Research Findings Report on FTSE Small Cap Directors Remuneration

Transcription

1 Research Findings Report on FTSE Small Cap Directors Remuneration 2009/10

2 Report on FTSE Small Cap Directors Remuneration 2009/10 Contents Review of 2008/09 and Likely Future Trends 3 7 Key Statistics 8 Base Salary 9 11 Annual Bonus Long-Term Incentives The Total Package: Quantum and Balance Pension Contracts 31 Non-Executive Directors Methodology 34

3 Review of 2009 and Likely Future Trends There has been great focus on executive pay over the last year as companies have had to take account of the economic downturn and investors and regulators have voiced their concerns over undue risk-taking and rewards for failure. Investors are scrutinising remuneration packages and policies like never before. Investor bodies are criticising salary increases, levels of bonus payments and longterm incentive awards in companies where profits have fallen and shareholders have lost value. Many investor bodies have published guidance on what they expect companies to be doing in the current economic circumstances. Regulators have also reacted rapidly to the downturn, particularly in the financial sector. The FSA s Code of Practice and the Walker Review have severely criticised elements of existing remuneration practices. These reviews may result in a tougher regulatory regime and, if incorporated within the Combined Code, their impact will be felt more widely. In addition, proposed EU regulations may introduce further checks and balances. So how have companies reacted? This report shows that the majority of FTSE Small Cap companies froze salary levels in 2009 and reduced their bonus payments. Indeed, it appears FTSE Small Cap companies have controlled remuneration levels to a greater degree than larger companies, perhaps reflecting their greater need to reduce costs in order to protect the bottom line in uncertain trading conditions. Against this backdrop, this year s FTSE Small Cap survey offers guidance on the key market trends over the past year (and highlights differences to FTSE 250 practice), along with our thoughts on the likely changes to come over the next year. 3

4 Key Trends from the Past Year Shareholder activism Base salary Annual bonus Long-term incentives Shareholders are scrutinising all elements of remuneration and are more likely than before to oppose any material changes in pay structures (particularly where the change results in an increase in remuneration) when profits and shareholder value have fallen. This led to fewer companies seeking shareholder approval for new incentive arrangements as compared to previous years. Increased shareholder activism is evidenced by the fact that over a third of FTSE Small Cap companies received either an amber-top or red-top from the ABI for their Remuneration Report or new incentive scheme last year was the year of the salary freeze. Focussing on those companies that disclose 2009 pay settlements (rather than what was paid in 2008/09), nearly 80% of FTSE Small Cap companies disclosed a salary freeze for the Highest Paid Director (see Chart 1), a similar percentage as in the FTSE 250. A small number of companies actually reduced salaries, with some executives waiving salary increases. Companies that did increase salary levels attracted significant flak from the investor community. Bonus payments also fell. The median bonus payment to FTSE Small Cap CEOs was 30% of the maximum potential (see Chart 2), compared to over 65% in the previous year. The median bonus payment to CEOs in companies with a December 2008 year-end was 30% of the maximum. However as the downturn continued, the median bonus payment for CEOs in companies with a March 2009 year-end was even lower at around 15% of the maximum. This compares to a median in the FTSE 250 of 70% of the maximum for December 2008 year-ends and 30% for March 2009 year-ends. To take account of investor concerns in this area, some executives voluntarily waived part or all of their bonuses or agreed to defer part of the cash element of their bonus into shares. As regards the structure of annual bonuses for 2009/10, we have seen a few instances of the maximum bonus opportunity being reduced to take account of lower profit expectations. However, in most cases the bonus maximum has been left unchanged, with companies taking account of lower profits by setting more challenging targets relative to the (lower) budget. The type of long-term incentive arrangements operated have not changed over the last year, with Performance Share Plans ( PSPs ) remaining the most popular form of long-term share award for FTSE Small Cap companies (see Chart 3). There is some evidence of companies lowering share award levels for 2009, as a percentage of salary, to take account of lower share prices. In an admittedly limited sample of those that disclosed their LTIP policy for 2009 (only 17% of the FTSE Small Cap), nearly 45% disclosed a policy of lower grant sizes for 2009 than 2008, with the typical reduction being around 45% of the face value. Setting appropriate performance conditions has been challenging. A number of companies have adopted lower EPS growth targets, reflecting their lower earnings growth projections. A few others, faced by the current difficulty in setting robust three-year earnings targets, have moved away from EPS one of the more popular approaches here has been increasing the weighting on TSR. 4

5 Chart 1. Increases in Post Year-End Salary (where Disclosed) for the Highest Paid Director 80% % 60% 50% 40% 30% 20% 10% 0% <0% 0% 0.1% 5% 5.1% 7.5% 7.6% 10% >10% 2008 data relates to 31 December 2007 to 31 March 2008 year-ends 2009 data relates to 31 December 2008 to 31 March 2009 year-ends Chart 2. Median Actual Bonus Paid to the Highest Paid Director as a % of the Maximum: % 70% 60% 50% 40% 30% 20% 10% 0%

6 Key Trends from the Past Year Chart 3. Types of Long-Term Incentives Available to Senior Executives 50% 45% FTSE Small Cap FTSE Small Cap Top half FTSE Small Cap Bottom Half 40% 35% 30% 25% 20% 15% 10% 5% 0% PSP Only Other Sole LTI Only (Options or SMP) PSP & SMP PSP & Options Other Combination 6

7 The Year Ahead Making firm predictions about the direction of executive pay is inherently risky, particularly at the present time. However, we set out below a number of themes that we anticipate being important over the coming year: 1. Limited Salary Increases in Many companies will still consider it appropriate to conduct benchmark reviews to ascertain whether current pay levels are appropriate. However, we do not envisage the past trend of above inflationary salary increases returning. The widespread salary freeze of 2009 may thaw to a degree, but we anticipate executive salary increases for 2010 to generally not exceed inflation and/or workforce pay settlements. 2. Annual Bonus. If above target bonuses are paid this year, generally we would expect investors to raise more questions about the robustness of bonus structures and demand significantly enhanced disclosure on bonus targets, at least at the year-end. 3. Managing Risk. The need for better risk management has been a central conclusion from the recent regulatory reviews. We expect to see a greater use of risk-adjusted performance measures, more deferral of payments and an increase in clawback to protect against the payment of bonus for illusory short-term performance. Also, Remuneration Committees are likely to insist on processes by which they can ensure that undue risk-taking is not encouraged by the pay policy (e.g. through regular meetings with the Audit Committee/Risk function). 4. Long-Term Incentives. The choice of performance conditions and the level of award will become issues to be reviewed on an annual basis (if this is not already the case). Further, we expect more companies are likely to seek approval for completely new plans in 2010, particularly in companies facing retention pressures (due to the lack of value that is likely to be delivered through past awards) and/or where the business strategy has been revised. 5. Tax-Efficiency. The wide differential between the rates of income and capital gains tax from next April may lead to more companies considering a range of alternative structures to the traditional LTIP, with the aim of shifting rewards into the capital gains rather than the income tax regime. Despite the potential downsides of such structures (such as irrecoverable tax charges, reduced company corporation tax deductions and the risk of a future increase in capital gains tax), we expect that the potential relative savings will encourage some companies to adapt their existing LTIPs in a more tax-efficient manner. 6. Alternatives to Pensions. Forthcoming tax changes in 2010 and 2011 will result in companies exploring the viability of potentially more tax-efficient choices for their senior executives (such as employer-financed retirement benefit schemes or the use of trusts). 7. Service Contracts. We believe that shareholders wanting to avoid any reward for failure scenario will apply more pressure for enhanced disclosure of entitlements on the departure of an executive, for a further reduction in notice periods (say from twelve to six months) and/or a tightening of the basic entitlement on departure (to, say, base salary and benefits but not bonus). 8. Non-Executive Fees. It is generally accepted that there will be enhanced responsibilities and time commitment required from Non-Executive roles (particularly those of Committee Chairmen). As a result we would expect fee levels for such roles to rise commensurately, albeit not necessarily in the short-term. 7

8 Key Statistics Base Salary Of those FTSE Small Cap companies that disclose recent pay settlements, around 80% froze salary levels in 2009 (similar to the FTSE 250). The median salary of FTSE Small Cap Highest Paid Directors is around 325,000 ( 445,000 in the FTSE 250). The corresponding figures in the top and bottom halves of the FTSE Small Cap (by market capitalisation) are around 335,000 and 310,000 respectively. The median salary of FTSE Small Cap Finance Directors and Other Executive Directors is around 215,000 ( 295,000 and 270,000 respectively in the FTSE 250). Annual Bonus The median annual bonus potential for Executive Directors is 100% of salary (unchanged from the previous year and the same as the FTSE 250). Actual bonuses paid to all Directors in 2009 at the median were around 25% of salary. This compares to around 50% of salary in Nearly 25% of companies require part of the bonus to be deferred in shares for a period of time (typically three years). Long-Term Incentives The most common approach is the sole operation of a Performance Share Plan (around 45% of companies), although 25% still operate option plans. FTSE Small Cap Highest Paid Directors typically receive long-term incentive awards with an expected value of around 55% of salary (compared to 80% for a FTSE 250 Highest Paid Director). This broadly equates to an LTIP award with a face value of 100% of salary or an option grant of 275% of salary (broadly unchanged from the previous year). EPS and TSR remain the most common measures used in long-term incentive arrangements. 40% of companies have a formal shareholding guideline. The median level of shareholding required is 100% of salary for Executive Directors. Pensions Defined Contribution pension plans remain the most common approach for Directors (60% of Directors). The median contribution to a Defined Contribution plan is around 15% of salary, whilst the median cash salary supplement is around 20% of salary (although the difference in contribution rates between these two types of arrangements is more due to a difference in the constituent companies rather than there being a compelling rationale for higher cash supplements). Total Remuneration Target total remuneration for Highest Paid Directors is around 745,000 ( 1.2m in the FTSE 250). For Finance Directors and Other Directors it is 455,000 and 440,000 respectively ( 740,000 in the FTSE 250). Balance of Package Variable pay (i.e. annual bonus and long-term incentives) accounts for around 40%-45% of a typical FTSE Small Cap Executive Director s remuneration package (compared to 25% in 2003 and 55% in the FTSE 250). Approximately 50% of variable pay relates to long-term performance (60% in the FTSE 250). Service Contracts Service contracts containing notice periods of 12 months are now the norm. However, 15% of FTSE Small Cap Directors have notice periods of less than 12 months. Less than 25% of contracts have liquidated damages clauses. Of these, 35% disclose the inclusion of bonus in the calculation of the termination payment. Non-Executive Directors The median Non-Executive Chairman s fee is 100,000 ( 150,000 in the FTSE 250). Typically, fees for other Non-Executive Directors range between 35,000 and 40,000 depending on their role ( 40,000-50,000 in the FTSE 250). 8

9 Base Salary Key Points to Note Around 80% of FTSE Small Cap companies which disclosed their pay settlement for 2009 disclosed a salary freeze for the year. Finance Directors salaries tend to be around 65% of their CEO s salary. Executive Committee level roles tend to receive salaries around 70% of their Finance Director s salary. Rates of Increase In response to the economic downturn, around 80% of FTSE Small Cap companies froze salaries for disclosed pay settlements for This compares to 80% in the FTSE 250 and 60% in the FTSE 100. Chart 4. Increases in Post Year-End Salary (where Disclosed): 31 December March 2009 Year-Ends Only 100% 90% Highest Paid Director Finance Director 80% 70% 60% 50% 40% 30% 20% 10% 0% Reduction 0% 0.1% 5% 5.1% 7.5% 7.6% 10% 9

10 Base Salary Salary Levels Table 5 sets out a quartile analysis of Executive Directors salary levels and Table 6 sets out data on Executive Committee level roles. Due to the economic downturn, some companies have fallen in size and their pay reflects their old, rather than current, size. This results in some anomalies such as the fact that the median salary for Other Directors and Operational Directors in the top half of the FTSE Small Cap is lower than in the bottom half. Table 5. Quartile Analysis of Base Salary FTSE Small Cap FTSE Small Cap Top Half FTSE Small Cap Bottom Half LQ M UQ LQ M UQ LQ M UQ Highest Paid Director 267, , , , , , , , ,000 Finance Director 183, , , , , , , , ,000 Other Directors 180, , , , , , , , ,000 Operational Directors 186, , , , , , , , ,000 Functional Directors 171, , , , , , , , ,000 LQ= Lower Quartile; M = Median; UQ = Upper Quartile Table 6. Quartile Analysis of Base Salary for Executive Committee Level Roles FTSE Small Cap LQ M UQ Executive Committee 125, , ,000 10

11 As pay levels vary by size of company, they also differ between industries. Chart 7 shows median base salaries in different industries. We have only set out details for those industry sectors with a reasonable number (i.e. at least six) of executives in post throughout the year. Also, to provide a more meaningful analysis and to reflect the differing size of companies in each of these sectors, the data has been regressed to a common market capitalisation of 150m (the FTSE Small Cap median as at 31 August 2009). Whilst external market data is a useful tool when setting salary levels, internal, company-specific factors also need to be considered (for example, the responsibilities of the executive, the performance of the individual and relativities between posts). As regards pay relativities, typically, FTSE Small Cap Finance Directors and other Director s receive salaries of around 65% of their Chief Executive s (although the actual differential should reflect the specific role and responsibility of the particular Executive Director). Looking at the next tier of executives, salaries of Executive Committee level roles tend to be around 70% of the Finance Director (although, once again, the relationship will be shaped by the specific role and sector). Chart 7. Regressed Base Salary by Industry 400 Highest Paid Director Finance Director Other Directors Consumer Goods Consumer Services Financials Health Care Industrials Technology 11

12 Annual Bonus Key Points to Note Bonuses paid in 2009 fell compared to previous years, reflecting the current economic downturn. The payment to all Directors was typically around 25% of salary (compared to around 50% in the previous year). There was a stark difference between December 2008 year-ends (around 25% of salary) and March 2009 year-ends (around 10% of salary). The median maximum bonus remained unchanged since last year at 100% of salary for Executive Directors. Nearly 25% of companies require part of their bonus to be deferred in shares (typically for three years). Profit and personal performance measures are the most common annual performance metrics. Few companies thus far have disclosed the use of clawback provisions. Maximum Bonus Opportunity Chart 8 shows annual bonus potential over time and Table 9 shows a quartile analysis of bonus potential broken down by role and FTSE Small Cap group. Below Board, the median maximum bonus opportunity for Executive Committee members in FTSE Small Cap companies is 60% of salary. Chart 8. Median Maximum Bonus Potential (as a % of Salary) for the Highest Paid Director: % 100% 80% 60% 40% 20% 0%

13 Table 9. Quartile Analysis of Maximum Bonus Potential FTSE Small Cap FTSE Small Cap Top Half FTSE Small Cap Bottom Half LQ M UQ LQ M UQ LQ M UQ Highest Paid Director 80% 100% 100% 96% 100% 123% 79% 100% 100% Finance Director 75% 100% 100% 75% 100% 118% 65% 80% 100% Other Directors 75% 100% 100% 75% 100% 103% 65% 80% 100% Of the companies that amended their bonus potential over the last year, 10 FTSE Small Cap companies increased their bonus potential (at least for the Highest Paid Director), with the typical increase being 25% of salary. Interestingly, 11 companies reduced their bonus potential (median decrease 25% of salary, no doubt reflecting lower profit expectations). While, in the majority of cases, bonus opportunity appears to be the same percentage of salary for all Directors within a company, a quarter of companies specify a higher maximum bonus as a percentage of salary for the Highest Paid Director compared to the other Executive Directors. In these companies, typically the Highest Paid Director has a bonus potential of 25% of salary more than other Executive Directors. The bonus opportunity also varies between industries (see Chart 10). Again, the data has been regressed to a common market capitalisation of 150m, with only the most represented industries shown. Chart 10. Regressed Bonus Opportunity (as a % of Salary) by Industry 120% 100% 80% 60% 40% 20% 0% Consumer Goods Consumer Services Financials Industrials Health Care Technology 13

14 Annual Bonus Target Bonus Opportunity While 77% of FTSE Small Cap companies disclose their bonus maximum, only around 16% (compared to around 20% of FTSE 250 and 50% of FTSE 100 companies) disclose their on-target level of bonus (which is often delivered for achieving a reasonably stretching budget). The typical on-target bonus is around 50% of the maximum bonus opportunity. Actual Bonuses Paid While bonus opportunity (whether it be target or maximum) is important, so is the level of bonus actually paid, particularly in current economic conditions. Chart 11 shows the median level of actual bonus paid, as a percentage of salary. As can be seen, this increased up to 2008, but fell in 2009 to around 25% of salary, reflecting the economic downturn. In fact, even during 2009 bonus payments fell. The median bonus paid to all Directors in companies with a December year-end was around 25% of salary, but this fell to around 10% of salary in companies with March year-ends. This decline is greater than in the FTSE 250, where bonus payments for all FTSE 250 Directors fell from around 70% of the maximum for December year-ends to around 40% of the maximum for March year-ends. Chart 11. Median Actual Bonus Paid (as a % of Salary): % Highest Paid Director Finance Director Other Directors 50% 40% 30% 20% 10% 0%

15 Table 12 shows the value of total cash i.e. salary and actual bonus paid. At the median, total cash levels are marginally lower than in the prior year, reflecting lower bonus payments. Table 12. Quartile Analysis of Total Cash FTSE Small Cap FFTSE Small Cap Top Half FTSE Small Cap Bottom Half LQ M UQ LQ M UQ LQ M UQ Highest Paid Director 325, , , , , , , , ,000 Finance Director 215, , , , , , , , ,000 Other Directors 200, , , , , , , , ,000 Performance Measures Companies tend to use more than one performance measure in annual bonus plans; often at least two measures are used. Further, a considerably wider variety of measures are used in annual bonus plans than in long-term incentive plans. Chart 13 shows that (i) the most commonly used financial measure is profit, (ii) 40% of companies include an element of personal performance and (iii) around 15% also include non-financial measures. The current economic climate may increase focus on personal and non-financial targets. Some companies may not wish to pay a bonus for the achievement of such metrics if financial targets have not been met. Others may take a contrary view, wishing to ensure that some bonus is payable for achieving non-financial strategic targets even if they fail to achieve hard financial targets. Where personal performance or non-financial metrics are used they tend to be a minority element of the bonus, typically only accounting for 15%-25% of the bonus. Interestingly, over the last year there has also been an increase in the use of cashflow as an annual bonus measure, reflecting the importance now placed by many (particularly highly geared) companies on cash generation. 15

16 Annual Bonus Chart 13. Performance Measures in Annual Bonus Plans 60% % 40% 30% 20% 10% 0% Profit Personal Performance Other Specific Financial Measure Cashflow EPS Non- Financial Measure Strategic EBITDA Turnover Return- Based Measure NAV TSR N.B. Companies may have more than one measure Bonus Deferral Nearly 25% of FTSE Small Cap companies (compared to nearly 40% of the FTSE 250) compulsorily require part of the bonus to be deferred in shares under a Deferred Share Bonus Plan. These plans tend to be structured so that part of the bonus is not paid out in cash immediately but, instead, is deferred into shares which are released at a later date, subject to continued employment but no other performance conditions (as the bonus has already been earned). The most common level of deferral is 50% of any bonus paid and the typical length of deferral is three years (although around 30% of companies allow all or some of the shares to vest sooner). Over 15% of the companies that require part of the bonus to be deferred in shares also grant a corresponding award of matching shares under a Share Matching Plan (see LTIP section). 16

17 Long-Term Incentives Key Points to Note The most common form of long-term incentive in the FTSE Small Cap is the sole operation of a Performance Share Plan (around 45% of companies), although 25% still grant options. A small number (15%) operate a Share Matching Plan. The median expected value of long-term incentive provision is around 55% of salary (i.e. equivalent to a 100% of salary LTIP award or 275% of salary option award). There is evidence that some companies have lowered award levels to take account of lower share prices. EPS and TSR are still the most prevalent metrics used in LTIPs, often in combination. Types of Long-Term Incentives The two main types of long-term incentive arrangement traditionally operated by FTSE Small Cap companies are: Share option plans, under which market value options are granted that vest three years later subject to continued employment and performance conditions; and Long-Term Incentive Plans (or LTIPs ), under which conditional awards of whole free shares are granted which also vest three years later, again subject to continued employment and performance conditions. There are two main types of LTIP: Performance Share Plans, under which conditional awards of shares are made without executives being required to invest in shares themselves; and Share Matching Plans, under which conditional awards of shares are made that match the number of shares invested (using bonus, other monies or shares already held) and retained by the executive in the Plan. Chart 14 shows the split between companies using options and LTIPs over time. It shows that the use of LTIPs is now the norm, as over the last few years companies have shifted away from using options (which are now viewed as a potentially overly-volatile incentive, worthless if underwater and which are typically less efficient than LTIPs from a dilution and accounting cost perspective). 17

18 Long-Term Incentives Chart 14. Types of Incentives Available to Senior Executives: % % 50% 40% 30% 20% 10% 0% Options Only LTIP Only Both Neither 15% of FTSE Small Cap companies operate a Share Matching Plan, typically in tandem with another longterm incentive arrangement. Share Matching Plans are rarely used on their own as the upfront investment in shares tends to be funded via annual bonus (even if other funding routes are available), which may lead to a possible lack of executive lock-in if the bonus for a year is poor (i.e. if there is little bonus to invest, there can be little in the way of matching shares). Also, it could be the case that it is only those who have the financial means to invest that can participate in a Share Matching Plan, which may not necessarily capture the entire executive population that the company wishes to incentivise. 18

19 Award Levels Amongst FTSE Small Cap companies, the median maximum annual limit in face value terms in a Performance Share Plan is 100% of salary and in an Option Plan is 175% of salary. Share Matching Plans are structured slightly differently. Companies tend to disclose the maximum level of match and investment (either as a percentage of the bonus payable or of salary). The most common level of maximum match is 1:1 (50% of companies), with around 25% of companies offering a 2:1 match. The corresponding typical up-front investment in shares on a compulsory basis is around 25% of salary. As companies often operate more than one plan at the same time, it is important to look at the aggregate awards granted each year under all plans. Table 15 shows the actual expected value of awards made (where an award was made, which was typically the case as most companies make regular annual awards). It shows that the median aggregate expected value of awards for Executive Directors in the FTSE Small Cap is around 55% of salary (compared to around 40% the previous year and 80% in the FTSE 250). This equates to an LTIP award of 100% of salary in face value terms, or an option award of 275% of salary. In comparison to Executive Directors, as one would expect, Executive Committee roles receive lower long-term incentive awards with an expected value of around 35% of (a lower) salary, which equates to a face value LTIP grant of 65% of salary or an option grant of 175% of salary. Table 15. Quartile Analysis of Expected Value of Actual Long-Term Incentive Awards Made in the Last Reported Year (as a % of Salary) FTSE Small Cap FTSE Small Cap Top Half FTSE Small Cap Bottom Half LQ M UQ LQ M UQ LQ M UQ Highest Paid Director 44% 56% 84% 52% 56% 83% 42% 55% 87% Finance Director 37% 55% 82% 43% 55% 82% 31% 57% 80% Other Directors 37% 55% 82% 54% 66% 83% 27% 42% 63% There is evidence that some companies are lowering award levels to take account of falling share prices (and the related impact on dilution headroom). Of those that disclosed their 2009 LTIP policy (based on a limited sample of 17% of companies), nearly 45% disclosed a lower policy. The typical reduction was around 45% of the face value. In the FTSE 250 a similar proportion of companies (18%) disclosed their LTIP policy. Around a third of these FTSE 250 companies disclosed a lower policy, with the typical reduction being of a similar level to that in the Small Cap. 19

20 Long-Term Incentives Performance Conditions Chart 16 shows the types of performance conditions used in LTIPs. EPS and TSR remain the most common measures (including when used in combination with another measure). In the vast majority of cases (over 90% of plans) performance is measured over three years and awards vest at the end of the performance period (in around 95% of cases). Around 5% of plans specify an additional holding period for some or all of the award before it can vest. Whilst not fully reflected in the data, a number of companies have amended how their performance conditions are structured. For example, some companies have moved away from EPS, due to the current difficulties in setting robust long-term EPS targets. Some of these companies have introduced an element based on TSR or increased the weighting of the TSR element. A small minority of others have introduced a strategic or cashflow target. Where companies have retained EPS, some have moved from measuring out-performance above RPI to using absolute EPS targets (of Xp to Yp), particularly where actual EPS growth is expected to be modest (or non-existent). Chart 16. Performance Measures in LTIPs 35% % 25% 20% 15% 10% 5% 0% EPS TSR EPS & TSR TSR & Other Profit Other Combination N.B. Companies may have more than one measure Share Price Other 20

21 Charts 17 and 18 show details of how EPS and TSR targets are structured in LTIPs. In LTIPs using an EPS measure, the median performance range is EPS growth of RPI plus 4% p.a. to RPI plus 10% p.a. However, when setting targets, particularly financial targets such as EPS, more consideration needs to be given to the specific circumstances and strategic objectives of the company, rather than to what targets are applied by other companies. A few companies have reduced their EPS targets for future awards to take account of the current environment and likely future performance. However, changing performance conditions for existing awards is rare and requires very robust justification. Chart 17. EPS Targets for Minimum to Maximum Vesting in LTIPs Using an EPS Against RPI Performance Measure 24% 22% 20% 18% 16% EPS > RPI + X% p.a. 14% 12% 10% 8% 6% 4% 2% 0% Each bar represents one plan 21

22 Long-Term Incentives Chart 18. TSR Targets for Maximum Vesting in LTIPs Using a Relative TSR Performance Measure Above Top 10% Top 10% (i.e. upper decile) Between Top 10% and 20% Top 20% (i.e. upper quintile) Between Top 20% and 25% Top 25% (i.e. upper quartile) In LTIPs using TSR, all plans require the company to be ranked at least median for awards to start to vest (at which point typically 25% vests). While upper quartile performance is still the most common level at which awards vest in full, 28% of plans require above upper quartile performance for awards to vest in full. Share Ownership Guidelines 40% of FTSE Small Cap companies now disclose having a shareholding guideline for Executive Directors (compared to only 4% in 2003 and nearly 60% in the FTSE 250). The median level of shareholding required by CEOs and Executive Directors in FTSE Small Cap companies is 100% of salary (the same as in the FTSE 250). That said, around 10% of companies have a higher shareholding requirement for their CEO than other Executive Directors. Where this is the case, the CEO s shareholding requirement is typically 50% of salary higher than that of the other Executive Directors. 22

23 The Total Package: Quantum and Balance Key Points to Note Typically around 40%-45% of FTSE Small Cap Executive Directors packages consist of variable pay, of which around 50% is focused on long-term performance. FTSE Small Cap packages tend to be less highly geared than their FTSE 100 and 250 counterparts. Below Board executives packages are less performance-linked than Executive Directors packages. Quantum Chart 19 shows the total target/expected value of Executive Directors remuneration packages, as well as the breakdown between each element of pay (further details of the methodology we have used to value each element of the package are set out on page 34). Table 20 provides a more detailed quartile analysis of target total remuneration levels and also divides Other Directors into operational and functional roles. Chart 19. Median Target Total Remuneration Salary Benefits Pension On-Target Bonus EV of LTIs Highest Paid Director FTSE Small Cap FTSE Small Cap Top Half FTSE Small Cap Bottom Half Finance Directors FTSE Small Cap FTSE Small Cap Top Half FTSE Small Cap Bottom Half Other Directors FTSE Small Cap FTSE Small Cap Top Half FTSE Small Cap Bottom Half

24 The Total Package: Quantum and Balance Table 20. Quartile Analysis of Target Total Remuneration FTSE Small Cap FTSE Small Cap Top Half FTSE Small Cap Bottom Half LQ M UQ LQ M UQ LQ M UQ Highest Paid Director 522, , , , , , , , ,000 Finance Director 362, , , , , , , , ,000 Other Directors 325, , , , , , , , ,000 Operational Directors 355, , , , , , , , ,000 Functional Directors 312, , , , , , , , ,000 Over the past few years, target total remuneration has increased due to increases in salary and variable pay. Table 21 shows, at the median on a matched sample basis, target total remuneration did not increase last year. Table 21. Median Increases in Target Total Remuneration 2004/5 2005/6 2006/7 2007/8 2008/9 Highest Paid Director 10% 9% 8% 12% 0% Finance Director 10% 10% 10% 11% 0% Other Directors 13% 10% 7% 12% 0% Market capitalisation, in a stable environment, is accepted as one of the key drivers of pay levels. Recent fluctuations in market capitalisation can result in potentially misleading benchmarking results. Therefore, as an alternative, the size of a company can be determined by turnover (which is usually less volatile than market capitalisation). The median turnover of FTSE Small Cap companies is 250m (if financial companies are excluded, for whom turnover is of less relevance). The medians of the top and bottom halves of the FTSE Small Cap ranked in terms of turnover are 450m and 100m respectively. Table 22 sets out quartile analysis for FTSE Small Cap companies for these three groups of companies. Table 22. Quartile Analysis of Target Total Remuneration by Turnover FTSE Small Cap Median 250m FTSE Small Cap Top Half Median 450m FTSE Small Cap Bottom Half Median 100m LQ M UQ LQ M UQ LQ M UQ Highest Paid Director 567, , , , , , , , ,000 Finance Director 369, , , , , , , , ,000 Other Directors 355, , , , , , , , ,000 24

25 While it seems reasonable that the size of the company should have a role to play in determining pay levels, Remuneration Committees should take a rounded view of the size of a job, its complexity and the individual s experience and performance and avoid an overly mechanistic approach to pay setting. This is particularly key during a period of market uncertainty, such as the one we are currently facing, when a company s market capitalisation may be affected by short-term volatility. Ultimately, a commonsense view must be taken. As well as looking at target total remuneration, we have also looked at actual payments based on actual bonus paid and the value of vested long-term incentives. The value of vested long-term incentives relates to the value of LTIP awards that vested and/ or options that were exercised during the year but granted in earlier years (and, in relation to options, what individuals chose to exercise during the year even though they may have become exercisable in earlier years). Chart 23 shows for each Highest Paid Director the variance between the actual total remuneration value and the target level. At the median, actual total pay last year was around 15% below the target level (similar to FTSE 250 and FTSE 100 levels). Chart 23. Actual v Target Total Remuneration for the Highest Paid Director 100% Greater than 100% 80% 60% 40% % from Target 20% 0% -20% Median: -14% -40% -60% -80% 25

26 The Total Package: Quantum and Balance Fixed and Variable Pay Chart 24 looks at the relative weighting between fixed and variable pay, as well as between short-term bonus and long-term incentives. It shows that around 40%-45% of an Executive Director s remuneration package is linked to variable pay (compared to approximately 40% in the previous year and 25% in 2003). Of the variable pay element, around 50% is linked to long-term performance. Larger companies tend to have a larger portion of variable pay in their packages and a greater weighting on long-term performance. In the FTSE 250, 50% of packages tend to consist of variable pay, of which 55% is focussed on long-term performance. In addition, Highest Paid Directors tend to have more variable and long-term performance related pay than other Directors. Chart 24. Fixed v Variable Pay by Role Fixed Pay On-Target Bonus EV of LTIs Highest Paid Director Finance Director Other Directors 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 26

27 Total Remuneration at Target and Superior Performance Our expected value methodology is a robust approach and the most common way of attributing a value to each element of total remuneration. However, to see how gearing in packages can impact on the ultimate value of rewards delivered, particularly given recent observations/criticisms regarding the leverage inherent in Directors packages, it is also interesting to look at the potential rewards that can be delivered assuming different levels of performance. Chart 25 shows the value of packages for target and superior performance for the Highest Paid Director. For target performance, we have assumed 50% of the maximum bonus is awarded, one-third of options vest (where granted), 25% of LTIP awards vest and there is share price growth of 5% p.a. over three years. For superior performance, we have assumed the maximum annual bonus is paid, all share awards vest in full which is accompanied by a share price growth of 10% p.a. over three years. Chart 25 shows the potential leveraging effect of an increased weighting on variable pay, i.e. the greater the variable pay element, the more the package is worth at higher levels of performance. Remuneration at superior performance tends to be around 160% to 170% of the target performance level, compared to 190% in the FTSE 250. While some may argue that this degree of leverage encourages excessive risktaking on the part of executives, in our view, this level of gearing is appropriate if a company has in place robust operational risk controls. Chart 25. Total Remuneration Target and Superior Vesting for the Highest Paid Director Salary Benefits Pension On-Target Bonus EV of LTIs FTSE Small Cap Superior FTSE Small Cap - Top Half FTSE Small Cap - Bottom Half FTSE Small Cap Target FTSE Small Cap - Top Half FTSE Small Cap - Bottom Half ,000 1,

28 The Total Package: Quantum and Balance Executive Committee To provide further context, Table 26 sets out total remuneration data on FTSE Small Cap Executive Committee level roles (i.e. the tier below the main Board), taken from our Executive Total Reward Survey. The median level of total remuneration of an Executive Committee member tends to be around 55% of the Finance Director s package (although in the Finance sector it would be quite common for below Board executives to be paid significantly more than main Board Directors). Further, only around 30% of an Executive Committee member s package is made up of variable pay (compared to over 40% for a Finance Director). Table 26. Quartile Analysis of Total Remuneration for Executive Committee Level Roles FTSE Small Cap LQ M UQ Executive Committee 231, , ,000 28

29 Pension Key Points to Note Around 60% of Executive Directors participate in a Defined Contribution arrangement. The median company Defined Contribution rate is 15% of salary and the median cash supplement is around 20% of salary. Types of Pension Provision Chart 27 shows that the most common pension provision for FTSE Small Cap Executive Directors is the sole operation of a Defined Contribution plan (around 60% of Directors). If we just look at the pension arrangements offered to executives who joined companies, Defined Contribution plans remain the most common (50% of Directors), but there has been a significant increase in Directors not receiving any pension provision (24% of new joiners compared to only 12% of all Directors). There has also been an increase in the use of cash supplements (17% of new joiners compared to 13% of all Directors). Chart 27. Types of Pension Arrangement 70% FTSE Small Cap FTSE Small Cap Top Half FTSE Small Cap Bottom Half 60% 50% 40% 30% 20% 10% 0% Defined Benefit full salary* Defined Benefit plus salary supplement/dc Defined Benefit to cap * Includes Directors that receive separate funded/unfunded arrangements Defined Contribution DC & Cash Cash Only None 29

30 Pension Defined Benefit Plans Whilst some companies are closing Defined Benefit plans for new or all employees (due to the cost implications of their operation), others have tried to limit costs by reducing accrual rates for future service or are requiring executives to increase their contribution. Some companies are also trying to control costs by moving away from final salary Defined Benefit arrangements towards career average plans, i.e. pension is not calculated on the salary at retirement but on the average salary over the individual s career, thereby lowering the pension and the cost to the company. Where a precise accrual rate is disclosed, the most common accrual is 60ths (nearly a third of companies). A significant number of companies state that they provide a pension of up to two-thirds (which could be any accrual rate up to 30ths). Around 10% of companies provide 30ths. Defined Contribution Plans and Cash Supplements Table 28 shows contributions to Defined Contribution plans. The median rate of contribution is around 15% of salary. Where individuals receive only a cash supplement, the median supplement is around 20% of salary. The difference in contribution rates between these two types of arrangements is due to variations in the constituent companies. In fact, it would not be surprising for companies to contribute a lower amount to cash supplements due to the additional national insurance cost to the company of operating such arrangements. The new tax rules relating to pensions are likely to result in many companies reviewing their executives pension provision. The use of employer-financed retirement benefits schemes ( EFRBS ) and trust structures may well become more common. Table 28. Quartile Analysis of Company Defined Contributions and Cash Supplements FTSE Small Cap FTSE Small Cap Top Half FTSE Small Cap Bottom Half Defined Contributions 10% 14% 18% 11% 15% 19% 9% 13% 17% Cash Supplements 13% 19% 23% 13% 19% 23% 14% 19% 21% 30

31 Contracts Key Points to Note Notice periods are almost universally twelve months or less, although only around 15% of Directors have notice periods of less than 12 months. Less than 25% of contracts disclose having liquidated damages clauses. 35% of liquidated damages clauses are disclosed as including bonus in the calculation of termination payments. The vast majority of Executive Directors contracts have a notice period of 12 months (78%). While some shareholders encourage even shorter notice periods, only around 15% of contracts have a notice period of less than 12 months. As most contracts contain 12 months notice periods, the focus of attention is now more on how the termination payment of a departing executive is calculated, particularly in the current economic climate where avoiding rewards for failure is a key concern. Less than 25% of contracts contain liquidated damages clauses (which specifically define upfront the compensation payable on termination). The remainder rely on general principles of mitigation. While there was a time when shareholders favoured liquidated damages clauses, they are now less popular as investors believe they can over-reward a departing executive. Best practice is for only salary to be included when determining compensation payments. However, around 70% of clauses include benefits, 20% include pension and 35% include bonus (where disclosed in company accounts, although disclosure on this issue is poor). Shareholders encourage the use of phased payment of compensation as this can ensure that mitigation is taken into account, with phased payments ceasing as and when the departed executive finds alternative employment. However, only 2% of contracts disclose phased payments, although disclosure on this issue appears to be poor. We are also seeing a decline in contracts containing enhanced rights on a change of control (either to an increased notice period or a larger liquidated damages payment) in response to shareholder criticism of such provisions. Only 9% of FTSE Small Cap Executive Directors currently have enhanced protection on a change of control. 31

32 Non-Executive Directors Key Points to Note The rate of Non-Executive Director fee increases (if not the fees themselves), like executive salary increases, has fallen over the last year. Over 60% of companies specify base and additional committee fees. Table 29 provides a quartile analysis of Non-Executive Directors fee levels in FTSE Small Cap companies, divided between Non-Executive Chairmen, Senior Independent Directors, Remuneration Committee Chairmen, Audit Committee Chairmen and other Non-Executive Directors that chair no committees. Many companies now specify base fees and additional fees for chairing a committee or for being the Senior Independent Director. Around 30% of FTSE Small Cap companies adopt this approach and disclose base and committee fees, compared to around 60% of FTSE 250 companies. However, only around 15% of companies disclose paying an additional fee to their Senior Independent Director. Table 29. Quartile Analysis of Non-Executive Directors Total Fees FTSE Small Cap FTSE Small Cap Top Half FTSE Small Cap Bottom Half LQ M UQ LQ M UQ LQ M UQ Non-Executive Chairmen 71, , ,000 78, , ,000 63,000 91, ,000 Senior Independent Directors 35,000 40,000 45,000 35,000 40,000 45,000 35,000 40,000 45,000 Audit Committee Chairmen 35,000 40,000 45,000 39,000 41,000 46,000 32,000 37,000 43,000 Remuneration Committee Chairmen 35,000 37,000 43,000 35,000 38,000 44,000 33,000 35,000 41,000 Non-Executives Chair of no Committees 30,000 35,000 39,000 32,000 35,000 39,000 27,000 34,000 38,000 32

33 These additional fees (which are already included in Table 29 total fee analysis) are set out in Table 30. It is much less common for Non-Executive Directors to receive additional fees for being a member of a committee (less than 5% of companies disclose such a fee). Table 30.Quartile Analysis of Additional Fees FTSE Small Cap FTSE Small Cap Top Half FTSE Small Cap Bottom Half LQ M UQ LQ M UQ LQ M UQ Audit Committee Chairman 5,000 6,000 7,500 5,000 7,100 8,300 5,000 5,100 6,000 Remuneration Committee Chairman 5,000 5,100 7,100 5,000 6,000 7,500 5,000 5,000 6,000 Senior Independent Director 3,000 5,100 7,500 2,800 6,000 7,500 3,000 5,000 6,200 33

34 Methodology The FTSE Small Cap has been struck as at 31 August The median market capitalisation of the Index as a whole is 150m. The top half has a median market capitalisation of 230m and the bottom half of 90m. The Executive Director data has been sourced from public disclosures in Report & Accounts and circulars and includes all March 2009 year-ends. Data has been provided for the: Highest Paid Director either the Chief Executive or the full-time Executive Chairman; Finance Director; and Other Directors i.e. other main Board Executive Directors, excluding Chief Executives, Executive Chairmen and Finance Directors. These Other Directors have been split between Functional roles (e.g. HR, Legal) and Operational roles (e.g. Heads of Divisions). Data on Executive Committee roles has been taken from our participatory Executive Total Reward Survey. Target total remuneration has been calculated on an expected value basis. By this, we mean that a value has been attributed to each element of an executive s package. Table 31 sets out the assumptions used to calculate total remuneration. Only executives who have been in post throughout the relevant financial year have been included. Table 31. Calculating Target Total Remuneration Salary Benefits Pension On-target bonus Expected value of long-term incentives (EV of LTIs) Total remuneration Reported current salary or salary paid in the prior year. No ageing factor has been applied due to general salary freezes in Reported cash value. Defined contribution plans or cash supplements company contribution as a percentage of salary. Defined benefit plans an annual value has been calculated using actuarial assumptions based on each individual s accrual rate, retirement age, pension increase post-retirement and employee contribution (assuming an average age of 50). On-target bonus as a percentage of salary, if disclosed. If not disclosed (as is the case in around 85% of companies), then we have assumed an on-target bonus of 50% of the maximum bonus potential. If neither the on-target nor maximum is disclosed (the case in around 25% of companies), then we have used the actual bonus paid last year as a percentage of salary. Based on the company s grant policy, if disclosed (as it is in around 15% of cases) or the actual awards of options and LTIPs made in the last reported year as a percentage of salary. We have then applied an expected value for options 20% of the face value, for free share awards with performance conditions (i.e. LTIPs) 55% and for free share awards without performance conditions 100%. Salary + benefits + pension + on-target bonus + expected value of long-term incentives. 34

35

36 Hewitt New Bridge Street is the UK s leading executive remuneration consulting firm. We have a single focus to assist companies design and implement executive remuneration policies that will help them meet their business objectives. We are a multi-disciplinary team, combining the professional skills of accountants, lawyers, reward experts, investor relations specialists and actuaries. We are a named adviser in the Directors Remuneration Report of around 120 FTSE 350 companies and over 60 FTSE Small Cap companies, making us the most named adviser in both indices. We are part of the HR Consulting business of Hewitt Associates, the world s leading HR consultancy with over 24,000 associates in over 40 countries providing advice to our clients on a range of reward, executive remuneration, HR, pension and outsourcing issues. If you wish to find out how we can help you, please contact us. Hewitt New Bridge Street 6 More London Place, London SE1 2DA Tel: hnbs@hewitt.com Website: Hewitt Associates Limited This publication is designed to provide a summary of the main aspects of the subject matter covered. It does not purport to be comprehensive or to render advice. No responsibility can be accepted for loss occasioned to any person acting or refraining from acting as a result of any statement in this publication. SB1717