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Kay, Watson Wyatt Worldwide. Toggle navigation. New to eBooks. How many copies would you like to buy? Add to Cart Add to Cart. Escalating pay levels and high-profile pay issues, be it in relation to transaction bonuses or ongoing remuneration have prompted unprecedented shareholder attention. The experiences at GlaxoSmithKline and Mannesmann, for instance, have shown this very clearly, and the general consensus is that executive pay needs to be more carefully structured.

Against this backdrop, this article analyses:. General regulatory, legal, tax and other considerations for companies designing an executive pay package. How to design a pay package to balance retention and performance needs. The second part of this feature will examine the retention effect of contractual protections that may apply in the event of the departure of an executive or a change of control. General considerations In a multinational company, the structure of pay packages for local executives is likely to depend upon home country considerations such as:.

Corporate governance rules. Corporate governance rules Corporate governance rules, setting out regulators' and shareholders' expectations on executive pay, are having a significant impact on how companies design executive pay packages.

Fresh scrutiny of executive pay has increased regulation in the UK and the US, and led to new guidelines in countries including France, Germany and The Netherlands with draft guidelines expected in Belgium in June see also Executive compensation disclosure requirements: the German, UK and US. These advise on the structure of executive pay, and are increasingly conveying the message that executive pay should be linked to corporate and individual performance, in addition to strengthening disclosure obligations.

While the rules do not generally have legal effect, they can be highly influential in shareholder voting decisions see Shareholder approval requirements below. They are aimed at listed companies but are increasingly viewed as best practice by unlisted companies. The German and Dutch corporate governance codes and Association of British Insurers ABI guidelines, for example, recommend that unlisted companies observe their provisions. Shareholder approval requirements Prior shareholder approval may be required for elements of pay. Corporate governance rules, particularly in the US, have focused on disclosure to allow shareholders sufficient information, and indirect control over executive pay.

However, new measures are allowing shareholders to vote and have more direct control, for example:. The Dutch corporate governance code requires shareholder "adoption" of remuneration policy, and any material change in it, and of any share plan. This must include information on individual directors' remuneration.

The vote is only advisory and is non-binding, but negative votes and abstentions are being used to express dissatisfaction over executive pay. Following this lead, legislation is also pending in Australia to introduce a non-advisory shareholder vote on directors' and senior executives' pay.

Description

Effective communication with shareholders in formulating executive pay packages is important to avoid surprises. Shareholders must be consulted about the structure and justification of pay packages, particularly where elements of these are contentious from a shareholder perspective. Board responsibilities The negotiation of appropriate reward packages is primarily the responsibility of boards of directors and remuneration committees. Directors in the US, EU countries and Australia owe duties to act in the best interests of their company and shareholders generally more stringent for those of listed companies , and should bear these duties in mind when formulating pay packages.

Investigations by regulators and derivative lawsuits by shareholders are also pending in the US against a number of companies and other entities accused of overpaying their executives. The private lawsuits typically assert that directors breached their fiduciary obligations to shareholders by either not being involved at all in the process which led to the "excessive" compensation being paid, or being only so minimally involved that they breached the duty of care imposed on them as fiduciaries. Many US companies have consequently reviewed their corporate governance standards, and some have expanded their compensation committees and required CEO-related compensation to be approved by a company's full board of directors.

Tax and social security rules Different national rules on the tax treatment of cash, benefits in kind, share-based arrangements, pension and other forms of pay should be reviewed. These may vary considerably, particularly for share-based benefits and pensions. Where possible, the package should be tax-efficient for the executive and the company. Favourable share incentive and pension plans, enabling reduction of income tax and social security liability or deferral of payment, are available in a number of countries see Designing a pay package below.

The impact of personal income tax rates on higher income should be considered.

An executive in these countries may prefer to accept lower base pay and cash benefits in exchange for longer-term, more tax-efficient options. In Spain, for example, an executive may choose to defer pay so that it is treated as long-term income that is, income with a generation period of at least two years and benefit from tax reductions. In the US, executive pay packages are designed where possible to convert earned income otherwise taxed at ordinary income tax rates into more favourably taxed capital gains rates, usually by awarding equity incentives in lieu of cash incentives.

Companies will be concerned as to the availability of a corporate tax deduction for contributions to benefit plans where possible:. In most countries, a local subsidiary should be able to obtain a deduction in respect of the cost of share benefits provided it bears the cost, or reimburses the parent company in accordance with a written agreement. In many countries, employer contributions to pension plans which qualify for tax concessions under relevant legislation should also be deductible, subject to limits.

However, stricter rules apply on the deductibility of employer contributions to non-qualifying pension plans. In the UK, there are proposals by the UK Government see box: Executive pension provision: UK reform proposals to remove the deduction currently allowed for employer contributions to funded unapproved arrangements but to defer the deduction until pension benefits are paid. Social security can be a significant additional cost for companies, particularly on the value of share-based benefits.

Contractual issues An executive pay package will determine the financial compensation the executive may claim on termination of employment unless otherwise agreed. A major shareholder concern has become the situation where an executive leaves, either voluntarily or at the request of a board, after a short or unsuccessful appointment, with a significant financial reward see Contractual protections: Severance payments in the second part of this feature.

Companies must consider the terms, triggers and potential costs of various exit scenarios at the outset, in particular, the executive as a "good leaver" or "bad leaver" or on a change of control. Where possible, appropriate protections must be included in the executive's service contract and other documentation. This needs to be balanced against the need to recruit, retain and incentivise key executives and to monitor their performance.

From a retention viewpoint, potential severance packages should also not have the undesired effect of encouraging good executives to leave. Designing a pay package A number of different types of benefits can be used to balance retention and performance needs. These include:. Share incentive arrangements. Other benefits such as salary increases and benefits in kind. See Checklist: designing a pay package and box: Performance and retention features of a pay package for general issues to be considered.

Share incentive arrangements Share incentive plans enable executives to become shareholders in their business, thereby encouraging them to add value, while at the same time providing a retention hook through vesting and holding conditions. They have been a popular means of rewarding UK and US executives since the s.

Historically US companies have tied a large proportion of pay to equity, largely in the form of share options, and the use of performance conditions has been unusual. The level of equity reward in the UK has been lower, principally due to the influence of UK institutional shareholders over the design and operation of plans, the prevalence of performance conditions and more limited tax breaks. There are many different types of share incentive plans used for executives, but those most commonly used are:. Share option plans.

Under a typical share option plan, an executive is granted an option to acquire shares at a price fixed at the date of grant usually the market value of the underlying shares at that date. The option becomes exercisable that is, "vests" after a specified period, subject to the executive remaining in employment and sometimes the satisfaction of predetermined performance conditions - though this has not been market practice outside the UK. The executive therefore benefits from any increase in share price between the date of grant and date of exercise.

Chapter 19: Executive Compensation

Long-term incentive plans LTIPs. LTIPs can be designed in many different ways. In the UK, they are commonly "performance share plans" under which an executive is granted a right to acquire shares usually at no cost after a specified period, subject to the executive remaining in employment and usually the satisfaction of predetermined performance conditions.

In the US, they are commonly "restricted stock plans" under which an executive is granted shares usually at no cost up-front, which are acquired unconditionally after a specified period, subject to the executive remaining in employment or sometimes the satisfaction of performance conditions. In each case, the executive benefits from any increase in share price.

The use of LTIPs is also becoming more widespread in other EU countries where share option plans have been the preferred reward vehicle and Australia. However, the choice of plan depends on each company's requirements, and many companies are operating option plans and LTIPs in tandem together with other plans to afford themselves maximum flexibility. See boxes: Options or share awards? Deferred bonus plans. An executive is permitted or required to defer a proportion of annual bonus to buy shares. After a specified period and subject to remaining in employment, the executive receives the outstanding proportion of bonus in shares.

Share matching plans. In conclusion, the most important practical implication of this study is that the findings present an encouragement for the use of quantitative, hard CSP targets in executive compensation.

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Moreover, it provides evidence for the effectiveness of quantitative, hard targets to reduce especially CSP weaknesses. Several limitations apply to this study of which some could be addressed in future research. Firstly, the sample only includes large US firms. As such, some caution is needed in generalizing the findings across all kinds of firms. Using a more representative sample, future research could examine whether these conclusions also hold for smaller firms or firms from other regions.

Next to that, as an archival study we can only provide evidence on associations, not causality see, e. Thirdly, the data on CSP targets in executive compensation are collected from one single source, proxy statements. Although cross-checks were installed to minimize the effects of the human factor in the data gathering, there is still a possibility that some unidentified discrepancies remain. For future research to be able to perform more specific analyses of the effects that CSP targets have on CSP, firms would need to report the percentages of executive compensation that are linked to CSP targets and to financial targets.

This study might encourage other researchers to build upon the results and remaining questions. For example, it might be interesting to investigate the contribution of executive compensation packages to the disparity between executive and ordinary employee remuneration. While social inequality has risen in recent years and is becoming a significant ethical concern.