Perspectives. More annual bonuses in deferred shares. Deferred shares. A solution to executive remuneration alignment?

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1 Perspectives More annual bonuses in deferred shares A solution to executive remuneration alignment? Deferred shares Body Text Bold: Body Text: 9/12 Black aecenas orci ante, ultricies quis fermentum id, condimentum a lectus. Quisque vel magna diam, vitae tempor elit. Vestibulum ante ipsum primis in faucibus orci luctus et ultrices cubilia. a partial solution to executive remuneration alignment?

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3 Deferred shares a partial solution to executive remuneration alignment? Introduction The banking crisis and the subsequent decline in the FTSE All-Share Index has sparked a heated debate about whether current remuneration structures have been a contributory factor to the current economic situation. Were executives too focused on their annual bonuses? Was their pay aligned sufficiently with longer-term sustained performance? Recent academic studies of remuneration design and company performance in the recession are far from conclusive in proving any direct causal link. The debate has, however, prompted many remuneration committees to consider whether a higher proportion of executive remuneration should be: more long term (that is, only realisable beyond the typical annual and three-year performance cycles used for short- and long-term incentive schemes in the UK); and more in the form of shares rather than cash. As part of Towers Watson s research programme with Professor Brian Main of the Edinburgh University Business School, we have examined the potential impact of these design changes on the realised remuneration of executives. Does the deferral of part or all of annual bonuses into shares and longer-term holding of shares (so called career shares ) bring about a better alignment of executives with long-term shareholders? Deferring bonuses into shares The report by Sir David Walker on the banking crisis in 2009 suggested that senior executives and management in banks should have a proportion of their annual bonuses compulsorily deferred into shares held for at least three years. Subsequently, the Financial Services Authority mandated such an approach for key employees. Our first study looked at what difference such a policy would have had if it had applied to executives in FTSE 350 companies in each year from 1983 to The study looked at a simple case: Assume a bonus of 100,000 is paid in year zero in respect of performance in the previous year. A third is paid in cash and two-thirds are deferred into the company s shares to vest to the executive at the end of year three. For the element taken in shares it is assumed that the executive would expect to at least cover the prevailing risk-free rate of return over the period to break even. We then asked two questions: For each successive three-year cycle, how much more did an executive get for being in a company with upper quartile total shareholder return (TSR) performance compared with an executive in a lower quartile company? For each successive three-year cycle, what was the balance of winners and losers among those receiving a third in cash with the rest deferred, and those having the annual bonus entirely in cash and putting it into the bank? Deferred shares a partial solution to executive remuneration alignment? 3

4 The payment difference for being a high performer Below in Figure 01 we show the difference in value at the end of the three-year period for the upper and lower quartile TSR performers. The average difference in return between the upper and lower quartiles is 45% i.e. on average, an executive in an upper quartile company received 45% more than one in a lower quartile company. The difference between the top and lowest performers was significantly greater: an executive in the top performing company would have received on average eleven times the value received by the lowest performer. However, the differences between the value received by the upper and lower quartile performers varied dramatically between 75% over one cycle and 23% in another. Our conclusion is that the proposal to defer two-thirds of annual cash bonuses into shares could have a significant impact in aligning the remuneration and interests of executives and longer-term shareholders. Differences are likely to be compounded as longer-serving executives would have deferrals from three separate bonuses exposed to the company s share price at any one time. Figure 01. Present value of annual bonus with two-thirds deferred Present value (base = 100) Upper quartile Median Lower quartile Year 4 Deferred shares a partial solution to executive remuneration alignment?

5 An executive in the top performing company would have received on average eleven times the value received by the lowest performer. The balance of winners and losers While the research shows that executives in high-performing companies clearly receive returns superior to those in companies performing less well, this does not necessarily mean that they are always winners as a result of deferring their bonus into shares. All the executives are exposed to their company s TSR which is affected by the company s financial performance and prospects and by market sentiment in relation to general economic and sector prospects. This shows that when the stock market is buoyant even low performers can gain from deferring into shares. For example, over 90% of deferrals in 1984 and 2004 would have resulted in positive returns, but in 1987 even the upper quartile performers would have been losers by 1990 when the shares vested. A similar pattern emerges for those who received bonuses at the start of 2006 (and suffered the effects of the low early 2009 share prices). Figure 02 below shows, on a year-by-year basis, the percentage of executives who would have received real returns from deferring shares (winners) and those who would have received less than if they had been able to take their bonus entirely in cash and put it in the bank (losers). Figure 02. Winners and losers in deferring two-thirds of annual bonus % of firms observed in year Year Losers Winners Deferred shares a partial solution to executive remuneration alignment? 5

6 But what of banking bonuses? In Figure 03 we show the balance of winners and losers among banking executives if two-thirds of bonuses were deferred for three years. Here we can see that deferral into shares in 2005/2006 (with vesting three years later) would have resulted in losses for the majority of banking executives on the deferred element due to the effects of the 2008/2009 crash. Thus claw-back through deferral into shares would have been achieved. However, 2003 bonus deferrals vesting at the height of the banking bubble would have resulted in all executives experiencing real gains. Figure 03. Banks losers and winners % of firms observed in year Losers Winners Conclusion Our conclusion from this research is that bonus deferral improves alignment with sustained performance, but data dependency of both the award and its vesting remains an issue. Additionally, shareholders would have to accept that, in rising markets executives in poor performing companies may still benefit from share price growth. Conversely, in addition to the specific risks in their companies, executives who are required to defer bonuses into shares would be exposed to market risk. When there is a general share price decline even those performing well relative to the market might suffer absolute losses of value. Thus there is improved alignment with shareholders but the leverage to absolute share price does result in the rising tide of upward market sentiment, rewarding the average as well as the high performer, and the falling tide of recessionary sentiment penalising even the good performers. This will please those who look for rewards for absolute shareholder returns more than it does those who benchmark on a relative basis. However, what is clear, and probably welcome to most shareholders, is that the arrangement unambiguously links outcomes to forward performance and automatically effects a claw-back where one might be appropriate. For a copy of the full research paper please contact: Alex Little alex.little@ Vicky Wright vicky.wright@ 6 Deferred shares a partial solution to executive remuneration alignment?

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8 About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. Towers Watson is represented in the UK by Towers Watson Limited, Towers Watson UK Limited and Towers Watson Capital Markets Limited. The information in this publication is of general interest and guidance. Action should not be taken on the basis of any article without seeking specific advice. To unsubscribe, eu.unsubscribe@ with the publication name as the subject and include your name, title and company address. Copyright 2010 Towers Watson. All rights reserved. TW-EU November Cert no. SGS-COC-O620