Executive Compensation

Bulletin

Golden Parachutes: Still With Us, But for How Long?

By Sarah Hiester, Towers Watson
November 1, 2011

Although the trend toward eliminating the most egregious provisions continued this year, our research shows that golden parachute arrangements remain a staple of the pay package for over two-thirds of top U.S. executives today. In the say-on-pay and say-on-parachute era, lucrative change-in-control (CIC) severance payments to departing executives are clearly on the radar of shareholders. As a result, many companies have scaled back their CIC provisions to head off shareholder concerns and align with emerging best practices. Our latest analysis of CIC severance arrangements among Fortune 500 companies found that 149 companies almost half (45%) of those with parachute agreements made changes to these programs between January 2009 and March 2011. As was the case last year, the most typical action was to eliminate tax gross-up provisions. This article provides a detailed look at how parachute provisions have evolved over the past year.
Our latest analysis of CIC severance arrangements among Fortune 500 companies found that almost half of those with parachute agreements made changes to these programs between January 2009 and March 2011.

Key Findings
Specific changes to CIC agreements made over the past year include: Eliminating excise tax gross-up provisions: About one-third (32%) of companies eliminated excise tax gross-ups. About half of these companies eliminated gross-ups for agreements with both current and future executives. The other half adopted policies against entering into new or materially amended agreements with excise tax gross-ups, but preserved provisions in existing contracts for current executives. Discontinuing perquisites and benefits. A small percentage of companies (about one in 15) reduced or eliminated benefits that could be provided following termination, such as perk allowances, additional supplemental retirement credits or continued health benefits. Reducing severance multiples. A similar percentage of companies reduced the CIC severance multiple used to determine executives cash severance payments.

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Other recent changes that some companies have made to CIC agreements include: Changing the definition of bonus used in determining cash severance payments. The majority of companies shifted from using some definition that takes into account historical performance, such as a three-year average bonus, to using a target bonus. Expanding the number of employees covered by CIC arrangements. This can be accomplished through the adoption of broader-based CIC plans, either to establish formal CIC arrangements for the first time or to replace the use of individual agreements with a more streamlined plan. Eliminating good reason walkaway provisions. These allow executives to leave the company for any reason within some time window following a CIC and still receive severance. Our new analysis of golden parachutes focuses on programs in place among the 465 Fortune 500 companies that publicly disclose their executive compensation arrangements. Some companies do not offer enhanced CIC severance benefits, but instead provide executives with the same severance programs in the event of any involuntary termination (or termination for good reason), regardless of whether a CIC has occurred. These types of arrangements were excluded from our analysis. The data in this article are based on proxy disclosures for named executive officers (NEOs), incorporating information from public filings through March 2011. Data for this group of Fortune 500 companies are compared against data we reported in 2010. We report trends for CEOs and other NEOs separately because CEOs tend to be offered more generous parachute packages than other executive officers.
Sixty-nine percent of CEOs and 72% of other NEOs have contractual CIC severance arrangements.

Methods for Triggering CIC Severance Payments

Sixty-nine percent of CEOs and 72% of other NEOs have contractual CIC severance arrangements. Although the typical form of delivery for these benefits was individual severance agreements, the prevalence of these agreements declined by 4% for other NEOs in comparison to data in our previous report. In fact, there was an aggregate decrease of 7% of companies providing CIC severance through individual agreements (employment contracts, noncompete agreements, etc.), with a corresponding increase in the prevalence of other NEOs receiving CIC benefits through broader-based plans. Similarly, the percentage of CEOs with golden parachutes delivered through individual employment agreements decreased by 4% since our last report, while the percentage of CEOs participating in broad-based plans increased by 5%. This is indicative of a market shift toward adopting CIC plans covering broader groups of executives and away from individual arrangements negotiated on a caseby-case basis. Figure 1, next page, provides the prevalence of the types of golden parachute agreements commonly offered by Fortune 500 companies.

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Figure 1. Source of CIC severance

Severance agreement Employment contract Executive broadbased plan Employee broadbased plan 2% 3% 31% 17% 23% 28%

44% 45%

CEOs Other NEOs

For 7% of the sample, severance benefits were delivered through a combination of vehicles (e.g., employment agreements and broad-based severance plans). These companies were omitted for comparison purposes.

The majority of golden parachute severance arrangements (86% of CEOs, 89% of other NEOs) are subject to a double trigger before payouts will be made. In other words, severance payments are not made immediately upon a CIC, but rather upon an executives subsequent termination during a certain period following the CIC, typically two years. In fact, only two of the Fortune 500 companies included in our analysis still maintain single-trigger severance arrangements. Single-trigger provisions have long been criticized by shareholders since they can result in executives receiving severance payouts even while they remain employed following the transaction. In addition to a traditional single- or double-trigger approach to initiating golden parachute payouts, modified single-trigger arrangements allow covered executives to terminate employment for any reason following a CIC during a defined time window. These provisions are slightly more prevalent than single triggers (in place for 13% of CEOs and 7% of other NEOs) but are also unpopular with shareholders and have proved problematic for some companies in their say-on-pay votes. Institutional Shareholder Services (ISS) views companies that have golden parachute arrangements with these types of provisions as having high concern agreements. At times, such practices have led to ISS issuing recommendations for shareholders to vote against a companys say-on-pay proposal, even if the company passes all of its other tests.
The majority of golden parachute severance arrangements are subject to a double trigger before payouts will be made.

Severance Formulas and Continued Benefits

The primary components that determine the actual severance payment are the severance multiple and the compensation components covered (typically salary or salary plus bonus). The most popular multiple among CEOs is three times covered compensation (reported by 61% of the companies studied). A multiple of two times covered compensation arrangements surpassed three times pay for other NEOs over the past year; 32% of companies now use a two-times multiple for NEOs, while 30% use a three-times multiple. By comparison, 37% of companies used a three-times multiple for NEOs just a year ago, while 27% used a multiple of two. Figure 2, next page, shows the prevalence of common severance multiples among Fortune 500 companies. The use of a three-times multiple declined by more than five percentage points for both groups of executives when comparing our year-over-year data.

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Figure 2. Prevalence of common CIC severance multiples CIC severance multiple 3 2 2.99 2.5 CEOs 61% 21% 8% 3% Other NEOs 30% 32% 5% 2%

The percentages above dont add to 100% for several reasons. First, this table reflects only the top four most prevalent multiples. Also, for 24% of the sample, a variety of multiples are used for other NEOs (e.g., 3x for the COO and CFO, 2x for the CIO and CAO). These companies were omitted for comparison purposes.

The vast majority of CEOs and other NEOs cash CIC severance payments are based on a multiple of their base salary and bonus (95% and 94%, respectively). The most common approach is to use an executives target bonus when determining these severance payouts (Figure 3). Figure 3. Prevalence of common CIC bonus definitions CIC severance bonus definition Target bonus Average bonus Greater of average bonus and target Highest bonus Greater of highest bonus and target Most recent bonus Greater of most recent bonus and target CEOs 48% 16% 9% 9% 5% 4% 3% Other NEOs 43% 19% 8% 7% 4% 4% 3%

Table reflects only the top seven definitions of bonus used to determine severance payments.

As a supplement to the cash severance payment, the continuation or enhancement of certain benefits is often included in golden parachute arrangements. For example, nearly all executives are offered post-termination continuation of their health and welfare benefits, while slightly less than half receive retirement benefit enhancements, typically in the form of additional age and service credits, or continued contributions. In either case, these benefits are typically extended in direct relation to the cash severance multiple (e.g., if the multiple is 2.5, health coverage would continue for 2.5 years). While its more difficult to justify cutting post-termination health benefit continuation from severance packages, the argument for preserving retirement enhancements is often less compelling. Consequentially, eliminating this additional benefit from severance packages can be a relatively painless way for companies to materially reduce the value of golden parachutes in response to shareholder concerns. Our year-over-year data show evidence of companies moving in this direction, revealing a 5% decline in the number of companies offering retirement enhancements for both groups of executives.
As a supplement to the cash severance payment, the continuation or enhancement of certain benefits is often included in golden parachute arrangements.

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As Figure 4 shows, less than a third of companies provide executives with continued perquisites post-termination, a practice that also saw a slight decline in the past year, especially among other NEOs (a decrease of 3% for CEOs and 6% for other NEOs). This trend is consistent with the continuing reduction of perquisites as part of executive pay packages on the whole, as well as another way in which companies are streamlining severance programs in general. Two additional elements of CIC benefit packages that remained relatively stable in 2010 are outplacement benefits and interrupted bonus cycle payments. About two-thirds of executives are eligible to receive a payout of their mid-cycle annual bonus, with nearly all distributed on a prorated basis. Only 4% of CEOs and 3% of other NEOs are eligible for a full payout. These bonus payments are typically determined at target (46% of CEOs, 48% of other NEOs). Outplacement benefits were less prevalent available to 39% of CEOs and 45% of other NEOs in our sample and were typically capped at $25,000 or one year. Figure 4. Continued benefits offered in CIC severance agreements
Healthandwelfare Interruptedbonus payout Retirement Outplacement Perks 30 % 26% 43% 43% 39% 45% 67% 68% 94% 94% CEOs OtherNEOs

Restrictive Covenants
While some observers expected more companies to make a portion of cash severance payments contingent upon compliance with restrictions on competition, solicitation of employees and the like in order to minimize the possibility of triggering excise tax payments, the data show no significant increase in the prevalence of restrictive covenants in CIC agreements. By paying out only a portion of the total severance benefit upon the qualifying event (e.g., CIC or CIC-related termination) while delaying the remaining payment until the executive has complied with the contractual posttermination restrictions, only the initial payment would be considered for the purposes of 280G calculations. However, many companies seeking to curtail the 280G excise tax exposure tend to take a more direct approach, such as reducing severance multiples or eliminating certain benefit continuations or enhancements. Figure 5, next page, shows the prevalence of various restrictive covenants in executive CIC arrangements.

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Figure 5. Prevalence of restrictive covenants in CIC arrangements
69% 68% 55% 55% 51% 51% 36% 36% 28% 28% CEOs Other NEOs

Confidentiality Nonsolicitationof employees Noncompete Nonsolicitationof customers Nondisparagement

Excise Tax Gross-Ups

As weve seen over the past few years, excise tax gross-up provisions continue to receive the greatest scrutiny from shareholders and their advisors and, thus, have undergone more change than other parachute provisions. Excise tax gross-ups originally began to appear in CIC severance agreements in the mid-1980s following the addition of Sections 280G and 4999 to the Internal Revenue Code, which barred tax deductions for companies making excess parachute payments to certain executives following a CIC and simultaneously imposed a 20% excise tax on executives receiving such payments. As a result, boards were faced with the challenge of mitigating the tax impact on both executives and shareholders. While most companies decided to reimburse executives for any taxes incurred due to the imposition of excise taxes on CIC severance payments, the sometimes-exorbitant payouts that resulted relative to the net benefit to the executive prompted shareholder protest. In response, many companies adopted conditional gross-up provisions so that executives would only receive a reimbursement if their parachute payments exceeded the 280G limit by a certain percentage or dollar amount. (See Appendix, page 8, for the definitions of various types of excise tax gross-up provisions.) If calculated gross-up amounts failed to meet this threshold, the parachute payments would automatically be reduced to avoid incurring tax penalties. While this seemed to appease investors for a time, boards in recent years have found it increasingly difficult to justify any type of excise tax gross-up provision. Despite their general unpopularity among investor groups, full and conditional gross-up provisions remain fairly prevalent due to the practice of grandfathering these provisions for current executives. In particular, 75% of Fortune 500 CEOs and 59% of other NEOs are eligible for a full or conditional gross-up. Full gross-ups are most common for CEOs (42%), while conditional gross-ups are most prevalent for other NEOs (30%). Although 32% of companies reported curtailing tax gross-up provisions over the past year, half of those companies adopted policies that apply only to new or amended agreements. Thus, it appears likely that excise tax gross-ups will remain prevalent until the current slate of executives turn over or companies adopt new golden parachute agreements.
Excise tax gross-up provisions continue to receive the greatest scrutiny from shareholders and their advisors and, thus, have undergone more change than other parachute provisions.

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Nonetheless, excise tax gross-ups are clearly moving toward extinction as shareholders increase the pressure on companies to remove these provisions. In most cases, companies seem to be adopting best of net provisions, which either reduce parachute payments to below the 280G limit or provide a full payment but make the executive responsible for any 280G tax liability, depending upon which treatment provides the executive with the best aftertax position. Already, this type of provision saw about a 10% increase in the most recent year. Figure 6. Excise tax gross-up provisions

CEOs
Partial 1% Best of net 21%

Other NEOs
Range 14% Best of net 22%

Full 42%

Capped 3%

Capped 4%

Full 29%

Conditional 33%

Conditional 30%

Note: Fourteen percent of the companies studied used more than one type of gross-up among other NEOs; these companies are reported as Range in the chart. One company reported using a partial gross-up for other NEOs, and one company reported using a conditional and capped gross-up for other NEOs. Since each of these approaches represents less than 1% of the sample, they were excluded from the figure above. See Appendix, page 8, for definitions.

End of an Era?
While golden parachutes have been under attack for many years, the Dodd-Frank Wall Street Reform and Consumer Protection Act has armed shareholders with new weapons the say-on-pay and say-on-parachute votes that give shareholders additional opportunities to voice their displeasure. And proxy advisors like ISS have stepped up the pressure by including excessive parachutes, modified single-trigger CIC protection and tax gross-ups among their problematic pay practices that may prompt a negative-vote recommendation. While such negative-vote recommendations from proxy advisory firms are clearly no guarantee of a negative shareholder vote, the stigma associated with such recommendations has pressured several companies to preemptively revise their practices. Though the need to provide executives with meaningful CIC protection to help ensure that they put shareholder interests first when considering mergers and similar transactions has not diminished, it appears as though boards can no longer justify shielding executives from the adverse tax consequences of 280G. Since few companies seem inclined to risk negative shareholder votes to save these long-controversial provisions, the end may be near for the golden parachute programs of the pre-Dodd-Frank era.

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Appendix
Excise Tax Gross-Up Definitions
Full: Executives are reimbursed for the full amount of any excise taxes incurred as well as for any subsequent taxes resulting from the gross-up payment. Partial: Executives are reimbursed for part of the excise taxes incurred. For example, a company may only reimburse executives for 50% of the 280G excise tax liability, with the executives responsible for the remaining 50%. Conditional: Executives are reimbursed only if the severance payments exceed the 280G limit by a certain percentage or dollar amount (e.g., 10% or $50,000). If the payments do not exceed this threshold, they will be reduced below the 280G limit to avoid triggering excise taxes. Conditional and Capped: Same as a conditional gross-up, except that if payments do exceed the established threshold, the gross-up payments are limited to a certain amount (e.g., $2 million). Best of Net: Severance payments will either be paid in full (with the executive bearing responsibility for all taxes incurred) or reduced to avoid triggering the excise taxes, whichever provides the executive with the best net aftertax result. Capped: Severance payments are capped at the 280G limit and will be reduced to avoid triggering excise taxes, regardless of the aftertax benefit to the executive.

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About Towers Watson

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