Long-Term Incentives Gone Wild?:

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1 Long-Term Incentives Gone Wild?: Lessons Learned and Emerging Trends Jon Burg, Radford Brett Harsen, Radford May 14, 2010 Copyright 2010 Aon Corporation Any use of these Results by non-radford survey participants is prohibited

2 Topics 2009 Recap Current Trends Current Long-term Incentive (LTI) Vehicle Flaws Emerging Innovations Extending Performance to Broadbased Populations Questions and Answers

3 The Roller Coaster Both major indices have rebounded significantly since hitting bottom on March 10, 2009 Past 24 Months Stock Price Performance 0.00% % % % % % % 1/1/08 4/1/08 7/1/08 10/1/08 1/1/09 4/1/09 7/1/09 10/1/09 1/1/10 S&P 500 NASDAQ Composite

4 The Roller Coaster What really happened: Stock option exchanges were more common, but not majority practice 129 in in 2008 Nearly 230 since 2005 The more common strategy was to issue more shares Burn rates went up Number of shares issued per employee went up Value delivered per employee stayed flat/went down Less people receive stock, meaning more was allocated to key talent

5 Challenges With Existing Equity Vehicles Vehicle Stock Options Time-Vested Restricted Stock (or units) Performance Shares (or units) Challenges > Have the potential to deliver value during general market upswings that may not be a result of specific company performance > Vulnerable to falling underwater, threatening retention and morale /2009 was the second big wave of re-pricings that we saw (more than just technology this time) - Inflated overhangs if stock options cannot be exercised > Line of sight challenges for most employees who feel stock price performance is out of their control > Companies need to issue a lot of options to provide any real opportunity for value creation, which is dilutive for shareholders > Restricted shares always have retention value, but they have minimal performance linkage they vest with value whether or not the company has been successful > Retention value can serve as a hook for employees, but there are some employees that may stay who management might otherwise prefer to leave > Traditional measures of tying awards to company performance (e.g. revenue, EPS) create similar line of sight issues for employees as stock options > Entirely dependent on ability to set reasonable goals > Complexity of design often makes them difficult to explain to participants, decreasing their incentive motivation

6 Emerging Innovations Extending Performance LTI to Broad-Based Populations Copyright 2010 Aon Corporation Any use of these Results by non-radford survey participants is prohibited

7 Let s Throw Some Ideas at the Wall and See What Sticks MSUs Long- Term Cash Relative TSR More Granular Performance Shares Enhanced Bonus with Stock Deferral

8 What are Market Stock Units (MSUs)? Grant of stock units such that the number of shares earned is based on the ratio of the company s stock price at the vest date to the stock price at the grant date Target MSU Award (A) Stock Price at Grant (B) Stock Price at Vest (C) Payout Ratio (C/B) Shares Earned at Vest (AxC/B) Scenario 1 (appreciation) 10,000 $10.00 $ % 15,000 Scenario 2 (depreciation) 10,000 $10.00 $ % 5,000 Maximum payouts can be capped (e.g., 200%)

9 Reasons MSUs Are Not Gaining Traction MSUs have no compelling performance story Still only based on absolute stock price performance Delivers value whether stock price increases or decreases No consideration given to how well the company performs vs. peers A simple mix of options and RSUs achieves the same payout curve and functionality To date, only a few organizations have adopted MSUs (e.g., Biogen Idec, Xerox, CarMax)

10 Make Performance Shares More Granular? Linking senior executives to corporate financial and operational goals is appropriate Line-of-site to corporate performance is limited for broadbased employees More granular metrics may include: Business unit financials Project milestones Individual performance Customer satisfaction Quality metrics However, the difficulty of setting reasonable long-term goals and administering the awards is only compounded with increased granularity!

11 What are Relative Total Shareholder Return (TSR) Plans? Grant of stock units such that the number of shares earned is based on stock price performance vs. a peer group or index Sample Relative TSR Award Payout Schedule Awards Earned Upon Vesting MAXIMUM: 33% Above Comparator Group Median 200% For every 1% in above Comparator Group median, payouts increase by 3% of target Comparator Group Median TSR + 1% 103% TARGET: Comparator Group Median TSR 100% Comparator Group Median TSR - 1% 97% For every 1% below Comparator Group median, payouts decrease by 3% of target MINIMUM: 25% Below Comparator Group Median 25%

12 Relative TSR Delivers an Efficient Payout Curve $600,000 Employee Value Delivered Payout $500,000 $400,000 $300,000 $200,000 $100,000 $0 Zone 1 $0.00 $5.00 $10.00 $15.00 $20.00 $25.00 $ ,000 Stock Options 10,000 RSUs 8,000 Relative TSR Units Zone 2 Future Stock Price Zone 3 Zone 1 Downside Provides retention value when options otherwise fall underwater Avoids RSUs straight-lined giveaway often criticized by shareholders Zone 2 Reasonable Upside Greater upside leverage than RSUs Similar to or greater upside than options Zone 3 Outlying Upside Greater leverage than RSUs Does not excessively reward risk, as the outlying upside returns are less leveraged compared to stock options 1 Number of shares of each vehicle compared assumes equal grant date fair value with options valued at 30% of face value, RSUs at 100% and TSR at 125%. TSR payout also assumes peer group annualized return of 10%.

13 Can Relative TSR Work for Broad-Based Employees? Vast majority of current Relative TSR programs are reserved for senior executives However, Relative TSR may be the most viable way to push performance LTI deeper into organizations Cannot fall underwater like traditional stock options (payout is reduced if the stock price falls faster than comparators in a down market, however, a minimum value can be preserved for retention purposes) Provides strong pay-for-performance linkage through the requirement to match or beat comparator companies stock returns Does not depend on ability to establish, track or communicate long-term operational or financial goals Uses publicly-available daily stock price closes entirely transparent metrics for participants and shareholders alike, simplifying administration and removing any subjectivity in measuring performance Carries favorable fixed grant date accounting which does not require cumulative expense changes based on the number of shares that are actually earned, therefore making expense recognition level and predictable

14 In-Depth Historic Research: Relative TSR Would Have Performed Strongly 1 Hypothetical comparisons for All S&P 100 companies studied (each company individually analyzed vs. remaining 99) Two metrics assessed: Compensation Delivery (employee perspective): calculates the amount of value delivered to the award recipient Expense Efficiency (company perspective): calculates the ratio of compensation delivered to the employee vs. Topic 718/SFAS 123(R) expense Compensation Delivery Expense Efficiency Median Amount Standard Deviation (variability) Overall Relative Rank Median Amount Standard Deviation (variability) Overall Relative Rank Stock Options Restricted Stock Relative TSR Best Worst 1 Review our research on

15 Comparator Group Selection is a Challenge More than one peer group may apply to Relative TSR design Smaller Peer Group of Direct Competitors Broader Market Index Comments 1) Who gets an award? 2) What size is the award? Focus on direct labor market Industry/size/maturity Geographic location 3) How to measure performance? Investor portfolio perspective Consistency with CD&A disclosure Broad indices made possible by ready availability of daily stock price data Combination of both small & broad According to Radford s research of over 300 publicly disclosed Relative TSR programs 62% use a custom-defined peer group 46% use a broad index (S&P 500 most popular)

16 Administration and Communication Key to effectively deliver the desired results of an equity award is still getting the employees to fully understand and appreciate the value Relative TSR awards present new challenges on the communication front as it is not as simple to determine the TSR of each company, current rank, and expected payout Financial reporting requires the number of awards that are contingently issuable to be determined at each reporting period (diluted EPS) Same as saying the number of awards to vest Compensation Committees want to know where performance awards stand However, all of these are simpler to address than measuring progress of absolute / relative performance for internal financial metrics since stock prices are known at any point in time

17 Relative TSR is Gaining Traction Radford tracks Relative TSR programs at US companies as disclosed in SEC filings More than 315 since 2005 More than 210 since 2008 alone Predominant metric used for performance share plans in the UK and Australia View our research on:

18 Focusing Equity on High Performers Through Enhanced Bonus With Mandatory Deferrals Simplified example: Company Stock Price: $10.00 Employee Payout Realized Year 0 Year 1 Year 2 Year 3 Scenario 1 Normal Bonus: $30,000 $30,000 Ongoing RSU Award: 3,000 1,000 1,000 1,000 Scenario 2 Enhanced Bonus (2x) $60,000 $30,000 Mandatory Deferral Amount: $30,000 Deferral Converted to RSUs: 3,000 1,000 1,000 1,000 Ongoing RSU Award: NA Good mechanism for weaning off annual equity entitlement mentality (limiting awards to high performers only) Not a good solution for companies that do not have a strong performance-differentiated annual bonus plan

19 Long-Term Cash is Making a Comeback (of sorts) Radford has seen increased rate of inquiries of late However, increase in documented use is hardly measurable Percent of Long-Term Incentive Value Delivered in Cash Radford s Silicon Valley 100 Executive Compensation Study Last Year CEO Prior Year Last Year CFO Prior Year Other NEOs Last Year Prior Year Top 50 5% 3% 5% 4% 4% 4% Smaller 50 Statistically Insignificant (less than 1%) Still presents the same design challenges of performance shares (metric selection, goal setting, performance period determination) Cash scarcity makes it viable for a select few Public companies with limited share reserves/controlling dilution Private companies without equity plans

20 Which Equity Vehicle Aligns With Your Company s Profile and Objectives? Example Company Profile Traditional Startup Mid-Cap/ Developing Market Mid-Cap/ Mature Market Large Cap/ Mature Market Comments Innovative/ Cutting Edge Stock Options Only Restricted Stock Only Mix of Options/RS or MSUs Performance Shares (Corporate) Performance Shares (Granular) Long-Term Cash Relative TSR Emphasizes absolute stock price growth De-emphasizes stock price Retention and ownership in low growth Combines stock price growth incentive with retention/ownership Introduces performance contingencies with company-wide focus Pushes performance to more granular level Requires very accurate goal setting Requires maturity and cash reserves Metric and goal setting design challenges remain Reflects institutional investor perspective (portfolio performance) Maturity of market required for reliable comparator group/index Best Worst

21 Thank You! Questions? Jon Burg, or Brett Harsen, or Copyright 2010 Aon Corporation Any use of these Results by non-radford survey participants is prohibited