weighting of the variable compensation for Chief Executive Officer (immediate variable compensation and long-term incentive awards) varied between 51 percent in health care equipment and services grouping to 76 percent for pharmaceuticals. The variable compensation weighting was slightly lower for other Executive Board members. The proportion of long-term incentive awards alone was the highest in the biotechnology and pharmaceuticals groupings - 40 to 50 percent of total compensation on average in contrast to 23 to 27 percent in the health care equipment and services grouping. Annual bonus Realized annual bonus of Chief Executive Officer in 2015 was 120 percent of base salary on average, while the figure for other Executive Board members stood at 100 percent. These results represent a slight increase from the previous year, which was mostly attributable to pharmaceutical companies. The most widely applied key performance indicators to determine the annual bonus among the HCM Health Care companies were earnings- and revenue-based measures. The median bonus caps in sub-industry groupings varied between 100 percent and 200 percent of base salary for the role of Chief Executive Officer and between 90 percent and 165 percent of base salary for other Executive Board members. The highest maximum payout opportunities were observed in pharmaceutical companies, which capped their bonuses at about twice base salary level at median. Approximately 17 percent of the annual bonus earned for the financial year 2015 was further deferred as a long-term incentive. Long-term incentive awards When defining the grant size under long-term incentive plans, companies tended to use a budgeted approach (75 percent of the reviewed plans in place). The grant size of the remaining 25 percent of the reviewed plans related to the realized annual performance of the respective company. In terms of vesting design, 35 percent of the long-term incentive awards were time-based, mostly with payout subject to service conditions. These awards were mainly presented as restricted shares and stock options. Performance-based vesting awards remained the most common form of long-term incentive awards for Executive Board members (65 percent of the plans) with performance shares/units as the most popular instrument. Such plans were subject to achievement of performance targets, typically defined in terms of Total Shareholder Return (or share price performance) and measured either in absolute terms or relative to a peer group. Equity holding requirements Among the HCM Health Care companies, 12 firms specified requirements for Executive Board members to hold company shares, aiming to strengthen the alignment between the managers and shareholders interests. In addition to these traditional ownership guidelines, four of the analyzed companies introduced extended blocking periods on the vested long-term incentives. 4 HCM Health Care Study

5 DATA SAMPLE This study covers publicly available data published through 30 June in the remuneration reports of 40 European health care companies, which are constituents of the STOXX Europe 600 Health Care index (hereinafter HCM Health Care). To heighten the comparative relevance for readers in different health care companies, we have segmented the data into sub-industry groupings: Biotechnology (11 companies); Pharmaceuticals (15 companies); Health care equipment and services (14 companies). Figure 1 presents the distribution of the free float market capitalization within the mentioned sub-industries as well as the share of each sub-industry in the HCM Health Care sample. This study focuses on publicly available data related to the remuneration of the Executive Board members, disclosed in the companies annual reports. The analysis deals with the total direct compensation components only, excluding social securities, pensions, expense allowances, other benefits, replacement awards, severance payments and gains from share purchase programs. Variable compensation attributable to the years under review (accrued or granted, rather than paid out) was analyzed. Where possible, long-term incentive awards were estimated at their fair value upon grant. The companies providing insufficient compensation data for the analysis were not included in the samples. Moreover, Chief Executive Officers (CEOs), who were not in office for the full year were also excluded from any trend analysis. For transparency reasons, the relevant sample sizes are reported throughout the study as part of tables and graphs. Free float market capitalization (CHF million) Lower quartile Median Upper quartile Share in HCM Health Care Biotechnology (n=11) % Pharmaceuticals (n=15) % Health care equipment and services (n=14) % HCM Health Care (n=40) % Figure 1. Free-float market capitalization as of 31 December 2015, split by sub-industry. 1 Data for 98 percent of the HCM Health Care companies has been analyzed. HCM Health Care Study 5

6 MARKET DATA OVERVIEW Compensation level Regular reviews of the executives compensation, mainly on an annual basis, were disclosed by 77 percent of the companies analyzed. These reviews were most often applied to compensation level and structure. Moreover, the vast majority of the HCM Health Care companies (82 percent of the companies under review) also stated that they periodically conduct external benchmarking against peers that are comparable in terms of size, nature and complexity of their business. These benchmarks were usually conducted with respect to base salary or total direct compensation level on aggregate. Chief Executive Officer We looked at the level of total direct compensation of the Chief Executive Officer from two perspectives. Figure 2 illustrates the regression analysis of compensation vs. company size (free float market capitalization), whereas Figure 3 presents the median compensation figures, split by sub-industry groupings. The median level of total direct compensation of Chief Executive Officer stood at CHF 4.3 million, which was slightly higher than in the previous year. The most significant increase was observed in the pharmaceuticals grouping, where the annual bonus increased by 45 percent on average. However, the opposite was true for biotech companies: year-on-year changes in the compensation level were on average negative due to a significant decrease in the annual bonus earned for Based on regression data in Figure 2, we conclude that size made a significant influence on the total direct compensation of the Chief Executive Officer and explained 57 percent of its variation. The link between market capitalization and compensation was more evident, when CEO compensation in the pharmaceuticals and health care equipment and services groupings was regressed separately from biotech companies (explanatory power reaches 70 percent). Indeed, the link between the size of the company and level of compensation paid to the CEO was weaker for biotech firms (explanatory power of 13%). Based on the regression analysis, we found out that compensation in the biotech industry was not in line with other firms in the health care sector due to a number of factors, which influence the compensation level. Notably, the companies in the biotech industry were more diverse in terms of: goals: organic growth as a separate company or merger with the larger biotech or pharma market player. agent-principal relationship: whether or not the company is managed by its main investors (founders). degree of innovation: amount of R&D expenses, research timeline, riskiness of the products under development etc. These factors significantly influenced the level, structure and design of the compensation package in the biotech companies, which resulted in high dispersion. A similar conclusion about the size factor can be drawn from Figure 3, when data sample characteristics are considered. The pharmaceuticals comprised the largest companies in terms of size and therefore demonstrated the highest compensation level of CHF 9.0 million and thus outpaced median CEO compensation in the Biotechnology and Health care equipment and services groupings by 3.3 and 4.1 times respectively. The biotech companies, which are comparable with health care equipment and services grouping in terms of market capitalization, granted significantly higher levels of compensation in 2014 and This is consistent with a riskier business model followed by firms in this industry. The gap in compensation levels between pharmaceuticals and other sub-industry groupings was more prominent in 2015: total direct compensation increased in 70 percent of pharmaceutical companies under review, whereas changes in other industry groupings were moderate. This increase in the pharmaceuticals grouping was mainly determined by the annual bonus component as a result of a successful financial year (as described in the annual reports). In contrast, CEO compensation level in health care equipment and services was the lowest in all three sub-industry groupings (CHF 2.2 million). The internal dispersion of compensation level within this grouping was also small the interquartile range was between CHF 2.0 and 4.5 million. Moreover, year-on-year changes in total direct compensation level were moderate on a per company basis. 6 HCM Health Care Study

7 Link between the compensation level and the size of a company 17 Total direct compensation in CHF, scaled by taking natural logarithm R 2 = 57% n= Free float market capitalization in CHF, scaled by taking natural logarithm Biotechnology Pharmaceuticals Health care equipment and services Figure 2. Total direct compensation for the role of Chief Executive Officer vs. Free float market capitalization as of 31 December Median total direct compensation, CHF million HCM Health Care (n=28) Biotechnology (n=8) Pharmaceuticals (n=10) Health care equipment and services (n=10) Figure 3. Total direct compensation for the role of Chief Executive Officer, split by sub-industry. HCM Health Care Study 7

8 The sample of biotech companies showed the median compensation level of CHF 2.7 million, which reflected a slight decrease from the previous-year median level (CHF 3.0 million). Indeed, most companies in the biotech sample recorded a decrease in total direct compensation, which was mostly attributable to the drop in annual bonus in Overall differences in the total direct compensation across the sub-industry groupings were attributable to the divergence in the value of the long-term incentive awards. The median long-term variable compensation for pharmaceutical companies was about seven times higher than that for the health care equipment and services firms and about three times higher than that for the biotech companies. Differences in the level of base salary and immediate variable compensation were less significant. The structure of CEO compensation is discussed in detail in the next section on pages Other Executive Board members Trend analysis of total compensation level vs. company size and the median compensation figures for other Executive Board member (on average) are presented in Figure 4 and Figure 5. The HCM Health Care companies typically paid CHF 1.7 million of total direct compensation to other Executive Board members on average in The overall compensation level in the HCM Health Care sample did not show significant changes from the previous year, however a slight decrease was observed in the biotechnology grouping due to a lower amount of annual bonus earned in The opposite was observed for the pharmaceuticals grouping - the level of compensation for other Executive Board members has slightly increased due to positive change in annual bonus payments. Similar to the Chief Executive Officer position, size was also a critical factor explaining differences in compensation level among other Executive Board members. The regression analysis shown in Figure 4, reveals that almost half of variation in compensation level was captured by free float market capitalization. This relationship is slightly weaker than for Chief Executive Officer, however, computational reasons may also play a role compensation for other Executive Board members represents an average compensation figure for several executive positions rather than compensation level for one single person. Moreover, a number of the Executive Board members and their responsibilities can vary and these differences are mostly related to country-specific corporate governance rules and practices. The link between market capitalization and compensation is more evident if the pharmaceuticals and health care equipment and services groupings are analyzed separately (R-squared reaching 65 percent). In contrast, the size factor explained only 15% of variation in biotech companies. Indeed, similar to the observation made for the CEO position, differences in the business goals, innovation levels and involvement of the owners in the company administration contributed to the dispersion observed in the biotech industry in Figure 4. A similar conclusion about the size factor can be drawn from Figure 5, when data sample characteristics are considered. A higher amount of total direct compensation was granted in the pharmaceuticals grouping CHF 4.2 million at median. This compensation level was 4.7 times higher than for health care equipment and services providers. Such differences in total compensation primarily come from the variable compensation level. The median compensation level in biotech companies in 2014 and 2015 was considerably higher than in the health care equipment and services grouping despite similar size characteristics. This is consistent with a riskier business model followed by firms in the biotech industry. Differences in the level of total direct compensation across the sub-industry groupings were attributable to the divergence in value of the long-term incentive awards. The median long-term variable compensation for pharmaceutical companies was about six times higher than that for health care equipment and services firms and three times higher than that for biotechnology companies. Differences in the level of base salary and immediate variable compensation were less significant. The structure of other Executive Board members compensation is discussed in detail in the next section on pages HCM Health Care Study

9 Link between the compensation level and the size of a company 16 Total direct compensation in CHF, scaled by taking natural logarithm R 2 = 49% n= Free float market capitalization in CHF, scaled by taking natural logarithm Biotechnology Pharmaceuticals Health care equipment and services Figure 4. Total direct compensation for other Executive Board members on average vs. Free float market capitalization as of 31 December Median total direct compensation, CHF million HCM Health Care (n=27) Biotechnology (n=8) Pharmaceuticals (n=9) Health care equipment and services (n=10) Figure 5. Total direct compensation for other Executive Board members on average, split by sub-industry. HCM Health Care Study 9

10 Compensation structure The structure of total direct compensation reflects the split between fixed compensation (base salary), immediate variable compensation and long-term incentive awards. It reflects the degree of incentivization given to an executive officer to deliver specific company results via a constructed compensation package. The manner in which public health care companies in Europe compose the compensation packages for their executives is typically driven by the role and responsibilities of the respective executive. However, factors such as the size of the company, the sub-industry grouping which the company belongs to and local legal requirements also strongly influence the compensation features. Chief Executive Officer The average compensation structure for Chief Executive Officer is presented in Figure 6. Overall, variable pay prevailed in CEO compensation package, reaching almost two thirds of total direct compensation in the HCM Health Care sample. Base salary weighting was quite low for pharmaceutical and biotech firms (24 percent and 35 percent respectively), but reached half of total pay for the health care equipment and service grouping. A narrower range was observed for immediate variable compensation, which accounted for 21 percent (biotech companies) to 26 percent (pharmaceutical companies) of total direct compensation. Long-term incentive awards accounted on average for 40 percent of total direct compensation of HCM Health Care companies. This compensation element had the highest proportion in compensation packages of biotech and pharmaceutical firms 44 and 50 percent respectively. Significant weighting of long-term incentive awards addresses particular business model features in these sub-industry groupings. Specifically, pharmaceuticals and biotechnology are considered as sectors with high R&D intensity, with above 5 percent of sales being contributed towards research and development activities, which tend to materialize in the longer term. Companies in the pharmaceuticals industry were generally larger in terms of market capitalization and granted the highest amount of total direct compensation to their Chief Executive Officers. Compensation packages in this sub-industry were split in the following way: 26 percent as immediate variable compensation, 24 percent as base salary and 50 percent as long-term incentive awards. Indeed, a larger company size implies broader responsibilities for Chief Executive Officer and increased attention from the investment community, which translated into more performance-sensitive pay packages. This conclusion is supported by Figure 7, where compensation packages are presented relative to the weight of the long-term incentive awards and free float market capitalization. An upper quartile weight of longterm incentive awards (above 60 percent) was reached by four pharmaceutical firms, which were among the largest in terms of market capitalization in the HCM Health Care sample (above CHF 90 billion in total) and which granted the highest amount of total direct compensation (CHF 9.6 million or more). These pharmaceutical companies were among the Top 30 companies worldwide in terms of long-term R&D investments in In contrast, health care equipment and services providers paid 49 percent of the total direct compensation as base salary and awarded only 27 percent of compensation under long-term incentive programs (Figure 6). Four out of ten companies in this sub-industry grouping did not grant any long-term incentive awards to their Chief Executive Officers in As shown in Figure 7, firms in the health care equipment and services grouping were typically smaller in terms of market capitalization (observed in the left-hand side of the graph), which translated into a lower total compensation level (up to CHF 6.0 million). Most firms in this sub-industry grouping were located below the median with regard to the proportion of long-term incentive award (considering that many companies are located at a zero-percent level of the long-term incentive awards). Even though the portion of long-term incentive awards is often positively correlated with the size of total direct compensation and company size, this does not hold for biotech firms. These firms had median market capitalization and total direct compensation comparable to that of health care equipment and services providers, but granted on average 44 percent of their compensation as 2 According to EU R&D Scoreboard HCM Health Care Study

11 Average compensation structure, percentage of total direct compensation HCM Health Care (n=28) 36% 24% 40% Biotechnology (n=8) 35% 21% 44% Pharmaceuticals (n=10) 24% 26% 50% Health care equipment and services (n=10) 49% 24% 27% Base salary Immediate variable compensation Long-term incentive awards Figure 6. Average structure of total direct compensation for the role of Chief Executive Officer, split by sub-industry. Link between the level of long-term incentive awards and the company size Long-term incentive awards (percentage of total direct compensation) 100% 80% 60% 40% 20% 0% 0 10'000 20'000 30'000 40'000 Size of a bubble corresponds to the total direct compensation of a Chief Executive Officer (CHF million) Free float market capitalization in CHF million Interquartile range 80' ' ' '000 Biotechnology Pharmaceuticals Health care equipment and services Figure 7. Long-term incentive awards for the role of Chief Executive Officer on vs. Free float market capitalization as of 31 December HCM Health Care Study 11

12 long-term incentive awards. Indeed, long-term incentive awards allowed for aligning the uncertainty and duration of the compensation package with that of the business activities performed by these companies. Most biotech companies under analysis were located in the upper left corner of the graph in Figure 7 corresponding to small market capitalization and high weighting of longterm incentive awards. As discussed earlier, firms in this sector rely heavily on the long-term incentive awards for industry-specific reasons. Other Executive Board members The structure of compensation packages for other Executive Board members typically mimicked the structure of Chief Executive Officers pay with a slightly higher proportion of base salary and a lower proportion of long-term incentive awards. As shown in Figure 8, the total direct compensation of other Executive Board members in the HCM Health Care sample consisted of 40 percent base salary, 24 percent immediate variable pay and 36 percent long-term variable compensation on average. The proportion of base salary in total pay varied from 30 percent in the pharmaceuticals grouping to 50 percent in health care equipment and services firms. Biotech companies granted around 38 percent of compensation as base salary. A narrower range was observed for immediate variable compensation, which accounted for 18 percent (biotech companies) to 27 percent of total direct compensation (pharmaceutical firms and health care equipment and services providers). Significant differences were observed in the level of longterm incentive awards in the three sub-industry groupings. The lowest proportion (23 percent on average) of longterm variable compensation was awarded to the Executive Board members in the health care equipment and services grouping. This figure was considerably higher for pharmaceutical firms (43 percent) and for biotechnological firms (44 percent) due to the size and industry specific factors discussed earlier. which was also linked to the size of the company (measured by free float market capitalization). This relationship was weaker than for the role of Chief Executive Officer, however, computational reasons may also play a role compensation level and weighting of long-term incentive awards for other Executive Board members was computed as an average figure for a number of executive positions. Moreover, the number of Executive Board members and their level of responsibilities can vary from company to company due to country-specific corporate governance rules and practices. The four largest pharmaceutical companies are located in the upper right corner of the graph (median to upper quartile weighting of long-term incentive awards and large market capitalization). The level of the total direct compensation in these firms fluctuated between CHF 2.4 million and CHF 7.3 million per member of the Executive Board. The relationship between the size and weight of deferred compensation could also be observed for health care equipment and services providers - companies in this grouping were smaller in terms of market capitalization and granted only 24 percent of the compensation package as long-term incentive awards (Figure 8). Four out of ten companies in this sub-industry grouping did not grant long-term incentive awards to other Executive Board members in This pattern is also observable in Figure 9, were most health care equipment and services providers were located in the lower left corner of the graph. Even though long-term incentive awards were common in large companies, an average weighting of this compensation element within the biotech sample was comparable to the pharmaceuticals grouping 44 percent. As illustrated in Figure 9, most biotech companies were located in upper left corner of the graph, indicating median to upper quartile weighting of long-term incentive awards and small market capitalization. As shown in Figure 9, the proportion of long-term incentive awards for other Executive Board members generally increased with the level of the total direct compensation, 12 HCM Health Care Study

13 Average compensation structure, percentage of total direct compensation HCM Health Care (n=27) 40% 24% 36% Biotechnology (n=8) 38% 18% 44% Pharmaceuticals (n=9) 30% 27% 43% Health care equipment and services (n=10) 50% 27% 23% Base salary Immediate variable compensation Long-term incentive awards Figure 8. Average structure of total direct compensation for other Executive Board members, split by sub-industry. Link between the level of long-term incentive awards and the company size Long-term incentive awards (percentage of total direct compensation) 100% 80% 60% 40% 20% 0% 0 10'000 20'000 30'000 Free float market capitalization in CHF million Size of a bubble corresponds to the total direct compensation of other Executive Board members on average (CHF million) 80' ' ' '000 Biotechnology Pharmaceuticals Health care equipment and services Interquartile range Figure 9. Long-term incentive awards for other Executive Board members on average vs. Free float market capitalization as of 31 December HCM Health Care Study 13

14 Variable compensation design Despite the observed variety in pay practices across firms, most executives total direct compensation packages included three components: base salary, annual bonus and long-term incentive awards (LTI). The majority of companies regularly review and benchmark their compensation systems in terms of variable pay design and implement changes to annual bonus and long-term incentive plans. The majority of the companies under review (86 percent) operated one annual bonus plan, while 11 percent disclosed multiple annual bonus plans (mostly related to the separation into regular and discretionary or one-off awards) and only 3 percent did not report operating any annual bonus plan. Long-term incentive awards were granted by 89 percent of the analyzed firms. The majority of these companies operated multiple plans for Executive Board members. Eleven percent of firms did not provide long-term incentive awards to their executive directors. They were all part of the health care equipment and services grouping. In this section we focus on the way the annual bonus and long-term incentive plans are constructed and what payout opportunities are provided to Chief Executive Officers and other Executive Board members. Please note that the sample used in this section may differ from the one in the Compensation Level and Compensation Structure sections and depends on the level of details disclosed about the compensation design. Annual bonus Based on performance results, the annual bonus paid out to a Chief Executive Officer was 120 percent of the base salary on average, while the figure for other Executive Board members stood at around 100 percent of base salary. These results represent a slight increase from the previous year. This growth was mostly attributable to pharmaceutical companies, where increases in annual bonus were observed in absolute terms as well as relative to base salary. In contrast, realized annual bonus has slightly decreased in biotech firms as compared to the previous year. Over the last years, a greater number of companies disclosed target bonus rates, i.e. the annual bonus level expected at 100 percent target achievement. In 2015, the target bonus levels were specified by approximately two thirds of the companies analyzed. The median target bonus for the Chief Executive Officers ranged from 70 to 100 percent of the base salary across the sub-industry groupings (Figure 10). For other Executive Board members, the median target bonus varied between 50 and 85 percent of the base salary in 2015 (Figure 11). Most companies provided other Executive Board members with lower target annual bonus opportunities than for the CEO. The gap between target annual bonus opportunities for CEO and other Executive Board members was typically between zero and 30 percent. Indeed, other Executive Board members were provided with more conservative compensation packages. Annual bonus targets were significantly higher in the pharmaceuticals sub-industry, than in biotechnology and health care equipment and services. Similarly to compensation level, size differences between groupings made a decisive influence on the annual bonus design. Indeed, large companies worldwide tended to construct compensation packages with the highest payout opportunity for CEO and other Executive Board members.3 On the one hand, this allowed the firms to attract the best talents needed to lead a large organization with a superior degree of business complexity and global scope. On the other hand, the Executive Board members in these companies typically faced more challenging business goals commensurate with the leading position of large-sized companies in the market. Maximum annual bonus opportunities in HCM Health Care companies stood at 200 percent of base salary for Chief Executive Officers and at 150 percent for other Executive Board members. This figure fluctuated substantially among sub-industry groupings. The median levels varied from 100 to 200 percent of base salary for Chief Executive Officers and from 90 to 165 percent of base salary for other Executive Board members. Most companies in the HCM Health Care sample capped the maximum payout of annual bonus at percent of the target amount. Similar to annual bonus target, pharmaceutical companies also provided the highest maximum annual opportunity level relative to base salary. As a result of large 3 HCM follows compensation practices with a global scope and covers 17 countries. You can see HCM Global 300 report for further information. 14 HCM Health Care Study

15 Median annual bonus opportunity for Chief Executive Officer, percentage of base salary HCM Health Care (n=22) 100% 200% Biotechnology (n=5) 70% 100% Pharmaceuticals (n=11) 100% 200% Health care equipment and services (n=6) 80% 160% Maximum Target Figure 10. Annual bonus target and maximum opportunity for the role of Chief Executive Officer, split by sub-industry. Median annual bonus opportunity for other EB members, percentage of base salary HCM Health Care (n=21) 70% 150% Biotechnology (n=5) 50% 90% Pharmaceuticals (n=9) 85% 165% Health care equipment and services (n=7) 50% 100% Maximum Target Figure 11. Annual bonus target and maximum opportunity for other Executive Board members, split by sub-industry. HCM Health Care Study 15

16 size and demanding business environment, annual bonus programs in pharmaceutical companies were designed as more performance-sensitive with the rewarding superior performance. Biotech companies provided the lowest payout opportunity in annual bonus plans 100 percent of base salary for Chief Executive Officer and 90 percent of base salary for other Executive Board members, which was lower than in the health care equipment and services grouping. Even though the biotech industry can be regarded as risky and demanding from the management perspective, annual bonus element does not fully address its long-term business goals and was therefore designed with lower payout opportunities. With regard to the key performance indicators (KPIs) used for the annual bonus plans, half of the reviewed companies applied a combination of individual and corporate performance metrics. Individual performance determined between 10 and 100 percent of the total annual bonus awarded to the Executive Board members and was assessed through a mixture of qualitative (e.g., competency, leadership, personal development) and quantitative (e.g., specific project-related objectives) metrics. In general, companies did not disclose the specific details regarding individual targets or their degree of attainment due to competitive reasons. Around 60 percent of the companies used a combination of one to three corporate financial performance metrics for their annual incentive plans in Figure 12 presents the most common performance metrics applied to the Executive Board members when evaluating annual performance at the corporate level in Almost all companies used earnings measures to define annual bonus for Executive Board members. In general, this group of key performance indicators may include net income, operating income, EBITDA, earnings per share, profit before tax, profit margin etc. Among all earnings indicators, operating income and net income were particularly popular in the HCM Health Care sample. Revenue and cash flow measures were also important key performance indicators, which were used by 71 and 32 percent of companies respectively. Both indicators were more often used by biotech firms and health care equipment and services providers, than in the pharmaceuticals grouping. Annual bonus plans in the majority of pharma companies rewarded qualitative performance of the Executive Board members. Apart from common qualitative KPIs such as leadership and personal development, qualitative performance indicators in the health care sector were typically related to encouraging innovation, enhancing R&D activities and attracting high-quality workforce. There were also a number of industry-specific KPIs, which were included in the Other category, such as the number of products registered and recalled, size and quality of company product portfolio, trials success and acquisitionled growth. There are two common approaches with regard to the payout of the earned annual bonus: it is either paid out shortly after the end of the financial year (immediate variable compensation) or a portion of annual bonus is further deferred, with the payout occurring later in the future. The bonus deferral framework is regarded as an instrument encouraging sustainable growth and ensuring that short-term achievements will not hurt long-term performance results. Only 30 percent of annual bonus plans under analysis applied deferral mechanisms to a portion of the annual bonus earned. The minimum deferral rate required under such annual bonus plans typically ranged between 25 and 50 percent with a three-year vesting period. Figure 13 provides details on an average payout schedule applied to annual bonus plans in Deferral mechanisms can also be perceived as a way to increase the riskiness of the compensation paid to the members of the Executive Board. In line with this conclusion, the portion of annual bonus deferral was above 20 percent on average for the pharmaceuticals and biotechnology groupings and stood only at 6 percent for health care equipment and services. 16 HCM Health Care Study

17 Annual bonus performance measures, percentage of companies Revenue Earnings measures Cash flow Return measures Capital and investments Qualitative performance Overall efficiency Other HCM Health Care (n=28) 71% 96% 32% 4% 7% 46% 11% 25% Biotechnology (n=6) 83% 100% 50% 33% 33% Pharmaceuticals (n=14) Health care equipment and services (n=8) 57% 93% 14% 7% 64% 14% 21% 88% 100% 50% 25% 25% 13% 25% Figure 12. Annual bonus performance measures, split by sub-industry. Annual bonus payout timing, percentage of annual bonus on average HCM Health Care (n=29) 83% 17% Biotechnology (n=8) 76% 24% Pharmaceuticals (n=12) 79% 21% Health Care equipment and services (n=9) 94% 6% Immediate payout Deferred payout Figure 13. Annual bonus payout timing, split by sub-industry. HCM Health Care Study 17

18 Deferred annual bonus was most often converted into blocked or restricted shares with no further performance conditions. The deferred annual bonus plans are further considered as a part of the long-term incentive awards with performance-driven grant levels. Long-term incentive awards The background of the award decision and its size is defined by the funding approach. This decision plays an important role in building an appropriate motivation framework for executives. We distinguish between LTI plans with: performance-driven grant level - financed by realized performance, typically measured on annual basis; budgeted grant level - pre-defined/fixed in terms of an absolute amount or number of shares/units. Figure 14 illustrates the split of long-term incentive awards with regard to funding decision. Budget-driven long-term incentive awards were most typical among the HCM Health Care companies (75 percent of the plans) in The majority of long-term incentive awards with budgeted grant level were awarded as a value grant fixed monetary amount or percentage of base salary each year. The proportion of plans with performance-driven grant level was the highest (almost 30 percent of LTI plans) in the pharmaceuticals and biotechnology sub-industry groupings. This figure reached only 14 percent for health care equipment and services providers. When considering the vesting of LTI awards, we distinguish between: awards with time-based vesting plans, in which payout is subject to service conditions (deferred cash, restricted shares, stock options), or awards without additional constraints (blocked shares); awards with performance-based vesting plans, in which payout depends on the achievement of predefined targets, often in addition to service conditions. Figure 15 summarizes the structure of long-term incentive awards with regard to payout conditions. Results are split in performance-driven and budgeted grant levels reflecting an opposite approach to designing LTI plans. When only plans with performance-based grant level were considered, 73 percent of the awards would have been granted with time-based vesting. Indeed, some companies see it as unnecessary to embed the performance-based vesting conditions into the LTI plan, when superior performance is already required at the grant stage. However, when only plans with budgeted grant level were considered, most companies would grant performancebased awards only. The prevalence of awards with performance-based vesting was also relevant for all subindustry groupings. Moreover, 16 percent of firms in the HCM Health Care sample (mainly the largest pharma companies) used a combination of performance-based and time-based LTI awards. Awards with time-based vesting With regard to time-based long-term incentive awards, the following instruments may be differentiated: deferred cash, blocked shares, restricted shares and stock options. Figure 16 depicts the utilization of time-based long-term incentive instruments among sub-industry groupings. Restricted share plans generally prevailed among the timebased long-term incentive instruments employed by the HCM Health Care companies (73 percent of plans), while stock options were utilized only in 14 percent of cases. Occasionally, the plans were also based on deferred cash or blocked shares awards (4 and 9 percent respectively). The instruments used for time-based long-term awards differed slightly among sub-industries. Notably, half of the plans employed in the health care equipment and services grouping contained stock options, while in the other half restricted share awards were used. Firms in other sub-industries mostly granted restricted shares more than 70 percent of plans in both biotechnology and pharmaceuticals groupings. Both sub-industry groupings used blocked shares in around 10 percent of cases. Pharmaceutical companies also used stock options (18 percent), while biotech firms opted for deferred cash in 11 percent in their time-based plans. Restricted shares awards so called pay for stay plain equity instruments with vesting solely subject to service 18 HCM Health Care Study

19 Split of long-term incentive awards with regard to funding decision HCM Health Care (63 plans) 25% 75% Biotechnology (18 plans) 28% 72% Pharmaceuticals (31 plans) 29% 71% Health care equipment and services (14 plans) 14% 86% Long-term incentives with performance-driven grant level Long-term incentives with budgeted grant level Figure 14. Split of long-term incentive awards with regard to funding decisions, split by sub-industry. Utilization of different long-term incentives, percentage of companies 18% 16% 13% 9% Performancedriven grant level Budgeted grant level 73% 71% Awards with time-based vesting Awards with performance-based vesting A combination of both Figure 15: Utilization of time-based and performance-based long-term incentive awards (percentage of companies). HCM Health Care Study 19

20 conditions commonly vested after a waiting period of two or three years. Around 60 percent of restricted share plans were subject to additional claw-back provision, i.e. a contractual agreement under which the staff member is obliged to repay the amount of compensation to the company in certain cases, such as involvement in fraudulent behavior, material misstatement of a company s accounts, etc. Stock options continued to be used in long-term incentive plans among the HCM Health Care firms. Stock option awards had a three-year vesting period at median followed by an exercise period of 2 to 7 years. Fully taxed but blocked for sale shares implying immediate transfer of ownership, had a sale and/or pledging restriction reaching ten years. Deferred cash typically vested in one year after grant. Both blocked shares and deferred cash instruments were the least used by the health care companies. Around 55 percent of all time-based long-term incentive plans analyzed additionally included a claw-back provision. Forfeiture clauses, under which unvested awards may be cancelled in case of early employment termination or misconduct, were disclosed under 70 percent of all timebased long-term incentives. Awards with performance-based vesting Performance-based awards include performance cash, performance shares/units and performance options. Performance shares/units were overall the most utilized (73 percent of all plans reviewed) long-term incentive instruments among the HCM Health Care companies (see Figure 17). The utilization of performance-based instruments varied across sub-industries. Pharmaceutical companies mostly used performance shares/units (80 percent of the plans), while performance options (15 percent) and performance cash (5 percent) were granted less often. In biotech firms, 89 percent of plans were also performance share/ unit plans, while the rest was granted as performance options. In case of health care equipment and services providers, performance shares/units represented only half of the plans, closely followed by performance options (42 percent). Performance cash instrument was used in 8 percent of plans in this sub-industry grouping. The typical vesting period varied by instrument. Performance cash and performance shares plans most often had a three-year vesting period, while performance options vested on average after a four-year performance period followed by an exercise period of 3-4 years. The number of performance conditions driving the vesting was typically one (44 percent of the plans) or two (25 percent of the plans) and a maximum of five. The most widely applied performance metric (64 percent of companies) was Total Shareholder Return (TSR), mostly measured on a relative basis. The TSR was often applied solely or in a combination with revenue and earnings indicators. Operating income and revenue measures were also popular among health care companies they were used in 25 percent of all plans. Sixty percent of plans with performance-based vesting had the payout capped at 100 percent of the granted award, thus providing only the potential of a malus adjustment. The remaining 40 percent of performance-based plans also rewarded over-achievement of performance targets with the potential for both bonus and malus adjustments. For these plans, the overall maximum payout opportunity was twice the granted award at median. The majority of the companies (96 percent of reviewed plans, excluding plans with performance cash) limited the maximum payout opportunity in terms of the number of vested shares/units rather than the absolute granted amount. Forfeiture clauses, under which unvested awards may be cancelled in case of early employment termination, were disclosed under 85 percent of all performance vesting long-term incentives. Half of all performance-based long-term incentive plans analyzed additionally included a claw-back provision. In general, the number of firms disclosing claw-back feature for long-term incentive awards has significantly increased over the last few years. 20 HCM Health Care Study

21 Time-based long-term incentive instruments, percentage of plans HCM Health Care (n=22) 4% 9% 73% 14% Biotechnology (n=9) 11% 11% 78% Pharmaceuticals (n=11) 9% 73% 18% Health care equipment and services (n=2) 50% 50% Deferred cash Blocked shares Restricted shares Stock options Figure 16. Time-based long-term incentive instruments, split by sub-industry. Performance-based long-term incentive instruments, percentage of plans HCM Health Care (n=41) 5% 73% 22% Biotechnology (n=9) 89% 11% Pharmaceuticals (n=20) 5% 80% 15% Health care equipment and services (n=12) 8% 50% 42% Performance cash Performance shares / units Performance options Figure 17. Performance-based long-term incentive instruments, split by sub-industry. HCM Health Care Study 21

22 Equity ownership guidelines Companies often use equity ownership requirements that oblige executives to hold a predefined minimum amount of stock in the company to ensure that the interests of the Executive Board members are more closely aligned with those of the shareholders. In 2015, 12 companies disclosed equity ownership policies for their Executive Board members. The majority (11 firms) expressed the stock ownership requirements as a multiple of the executives base salary. One company required a certain number of shares to be held. Figure 18 summarizes equity ownership requirements applied in The median estimated value of the required stock ownership in 2015 was CHF 4.5 million for Chief Executive Officer and CHF 1.5 million for other Executive Board members. Executives were expected to reach the required shareholding level within three to five years (four years at median) following their appointment. In some cases, the value of required stock ownership was not the same for other Executive Board members of one company and differed with regard to function. The types of shares that count towards the guidelines typically included directly owned shares and vested equity awards. One company disclosed the penalty for not satisfying the guidelines, which was an increased deferral rate of annual bonus awards. Four of the companies analyzed used extended blocking periods instead of, or in addition to, the traditional ownership requirements. Under an extended blocking period term, Executive Board members were required to hold vested performance or restricted shares for an additional period ranging from two to four years. In addition to equity ownership guidelines, many companies introduced the restriction of sale or purchase of shares during a specific time frame. These so-called blackout periods are typically in conjunction with earnings announcement date. 22 HCM Health Care Study

23 Equity ownership guidlines Stock ownership requirement in CHF million CEO Other EB members Median Interquartile range Stock ownership requirement type 8% 92% Number of shares Multiple of base salary Multiple of base salary: stock ownership requirement as percentage of base salary CEO 10% 300% 500% Other EB members 10% 200% 500% Median Minimum - maximum Build up period, years Median Minimum - maximum Figure 18. Equity ownership guidelines. HCM Health Care Study 23

24 OVERALL VIEW ON EXECUTIVE COMPENSATION Figure 19 depicts the relationship between the weighted average duration of the compensation package and its sensitivity to the long-term company performance, as well as the size of compensation allocated to the Executive Board members on average. A direct relationship between the amount of total direct compensation and its duration can be observed. In other words, the more executives are paid, the less immediate such compensation is. Most companies with significant compensation packages are located in the right-hand part of the graph, corresponding to an above median duration. Generally, the Executive Board members waited from 8 to 24 months (16 months at median) for the payout of their total direct compensation, when the lower and upper quartiles are considered. When looking at sub-industry groupings, the majority of pharmaceutical companies granted the compensation with a duration above median. Executives in most biotech companies had to wait more than 12 months for their compensation to be released. The Executive Board members of health care equipment and services providers received total direct compensation with a duration below median (8 months). The sensitivity of executive pay to long-term company performance also increased with the size of the allocated total direct compensation. The sensitivity va ried between 70 sensitivity p o i n t s ( l ow e r qu a r t i l e ) an d 157 sensitivity points (upper quartile) for most of the firms analyzed. Companies granting higher levels of total direct compensation generally designed the packages to be comparable with the sensitivity of a pure equity pay solutions such as blocked shares (100 sensitivity points), restricted shares (155 sensitivity points) or performance shares (180 sensitivity points). The remuneration of the Executive Board members in many pharmaceutical companies was highly sensitive (above median). This was directly correlated with the size of total pay granted. Smaller biotech firms reported a similar sensitivity level, since companies in this grouping have also relied heavily on equity instruments in their compensation structure. However, no such pattern can be observed in health care equipment and services grouping, where half of the firms granted compensation packages with zero sensitivity level. 24 HCM Health Care Study

25 Sensitivity and duration of total direct compensation 300 Interquartile range FRESENIUS MEDICAL CARE NOVOZYMES Sensitivity, in points MERCK FRESENIUS SE SANOFI GN STORE NORD COLOPLAST RECORDATI UCB LONZA BTG NOVO NORDISK GRIFOLS SONOVA NOVARTIS MORPHOSYS ACTELION INDIVIOR QIAGEN ASTRAZENECA GENMAB ESSILOR SMITH & NEPHEW HIKMA PHARMACEUTICALS SHIRE GLAXOSMITHKLINE ROCHE Size of a bubble corresponds to the total direct compensation of Executive Board members on average (CHF million) Interquartile range Weighted average duration, in years Biotechnology Pharmaceuticals Health care equipment and services Figure 19. Sensitivity, duration and level of total direct compensation for the Executive Board members on average. HCM Health Care Study 25

26 TERMINOLOGY Base salary Annual salary received over a 12-month period excluding any other payments or allowances. Total annual bonus Actual annual bonus paid (to be paid) for the considered financial year including any deferred portion of the annual bonus. Immediate variable compensation Actual annual bonus paid (to be paid) for the considered financial year as well as any allocated unblocked equity awards or a portion of the equity award with the vesting period not exceeding 12 months. Long-term incentive awards Variable awards, where the blocking/vesting period is longer than 12 months comprising: Deferred cash Contingent rights to cash payment with the vesting subjected to the satisfaction of continued employment. Blocked shares Fully taxed shares subject to a blocking period during which they cannot be sold. Restricted shares Contingent shares with the vesting subject to the satisfaction of continued employment. Performance shares/units Contingent rights to shares/units with the vesting subject to the satisfaction of continued employment and performance targets achievement. Performance options Contingent rights to buy shares at some point in the future at a specified price subject to the satisfaction of performance targets. Total direct compensation The sum of immediate compensation and long-term incentive awards. Weighted average duration of the total direct compensation, in years All elements of the total direct compensation have been considered depending on their vesting periods and schemes as described in annual reports, with zero duration assigned to immediate compensation. Sensitivity of executive compensation to company performance, in points HCM has developed a rating system with zero sensitivity points for immediate cash awards, 100 sensitivity points for fully taxed but blocked shares, and 350 sensitivity points for deferred instruments with a maximum pay-out opportunity of at least 200 percent; all other plans are assigned with zero to 350 sensitivity points accordingly. Stock options Contingent rights to buy shares sometime in the future at a specified price. Performance cash Contingent rights to cash payment with the vesting subjected to the satisfaction of continued employment and/or performance targets achievement. 26 HCM Health Care Study

27 NOTES HCM Health Care Study 27

28 ABOUT THE AUTHORS Olga Beregova Partner, Head Operations Olga Beregova has over 12 years of professional experience in consultancy in the fields of corporate governance, corporate finance and Board/executive compensation. She has successfully steered extensive compensation and governance changes for private companies, national and international public companies in different industries. As Head Operations Olga Beregova successfully manages a team of research analysts and consultants dealing with economic research, company performance analysis, corporate valuation, calibration of short- and long-term variable compensation plans, including the assessment of risk/payout profiles and fair value estimates. Olga Beregova holds a Master s degree in Finance and Capital Markets from University of Zurich and in Linguistics from Kyiv State University of Foreign Languages. olga.beregova@hcm.com Anastasiia Medianovska Analyst Anastasiia Medianovska is a research analyst primarily dealing with the analysis and evaluation of executive compensation frameworks, including assessment of risk/ payout profiles and calibration of short- and long-term variable compensation plans. Ms. Medianovska holds a Master of Science in Finance from the Universities of Neuchatel, Lausanne and Geneva, as well as a Master s degree in International Economics from Kyiv National Economic University. She passed all three levels of the CFA Program and may be awarded the charter upon completion of the required work experience. anastasiia.medianovska@hcm.com 28 HCM Health Care Study