“What the Top Compensation Consultants Are NOW Telling Compensation Committees” March 18, 2004 Presented by: Peter T. Chingos

1 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting Hot Topics: What We’ll Cover Today Pay for performance – Current environment – Best practices – Common pitfalls The future of equity – Current environment – Evaluating equity plans – Trends and directions – Common pitfalls CEO Benefits What every compensation committee should do now

2 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting Pay for Performance: Current Environment Several forces are driving a renewed emphasis on pay for performance Shareholder Objectives: Reduce share usage Manage overhang Respond to pressure from institutional shareholders (e.g., Calpers, ISS, etc.) Marketplace Objectives: Continue to attract and retain talent Continue to pay for performance Respond to underwater options and greater volatility in pay Executive Compensation Program Design Corporate Governance: Ensure full and transparent disclosure Adhere to stock ownership and holding requirements Commit to excellent corporate governance practices Financial Objectives: Reduce potential option expense Control EPS impact

3 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting Pay for Performance: Best Practices Compensation committees are demanding changes in traditional compensation philosophy and pay position Today’s Common PracticeBest Practice for the Future Total Target Opportunity Cash at or above median; long- term incentives at 60 – 75 %ile Median; let performance drive compensation higher Performance TargetsInternally focusedSet commensurate with pay position Investor Focus“If we hit our targets, we are delivering results to investors” “Will our internal targets meet investor expectations?” LeverageLimited testing of payout sensitivity and probability Testing of payouts at various performance levels Market DataData used without performance context Data used to validate both pay and performance Peer GroupDifferent peers used for pay and performance Same peers used for pay and performance Total CompensationFocus on cash and equityFocus on cash, equity, and other benefits and programs (SERP, deferred compensation, etc.)

4 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting Pay for Performance: Best Practices Compensation positioning must be set within the context of performance Company A vs. 15-Company Peer Group Percentile Performance Measure 25th 50th 75th Revenue Growth EPS Growth Operating Income Growth Return on Total Capital Total Shareholder Return Overall = Company A position relative to peer group 25th 50th 75th

5 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting Pay for Performance: Best Practices Companies must ask whether the relationship between pay and performance is directionally correct 75th 25th Median 75thMedian Low Pay - High Performance Financial Performance Versus Peers Total Compensation High Pay - Low Performance Low Pay - Low Performance High Pay - High Performance Use a consistent peer group for pay and performance comparisons Shift from internal to external focus Maintain defensible pay and performance relationships

6 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting Pay for Performance: Common Pitfalls Companies should move away from these common mistakes Guaranteed multi-year incentive payments or equity grants Mega-grants, especially those with limited performance link Overly generous severance or change in control payments Aggressive SERPs and deferred compensation programs Evergreen, or perpetual contracts that essentially mandate a severance payment to terminate

7 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting The Future of Equity: Current Environment Companies are asking hard-hitting questions about their historic equity practices Does the FAS 123 expense equal the perceived value to employees? Do other compensation vehicles offer better alignment among… Do other compensation vehicles deliver value more efficiently? Payout probability Expense Perceived value

8 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting The Future of Equity: Evaluating Equity Plans Long-term incentives are evolving TodayFuture Stock Options The primary long-term incentive Eligibility very deep and broad Significant reduction or elimination of stock options Equity used more selectively Instead of options, more cash or outright take-away for those whose participation is limited Performance Shares/Units Performance shares and units used with mixed results Difficulty setting long-term targets Annual milestone opportunity over three-year period Restricted Stock Limited to middle and lower management A portion of core long-term incentive award (e.g., 25%) Global Programs US long-term incentive practices exported globally Long-term incentives more locally driven

9 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting The Future of Equity: Evaluating Equity Plans Performance-based awards – FAS 123 levels the playing field Equity ProgramCurrent Thinking Traditional stock options Cost and perceived value are out of alignment Performance-based stock options – Performance-accelerated – Performance-contingent – Indexed Cost and perceived value are way out of alignment Performance shares and performance units Make great sense Difficult to set credible goals – Many using relative financial measures and TSR – Others using annual milestones over three years Restricted stock and performance- accelerated restricted stock Compromise between service-based and performance-based vesting

10 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting The Future of Equity: Evaluating Equity Plans The role of restricted stock is changing Limited use in “E” suite Recruiting/special recognition awards Becoming part of core LTI (i.e., 25%) Perceived as “give away” by shareholders Future service requirement and retention hook Differentiate grant by performance (front-end) “Once only” retention Discontinue “once only” every 3 years Sporadic use for middle and lower management Feather into core program – longer vesting Replacement for stock options as core plan for middle management and below Cost vs. perceived value is aligned Perceived value high 162(m) disqualified Career vesting for Top 5 FuturePast

11 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting The Future of Equity: Trends and Directions 2004 changes: First 100 Companies’ proxy data* Preliminary 2004 data indicates a 15.7% drop in the overall value of long- term incentive grants for CEOs at median – In 2003, median option values for CEOs decreased from $3.4 million in 2002 to $2.7 million in 2003 – Restricted stock at median increased from $0.9 million to $1.5 million New models are starting to emerge – Balanced portfolio – shifting long-term incentives from stock options to other full-value plans (e.g., restricted stock, performance shares/units) – Shifting from long-term to short-term with mandatory deferral – Offering choice – let employees choose among options, restricted stock and/or performance shares – Replacing stock options with cash – Limiting eligibility * Findings from analysis of first 100 companies to file of a total sample of 350, which will be reported in the Wall Street Journal

12 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting The Future of Equity: Common Pitfalls Shareholder approval of new plans is a key to success No cancellations and reissues without shareholder approval No evergreen provisions No reloads No discounted options Provide for a minimum vesting period in the plan Identify the maximum number of shares by element that can be granted Discuss holding period requirements and stock ownership guidelines

13 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting CEO Benefits: Potentially costly enhancements Typical BenefitsEnhancements Retirement SERP 2.0% final average pay (base + bonus) x years of service offset by qualified plan and Social Security Inclusion of LTI Additional service credit Subsidized early retirement or lump sum discount rate Secured funding arrangements with gross-up for taxes Deferred Compensation Salary + 100% annual bonus Interest rate tied to investment options or fixed Above market interest rate Investment options with floor rate Deferral period extends beyond termination of employment Life Insurance 200% - 300% of pay Post-retirement coverage Gross-up for gift and income taxes

14 G:\PREC\LADDIN\NASPP\Hot Topics- 2v.ppt Mercer Human Resource Consulting What Every Compensation Committee Should Do Now Test whether you are really sticking to your compensation philosophy Move from an internal view of pay for performance to external comparisons View compensation holistically (i.e., cash, equity, benefits, perks, etc.) Avoid surprises – test performance sensitivity at the beginning of the performance period Remember that capital accumulation occurs over a career, not a quarter