In this issue, answers to:

How can you tell a compelling story in troubled times?

How can tables and graphics simplify disclosure?

When must specific performance targets be disclosed?

What compensation policies should be highlighted?

As companies continue to adjust to the disclosure rules adopted by the Securities and Exchange Commission (SEC) in 2006 and prepare their proxy statements, the market downturn and volatility are likely to raise new issues in disclosure policy for the 2009 proxy season. In light of the current economic environment, companies and compensation committees should review their executive compensation programs to address the dramatic market shifts and uncertainties and be prepared to disclose the effect these times have had on their business practices.

The economic downturn primarily affects disclosure in two areas:

• Compensation decisions relating to payouts for 2008 performance. This would include, for example, the discussion of annual incentive payouts and multi-year performance plans.

• Actions being taken in 2009 that may affect a fair understanding of 2008 compensation. This could include salary freezes, long-term incentive grant changes and other program adjustments. In deciding whether to disclose 2009 actions, companies should consider the potential benefit of having shareholders understand efforts to adjust executive pay in response to the down market.

Companies should use the Compensation Discussion and Analysis (CD&A) section to explain how compensation policies and decisions have changed as a result of the economy. In general, the CD&A should cover the following topics with respect to each named executive officer's pay (typically, the CEO, CFO and three other most highly paid executives):

• The compensation program's objectives

• What the program is designed to reward

• Specific elements of compensation

• Why the company chooses to pay each element

• How the company determines the amount of each element

• How each element, and decisions about each element, fit into the overall compensation objectives and affect decisions about other elements

This Perspective provides tips for preparing clear and compliant disclosure of several key aspects of the CD&A based on the disclosure experience from the last two years under the SEC's rules and considering the current economic situation. (For more information about complying with the new disclosure rules, see Mercer's Executive Remuneration Perspective: "Preparing CD&A disclosure for 2008: Complying with the SEC staff guidance.")

1. Start with an executive summary

An executive summary can provide insight into the rationale for a company's compensation decisions and highlight significant events of the last completed fiscal year that have influenced compensation decisions. Among others, topics could include:

• The arrival or departure of key executives

• The implementation of new compensation plans

• Significant corporate transactions such as mergers, acquisitions and spinoffs

• An increased commitment to performance-based pay

• The elimination of a controversial perquisite

This year, many companies may use the summary to explain compensation decisions made in response to the current economic environment or weak corporate performance; examples of such decisions include repricing stock options; resetting incentive plan performance goals; eliminating bonuses or paying them when goals are not met; or increasing, freezing or reducing base salaries.

2. Focus on analysis over process

The CD&A should provide an analysis of the company's rationale for its compensation decisions. It is important to disclose the basis and context for granting different types and amounts of compensation and to discuss the factors the compensation committee considered in approving each element of pay. A discussion of tools used, such as tally sheets, wealth accumulation analyses or internal pay equity analyses, can show the factors considered in making pay decisions and the methods used to determine the appropriateness of total compensation amounts (see sidebar).

In lieu of boilerplate discussions about individual performance, the CD&A should provide a more specific analysis of how and why the company considered individual performance to determine executive pay. It is important to review the effect decisions about one element of pay will have on others, as well as the influence of performance achievement and committee discretion on specific award levels. For example, the market turmoil and stock price volatility are having a major impact on incentive pay plans, as companies address problems with underwater options and bonus plans that will not pay out. These and other material inputs into the "how" and "why" compensation actions were taken should be the focus of the disclosure.

3. Present pay elements in a table

A table is a concise way to summarize the various elements of pay - such as base salary, annual and long-term incentives, and benefit plans - the company provides to executives. A more detailed description of the different pay elements would follow in narrative form. A table similar to the example provided below could be included in the executive summary and used to highlight changes to the structure of compensation programs made in response to the changed economic environment.

4. Demonstrate pay mix using graphics

A pie chart or graph is an easy way to show the percentage of each executive's compensation that is performance-based and at-risk, to demonstrate the pay-for-performance link. For example, a chart such as the one below could show the amount of pay that is short-term versus long-term, fixed versus variable, and cash versus noncash.

Pie charts and graphs also can be used to demonstrate the mix of long-term incentive vehicles such as options, restricted stock and performance share units. In addition, if traditional stock options have been replaced by performance-vested options, multiple pie charts or graphs could be used to show this trend. These pictures can help a reader quickly grasp a company's pay-for-performance and compensation-allocation policies and shifts in these policies in response to shareholder concerns or the changing economy.

5. Draw peer group comparisons

The CD&A must disclose any benchmarks of total compensation or any material element of compensation, identifying the benchmark and its component companies. Under the SEC rules, benchmarking is using compensation data about other companies as a reference point on which, either wholly or in part, to base, justify or provide a framework for a compensation decision. Benchmarking does not include a situation in which a company reviews or considers a broad-based third-party survey for a more general purpose, such as to obtain a general understanding of current compensation practices.

The CD&A should disclose the pertinent characteristics of each component company included in the benchmark to give readers a sense of why these companies were chosen and what makes them comparable. These pertinent characteristics could be presented in a table and might include some or all of the following:

• Industry

• Revenue size

• Net income

• Market capitalization

• Number of employees

Furthermore, the CD&A should explain where pay is targeted in comparison to the peer group and clarify where actual payouts fell in comparison to these targets.

For companies that are changing their peer group companies in light of recent mergers, acquisitions, spinoffs or dissolutions, these changes could be reflected in two peer group tables and should be thoroughly explained in the narrative.

6. Disclose performance goals and/or history of goal achievement

The CD&A must disclose specific quantitative and qualitative performance-related factors for incentive-based compensation plans if they are "material." Performance targets generally would be considered material for completed performance periods, but arguably, future or current period targets may not be considered material and, thus, may not need to be disclosed. Companies may have recently reviewed the continued appropriateness of their incentive plan performance measures and altered the measures to reflect a change in focus for fiscal year 2009; any significant changes to performance targets should be discussed in the CD&A. Performance goals based on objective, identifiable measures, such as share price or earnings per share, should be disclosed, but subjective goals may be described without providing specific measures.

Many companies are reluctant to disclose specific performance goals if they are concerned that, in the hands of competitors, it could damage their business and jeopardize executive retention. Under the rules, specific performance goals do not have to be disclosed if they have been kept confidential and disclosing them would cause the company "competitive harm." There is probably not a single type of goal that, if disclosed, would always cause competitive harm. For example, it is not the case that operational targets, such as an increased number of store openings, would always qualify for the exception, or that financial targets, such as earnings per share or revenue, would never qualify. Rather, a "facts and circumstances analysis" that depends on each company's particular situation will lead companies to the right conclusion.

If performance goals are not disclosed, companies should be prepared to provide a very concrete, detailed analysis of how a competitor could use the actual target numbers to harm the company competitively. They should consider involving business forecasting personnel and legal counsel to defend their position. Also, SEC staff has suggested that companies conduct a "contemporaneous written analysis" at the time the decision to omit targets is made to ensure the arguments and analysis are clear and do not have to be recreated later.

Companies that do not disclose performance goals must state how difficult it would be to achieve the undisclosed targets. For example, they should provide the context and philosophy for the goals, why they were set at specific levels and whether the company has succeeded in meeting or failed to meet similar goals in the past. Companies have had trouble over the past two years determining what is a sufficient "degree of difficulty" statement. The discussion of the relationship between historical and future achievement of the performance standard may be even more difficult to establish in light of the significant market changes.

7. Highlight important compensation policies

The CD&A should highlight important policies on compensation issues to show a commitment to aligning management's interests with those of shareholders; such policies include:

• Share ownership guidelines - Discuss their rationale, including the specific ownership requirements for each executive, the types of equity included, the timeline for compliance, and whether the executives are currently in compliance and, if not, why.

• Antihedging policies - Disclose policies prohibiting executives from hedging the economic risk of their stock ownership.

• Holding periods - Discuss policies that require executives to retain stock for a certain period (for example, until or after retirement, or for a certain period after exercising stock options or vesting in shares).

• Recovery policies - Highlight policies requiring the adjustment or recovery of incentive awards (that is, "clawbacks") if the performance on which the awards were based is later restated or adjusted, so that the awards would not have been earned.

Some companies are reviewing their compensation policies in light of the federal bailout restrictions on executive pay under the Troubled Asset Relief Program (TARP). For example, the TARP provisions require participating institutions to adopt clawback policies, limit golden parachute payments and prohibit incentive plans that encourage executives to take excessive risks.

8. Describe new actions, decisions or policies

The rules require disclosure of actions taken after the company's last fiscal year end that could affect a fair understanding of an executive's compensation for the last fiscal year. This disclosure provides an opportunity to spotlight changes that demonstrate an increased commitment to pay-for-performance principles, enhanced alignment of management and shareholder interests, and improved corporate governance and pay policies. For example, in response to shareholder concerns and market turmoil, companies recently have been making changes to their compensation programs, such as:

• Increasing the emphasis on performance-based long-term incentives, including adding performance vesting to option awards

• Reducing the value of long-term incentives, in some cases, to reflect the impact of share price declines on the number of shares needed for equity grants

• Limiting severance compensation or adding double-trigger change-in-control provisions

• Downsizing or capping executive perquisites, including eliminating the personal use of company aircraft

9. Consider presenting risk assessment

Financial institutions participating in TARP must include a certification in their proxy statements that the compensation committee performed a risk assessment. The risk assessment considers whether the institution's incentive-based compensation programs might encourage executives to take "unnecessary and excessive risks that threaten the value of the financial institution."

Although companies that do not participate in the program are not required to certify to the performance of a risk assessment, some companies are addressing potential risks in their CD&As based on suggestions by the SEC staff that all companies should analyze incentive plan risks. The first examples of this disclosure are fairly simple statements that the committee evaluated the incentive compensation program and determined that it did not threaten the value of the company. However, it is likely that over time these statements will become more detailed and provide greater insight into the committee's risk evaluation and considerations.

10. Tell and sell your story

The CD&A should be written in clear, concise language and avoid legal and financial boilerplate. Short paragraphs and sentences can vastly improve a complicated explanation of dense material. Using tables and graphics to illustrate the story gives readers a clear picture of the executive compensation program and enhances shareholder understanding of how it helps achieve the company's overall business objectives. Headings and bulleted lists will add to the clarity and transparency of the disclosure and help readers to understand and appreciate the rationale behind the company's compensation decisions. Recasting technical language in plans or agreements will help readers unfamiliar with compensation and benefits terminology to understand it.

The CD&A is designed to allow companies to tell their stories about how they made compensation decisions and set compensation policies. These stories may be particularly difficult to tell this year to shareholders who have experienced unprecedented losses. However, stories are best told using clear presentation and the company's own words, emphasizing the specific challenges and successes of the last fiscal year and how they affected executive compensation decisions.

Why a compelling compensation story matters

Telling a compelling compensation story is particularly important during these economically turbulent times. Shareholders and regulators certainly will be looking closely at this year's filings to ensure technical compliance with the rules. But, perhaps more important, they also will be trying to determine whether companies have taken to heart the spirit of the rules and used the CD&A to explain how the current financial crisis affected compensation decisions in 2008 and may influence the company going forward.

A shareholder advisory vote on executive compensation ("say on pay") most likely will be a reality by 2010, as a result of legislation (President Obama supports say on pay) or policies adopted in response to shareholder pressure. Companies subject to say on pay will need to ensure their disclosures give shareholders an accurate and adequate view of compensation programs to avoid surprises next year when shareholders likely will be voting on executive pay.