Incentive Compensation:
Supplemental Case for Discussion
01 December 2004
Matthew D. Pulliam
Patrick S. O’Cull
Industry
Environment
Performance
Objectives
Business
Strategy
Culture
Incentive Design
Case Study
Process Overview
Industry
Environment
Performance
Objectives
Business
Strategy
Culture
Case Study
Industry Environment
How competitive is the industry?
What are the industry opportunities?
What are the implications for incentive plan design?
1 “Unassisted” excludes bank mergers resulting from failures
Source: Historical Statistics on Banking, FDIC
1
The industry has experienced significant consolidation over the last several years
This will make significant operating improvement difficult
Case Study
Industry Environment
Industry Environment
Increasingly competitive industry
Consolidation in industry via acquisition
Use of technology to achieve economies of scale
Less and less product differentiation
Attractive new market opportunities
Attractive markets in Southeast region (Florida, etc.)
New product opportunities
New markets outside of Southeast region
Incentive Plan Design Implications
Improving performance will become more difficult as competition increases
Focus managers on operating efficiency
Cost management
Economies of scale
Focus managers on growth
Encourage new product growth in existing markets
Leverage existing capabilities into new markets
Case Study
Industry Environment
Industry
Environment
Performance
Objectives
Business
Strategy
Culture
Case Study
Performance Objectives
How has ClientXYZ performed?
How difficult will it be to maintain this performance?
How difficult are ClientXYZ’s performance objectives?
Will this performance create value for shareholders?
1 “Unassisted” excludes bank mergers resulting from failures
Source: Historical Statistics on Banking, FDIC
ClientXYZ has delivered outstanding operating performance...
Case Study
Performance Objectives
Return on Average Equity
ClientXYZ
10%
15%
20%
Return on Average Equity
1995
1996
1997
1998
75th %ile
Peer Median
25th %ile
EPS Growth
ClientXYZ
0%
5%
10%
15%
20%
25%
30%
35%
40%
EPS Growth
1995
1996
1997
1998
75th %ile
Peer Median
25th %ile
...but maintaining this outstanding level of operating performance will be difficult,...
Case Study
Performance Objectives
Companies Maintaining Top Quartile EPS Growth
S&P 500
%
1%
2%
7%
23%
0%
5%
10%
15%
20%
25%
30%
0
1
2
3
4
5
6
7
8
Years
(1991-1998)
Percentage of Companies
0%
0%
0%
Companies Maintaining Top Quartile ROAE
S&P 500
6%
6%
7%
8%
10%
13%
17%
24%
0%
5%
10%
15%
20%
25%
30%
0
1
2
3
4
5
6
7
8
Years
(1991-1998)
Percentage of Companies
...increasing the difficulty of achieving ClientXYZ’s aggressive operating performance goals.
Case Study
Performance Objectives
Note: Peer percentiles represent average 75th, median and 25th percentiles over period (1995-1998)
ROAE Goal: 20% - 22% > 90th Percentile
EPS Growth Goal: 12% - 15%
Return on Average Equity
ClientXYZ
10%
12%
14%
16%
18%
20%
22%
Return on Average Equity
1995
1996
1997
1998
1999
Goal
2000
Goal
2001
Goal
75th %ile
Peer Median
25th %ile
90th %ile
75th %ile
Peer Median
25th %ile
90th %ile
EPS Growth
ClientXYZ
0%
5%
10%
15%
20%
25%
30%
35%
40%
EPS Growth
1995
1996
1997
1998
1999
Goal
2000
Goal
2001
Goal
Cumulative EPS
$
$
$
Will achieving this aggressive operating performance create value for shareholders?
Case Study
Performance Objectives
Value of $100 Invested in December 1996
$0
$50
$100
$150
$200
$250
dec96
feb97
apr97
jun97
aug97
oct97
dec97
feb98
apr98
jun98
aug98
oct98
dec98
Value of $100 Invested in December 1996
75th %ile
Peer Median
25th %ile
ClientXYZ
?
Creating shareholder value is a function of operating performance and investor expectations.
Case Study
Performance Objectives
Shareholder
Value
Operating
Performance
Investor
Expectations
ClientXYZ has created value as a result of increasing operating performance...
Case Study
Performance Objectives
ClientXYZ has significantly improved ROAE
This improvement has been recognized by investors as measured by market-to-book, M/B
Market to Book vs. ROAE
Compensation Peer Group
1995-1998
0
1
2
3
4
5
6
7
%
%
%
%
%
%
ROAE
XYZ 1995
1998
1996
1997
Peer trend line
ClientXYZ trend line
...as well as creating value resulting from increasing shareholder expectations.
Case Study
Performance Objectives
M/B has increased faster than ROAE as a result of increasing investor expectations
Market to Book vs. ROAE
Compensation Peer Group
1995-1998
0
1
2
3
4
5
6
7
%
%
%
%
%
%
ROAE
Market to Book
XYZ 1995
1998
1996
1997
Shareholder value from improved operating performance
Shareholder value from increased investor expectations
Peer trend line
ClientXYZ trend line
ClientXYZ’s current market value incorporates an expectation for ROAE improvement.
Case Study
Performance Objectives
Market to Book vs. ROAE
Compensation Peer Group
1995-1998
0
1
2
3
4
5
6
7
%
%
%
%
%
%
ROAE
Market to Book
XYZ 1995
1998
1996
1997
The peer trend line suggests that investors expect ClientXYZ’s ROAE to exceed 20%
Expected ROAE based upon
peer group (~21%)
Peer trend line
ClientXYZ trend line
Going forward, improvements solely in operating performance may not create shareholder value.
Case Study
Performance Objectives
Market to Book vs. ROAE
Compensation Peer Group
1995-1998
0
1
2
3
4
5
6
7
%
%
%
%
%
ROAE
Market to Book
XYZ 1995
1998
1996
1997
ROAE Goal
($43/share1)
($59/share1)
Shareholder value will reflect changes in operating performance and investor expectations
As ClientXYZ improves ROAE, will investor expectations remain constant?
Movement along ClientXYZ trend line implies share price of $59 assuming no growth in equity
Movement to peer trend line implies share price of $43 assuming no growth in equity
ClientXYZ’s investor expectations have increased, but are current high expectations sustainable?
ClientXYZ’s investors expectations have increased substantially during the last four years
Investor expectations currently reflect the achievement of ClientXYZ’s operating goals
ClientXYZ will have to exceed these operating goals to meet investor expectations
Case Study
Performance Objectives
Only one of the peers has sustained outstanding operating performance and market to book: shareholders recognize the 1997 improvement in ROAE by bidding up M/B ratio
The peer maintained this high ROAE in 1998, however market to book remains relatively flat as investors anticipated this high performance
Case Study
Performance Objectives
Operating vs. Shareholder Performance
First Tennessee National Corporation
0
1
2
3
4
5
1995
1996
1997
1998
Market to Book
16%
18%
20%
22%
ROAE
ROAE
M/B
First Tennessee sustained strong EPS growth at this ROAE, however, total shareholder return is affected by changing expectations
Case Study
Performance Objectives
0%
20%
40%
60%
80%
100%
1995
1996
1997
1998
TSR
0%
5%
10%
15%
20%
EPS Growth
EPS Growth
TSR
Operating vs. Shareholder Performance
First Tennessee National Corporation
We will recognize the relationship between investor expectations and shareholder value in the incentive plan design
Performance measurement issues:
External (., TSR) measures may not reflect the operating performance improvements
Internal (., ROAE and EPS Growth) measures reflect the results against communicated operating goals
Delivery vehicle:
Stock/Stock options: May provide insufficient rewards for achieving operating goals if expectations do not increase
Cash: Can be tied directly to achievement of operating goals or shareholder performance
Case Study
Performance Objectives
Performance Objectives
Strong historical operating performance
Strong focus on EPS growth and increasing ROAE
Target levels of performance are actually “outstanding”
Aggressive hurdles for new investment opportunities
ClientXYZ shareholder value is a function of both operating performance and investor expectations
Incentive Plan Design Implications
Consider difficulty of sustaining historical levels of performance
Reinforce EPS and ROAE goals
Provide appropriate leverage for outstanding performance ~ 90th percentile
Clearly communicate distinction between target and outstanding
Account for increased difficulty of achieving earnings growth at high ROAE
Reinforce both operating and shareholder performance
Case Study
Performance Objectives
Industry
Environment
Performance
Objectives
Business
Strategy
Culture
What is ClientXYZ’s plan to achieve the performance objectives?
What are the implications for incentive plan design?
Case Study
Business Strategy
Business Strategy
Double consumer banking contribution by 2000
Generate $50M in revenues from new sources
Leverage technology
Increase sales/service quality
Motivate work force
Enhance financial management
Maximize potential of StateABC franchise
Incentive Plan Design Implications
Encourage decisions that create long-term value
Market and product development
Technology
Customer relationships
Case Study
Business Strategy
Industry
Environment
Performance
Objectives
Business
Strategy
Culture
How strongly should pay be linked to performance?
How important is leadership?
How clearly are goals communicated?
What are the implications for incentive plan design?
Case Study
Culture
Culture
Incentives support already strong motivation of management team
Annual and long-term performance-based compensation
Stock ownership guidelines
Senior management desires strong alignment with shareholder value
Effective leadership team
Experienced & Focused
Organizational goals are clearly defined and effectively communicated
Internally to management
Externally to Wall Street
Incentive Plan Design Implications
Provide sufficient upside opportunity (leverage) to motivate participants, focus behavior and encourage effective decision making
Include equity or link to equity returns
Motivate and retain executives
Reinforce communicated goals to internal and external stakeholders
Case Study
Culture
Business Issues
Competition and consolidation in the industry will make it difficult to continue to improve performance
ClientXYZ has achieved outstanding performance
Future performance goals are aggressive and will be very difficult to achieve
Value is a function of operating performance and investor expectations
Incentive Plan Design Implications
Focus managers on growth (EPS) and efficiency (ROAE)
Recognize difficulty of performance goals
Reward the achievement of the goals with appropriate incentive plan awards
Case Study
Business Issues
Business Issues
ClientXYZ’s strategy is defined to achieve internal financial operating goals
ClientXYZ embraces pay-for-performance
Reward and retain key talent
Incentive Plan Design Implications
Focus managers on internal and external performance
Annual and/or long-term incentives must reinforce financial and strategic goals
ROAE & EPS growth
Strategic initiatives
Long-term compensation must include a link to equity to align management with shareholder value created
Case Study
Business Issues
Case Study
Incentive Plan Strawman: Combined Equity Long-Term Incentive
How strongly should pay be linked to performance?
Description: 50% of award delivered in cash upon achievement of internal financial objectives; 50% of award delivered through performance-based stock option plan
Characteristics:
Cash award based upon achievement of internal financial EPS and ROE objectives, and strategic initiatives
Option pricing: $60 (20% premium to $50 stock price)
Option term: 10 years
Vesting: 100% in year nine, or when internal financial objectives are achieved
Case Study
Incentive Plan Strawman: Combined Equity Long-Term Incentive
Individual performance component/discretion:
“Floor” at 80% of target award for level
20% of total options reserved for pool for each level, to be distributed at CEO’s discretion based on individual performance
“Ceiling” at 120% of target award for level
Strengths
Simple to understand
Encourages stock price appreciation and internal financial performance, as well as focus on strategic initiatives
Risks
More complex/complicated
Case Study
Incentive Plan Strawman: Combined Equity Long-Term Incentive
Earnings Growth
Return on
Equity
Cash Portion
Performance-
based
Option grant
AWARD
40%
40%
50%
50%
Performance on
Strategic
Initiatives
20%
ROAE and EPS
Performance
Performance Award (Cash)
<25%ile 0
25%ile
50%ile 1x
75+%ile 2x
