The Future of Executive Compensation George B. Paulin President & CEO, F.W. Cook & Co., Inc. October 6, 2004

The Future of Executive The Future of Executive CompensationCompensationGeorge B. PaulinGeorge B. PaulinPresident & CEO, F.W. Cook & Co., President & CEO, F.W. Cook & Co., Inc.Inc.October 6, 2004October 6, 2004

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BackgroundBackground

OVERVIEW OVERVIEW

5-year transition in executive 5-year transition in executive compensation . . .compensation . . .11stst Phase Phase 22ndnd Phase Phase

PeriodPeriod 2002-032002-03 2004-062004-06

CatalystsCatalysts Sarbanes-Oxley, Sarbanes-Oxley, stock exchange stock exchange rules, rules, institutional institutional investor investor initiativesinitiatives

New FASB rules, New FASB rules, option-valuation option-valuation refinements, refinements, political/labor political/labor pressurepressure

FocusFocus Corporate Corporate governancegovernance

Program designProgram design

ImpactImpact Board Board compensation compensation committee committee processprocess

Use of stock Use of stock optionsoptions

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TODAY’S DISCUSSION TODAY’S DISCUSSION

1.1. 22ndnd-phase market trends in executive -phase market trends in executive compensation transition compensation transition

2.2. New and proposed regulations New and proposed regulations

3.3. Shareholder initiatives and voting Shareholder initiatives and voting

Implications and outcomes from 3 Implications and outcomes from 3 areas . . .areas . . .

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METHODOLOGYMETHODOLOGY

Comes from the F.W. Cook & Co. data baseComes from the F.W. Cook & Co. data base— Generally, large-caps (i.e., Fortune 250)Generally, large-caps (i.e., Fortune 250)— But representative of broader public-company But representative of broader public-company

practicepractice Values options based on the Binomial model Values options based on the Binomial model

and standard assumptionsand standard assumptions

Competitive data used for Competitive data used for illustrations . . .illustrations . . .

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Market TrendsMarket Trends

TOTAL DIRECT TOTAL DIRECT

COMPENSATIONCOMPENSATIONTop-quartile outliers are moving back toward Top-quartile outliers are moving back toward the middle (75the middle (75thth percentile as percent of percentile as percent of median) . . .median) . . .

133%

145%

131%127%

153%

142%

50%

75%

100%

125%

150%

175%

CEO CEOCEOTop 5 Top 5Top 5

1996 2002 2004

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LONG-TERM GRANTS LONG-TERM GRANTS Share usage as a percent of Share usage as a percent of outstanding shares (“run rates”) outstanding shares (“run rates”) continues to decrease. . .continues to decrease. . .Share Usage as % Outstanding Shares

1996 2002 2004

Median

Options 0.94% 1.38% 1.01%

Other 0.05% 0.03% 0.10%

Total 1.07% 1.46% 1.09%

75th P

Options 1.32% 1.82% 1.43%

Other 0.16% 0.13% 0.24%

Total 1.45% 1.87% 1.55%

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LONG-TERM GRANTS LONG-TERM GRANTS

(cont’d.)(cont’d.)

Run rates (and dilution overhang) are no longer meaningful Run rates (and dilution overhang) are no longer meaningful as grant value shifts from optionsas grant value shifts from options

Grant-value changes are from 2 sourcesGrant-value changes are from 2 sources— Stock price variabilityStock price variability— Discounting in conversion from options for full-value grantsDiscounting in conversion from options for full-value grants

Reduction in lower-level grants only partially completeReduction in lower-level grants only partially complete— Driven by stock-exchange rules (not accounting), and manyDriven by stock-exchange rules (not accounting), and many board-board-

approved plans still have shares availableapproved plans still have shares available

Look carefully beyond the survey Look carefully beyond the survey numbers . . .numbers . . .

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LONG-TERM STRUCTURELONG-TERM STRUCTUREShift from options to full-value grants Shift from options to full-value grants (i.e., restricted and performance (i.e., restricted and performance stock/cash) . . .stock/cash) . . .

Annual MixAnnual Mix

YearYear LevelLevel OptionsOptionsFullFull

ValueValue

19961996 CEOCEO

Top-5Top-5

73.7%73.7%

73.2%73.2%

26.3%26.3%

26.8%26.8%

20022002 CEOCEO

Top-5Top-5

79.2%79.2%

78.0%78.0%

20.8%20.8%

22.0%22.0%

20042004 CEOCEO

Top-5Top-5

51.5%51.5%

49.8%49.8%

48.5%48.5%

50.2%50.2%

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OPTION STRUCTURE: More OPTION STRUCTURE: More

PrevalentPrevalentSome forms of options will be Some forms of options will be winners under new accounting . . .winners under new accounting . . .

Grant TypeGrant TypeAdvantage toAdvantage to

Plain-Vanilla OptionsPlain-Vanilla Options

Stock-only SARsStock-only SARs Fewer shares issuedFewer shares issued

Discount OptionsDiscount Options Low cost to intrinsic Low cost to intrinsic valuevalue

Options with Dividend Options with Dividend RightsRights

Low cost to intrinsic Low cost to intrinsic valuevalue

Performance OptionsPerformance Options Pay-for-performancePay-for-performance

Indexed OptionsIndexed Options Pay-for-performancePay-for-performance

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OPTION STRUCTURE: Less OPTION STRUCTURE: Less

PrevalentPrevalentOther forms will be losers . . .Other forms will be losers . . .

Grant TypeGrant TypeDisadvantage toDisadvantage to

Plain-Vanilla OptionsPlain-Vanilla Options

ISOsISOs No tax benefitNo tax benefit

ReloadsReloads Additive expenseAdditive expense

Cash-only SARsCash-only SARs Variable costVariable cost

Premium OptionsPremium Options High cost to intrinsic High cost to intrinsic valuevalue

ESPPsESPPs Fair value expense Fair value expense (no expense now)(no expense now)

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OPTION PROVISIONSOPTION PROVISIONS

3-4 year vesting will continue to spread expense accruals3-4 year vesting will continue to spread expense accruals 10-year terms will continue because the cost effect of 10-year terms will continue because the cost effect of

shorter terms is not linear shorter terms is not linear Post-termination exercise may become more limited to Post-termination exercise may become more limited to

conserve sharesconserve shares Grant dates may be moved to late in the year so value Grant dates may be moved to late in the year so value

aligns with annual TSR under new ISS guidelinesaligns with annual TSR under new ISS guidelines

Regulatory and shareholder considerations Regulatory and shareholder considerations will affect option design . . .will affect option design . . .

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LONG-TERM GRANT LONG-TERM GRANT

DETERMINATIONDETERMINATIONA new approach for determining A new approach for determining grant size is necessary but grant size is necessary but controversial . . .controversial . . .

Old MethodOld Method New MethodNew Method

Determine Determine competitive individual competitive individual grant valuesgrant values

Convert to company Convert to company shares (or cash)shares (or cash)

Add individual grants Add individual grants to determine total to determine total grantsgrants

Start with Start with competitive competitive aggregate grant aggregate grant value as a percent of value as a percent of company market capcompany market cap

Allocate to Allocate to individuals based on individuals based on competitive percent competitive percent of total grant valueof total grant value

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SHAREHOLDER APPROVED SHAREHOLDER APPROVED

PLANSPLANS

Employees and outside directors eligibleEmployees and outside directors eligible All possible grant typesAll possible grant types Administrative provisions in grant agreements, not the planAdministrative provisions in grant agreements, not the plan As-issued share countAs-issued share count ““Fungible” share pool for trading-off options and full-value Fungible” share pool for trading-off options and full-value

grantsgrants Potential for 3Potential for 3rdrd-party option transfers-party option transfers

Flexible omnibus-type structure will Flexible omnibus-type structure will become the standard . . .become the standard . . .

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SHAREHOLDER APPROVED PLANS SHAREHOLDER APPROVED PLANS


Traditional PoolTraditional Pool:: 10 million option shares with up to 3.3 10 million option shares with up to 3.3 million full value sharesmillion full value shares

Fungible PoolFungible Pool:: 16.6 million option shares with each full 16.6 million option shares with each full value share granted counted as 3 options (assuming 33% value share granted counted as 3 options (assuming 33% Binomial option value):Binomial option value):

Fungible share pool works best under Fungible share pool works best under ISS-type voting guidelines . . .ISS-type voting guidelines . . .

ISS “Cost” in ISS “Cost” in Option EquivalentsOption Equivalents Shares Available for Shares Available for

GrantGrant

Traditional Traditional PoolPool

6.7 + 9.9 = 16.6 6.7 + 9.9 = 16.6 millionmillion

10 Million10 Million

Fungible Fungible PoolPool

16.6 million16.6 million 5.5 to 16.6 million 5.5 to 16.6 million depending on mix of depending on mix of options and full value options and full value sharesshares

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EXECUTIVE OWNERSHIPEXECUTIVE OWNERSHIPPressure from shareholder groups will Pressure from shareholder groups will increase prevalence and enforcement increase prevalence and enforcement sanctions . . .sanctions . . .

““Best Practice”Best Practice” RealityReality

OwnershiOwnership p GuidelineGuideliness

Real ownership of Real ownership of specified salary specified salary multiple or multiple or number of shares; number of shares; usually after 5 usually after 5 yearsyears

About half of large About half of large caps; few small caps caps; few small caps and techs or West and techs or West of the Mississippiof the Mississippi

Retention Retention GuidelineGuideliness

Hold net shares Hold net shares from from compensation compensation program for at program for at least 1 year (i.e., least 1 year (i.e., no run-up and no run-up and flipping)flipping)

GE, Citicorp, Lilly GE, Citicorp, Lilly and a couple of and a couple of other early other early adopters; few adopters; few followersfollowers

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MISCELLANEOUSMISCELLANEOUS

Setting goals for annual bonuses to better balance pay for Setting goals for annual bonuses to better balance pay for performance and pay for performance and pay for resultsresults

Valuing SERPs, above-market interest on deferred compensation, Valuing SERPs, above-market interest on deferred compensation, and severance arrangementsand severance arrangements

Aligning outside directors’ compensation with their current Aligning outside directors’ compensation with their current responsibilities and risksresponsibilities and risks— And compensation committees again taking charge of directors’ And compensation committees again taking charge of directors’

compensation, where it has moved to nominating/governance committeescompensation, where it has moved to nominating/governance committees

More time will be spent on . . .More time will be spent on . . .

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New and Proposed RegulationsNew and Proposed Regulations

IN GENERALIN GENERAL

NYSE rules effective 6/30/03 (Nasdaq rules are NYSE rules effective 6/30/03 (Nasdaq rules are generally in parallel)generally in parallel)

FAS 123 proposal on accounting for equity-based FAS 123 proposal on accounting for equity-based compensationcompensation— Exposure Draft (ED) issued 3/31/04Exposure Draft (ED) issued 3/31/04

Legislation pending on taxation of deferred Legislation pending on taxation of deferred compensationcompensation

3 areas will be covered . . .3 areas will be covered . . .

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STOCK EXCHANGE RULESSTOCK EXCHANGE RULESOld “loopholes” from shareholder approval Old “loopholes” from shareholder approval eliminated . . .eliminated . . .

Former ExemptionsFormer Exemptions Current ExemptionsCurrent Exemptions

Broad-based plansBroad-based plans

Certain share Certain share authorizations not authorizations not exceeding 5%, i.e., exceeding 5%, i.e., “Broker No-Vote”“Broker No-Vote”

Grants in Treasury sharesGrants in Treasury shares

New-hire grantsNew-hire grants

Plan amendments other Plan amendments other than participant than participant eligibility, grant types, eligibility, grant types, and share limitand share limit

New-hire grantsNew-hire grants

Shares in lieu of cashShares in lieu of cash

““Immaterial” plan Immaterial” plan amendmentsamendments

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FAS 123 STATUSFAS 123 STATUSOutcome could have been worse . . .Outcome could have been worse . . .

Bad NewsBad News Good NewsGood News

Proposed rules will be Proposed rules will be adoptedadopted

Possibly later (1/1/06) Possibly later (1/1/06) than sooner (1/1/05)than sooner (1/1/05)

Option pricing models Option pricing models will be basis for expensewill be basis for expense

Flexibility in modeling Flexibility in modeling will reduce option will reduce option expenseexpense

Transition is inherently Transition is inherently painfulpainful

Choice between “modified Choice between “modified prospective” and prospective” and restatement, plus other restatement, plus other steps to moderate steps to moderate original EDoriginal ED

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FAS 123 STATUS FAS 123 STATUS (cont’d.)(cont’d.)

Straight-line accruals for installment vestingStraight-line accruals for installment vesting Lattice-binomial no longer specifically preferredLattice-binomial no longer specifically preferred Current accounting treatment for corporate Current accounting treatment for corporate

income taxes retainedincome taxes retained Safe-harbor for qualified ESPPsSafe-harbor for qualified ESPPs

— Purchase discount no greater than 5%Purchase discount no greater than 5%

Steps to moderate ED . . .Steps to moderate ED . . .

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TAX DEFERRAL STATUSTAX DEFERRAL STATUS

Many elections for bonuses earned (whole or part) in Many elections for bonuses earned (whole or part) in 2004 and paid in 2005 could be invalid2004 and paid in 2005 could be invalid— If annual compensation, elections must pre-date 1/1/04If annual compensation, elections must pre-date 1/1/04— If multi-year, must pre-date 2005 payment date by at least If multi-year, must pre-date 2005 payment date by at least

12 months12 months Elections for compensation earned in 2005 and paid Elections for compensation earned in 2005 and paid

in 2006 must be before 1/1/05in 2006 must be before 1/1/05

Timing is uncertain and changes to Timing is uncertain and changes to current proposals are likely . . .current proposals are likely . . .

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TAX DEFERRAL STATUS TAX DEFERRAL STATUS


No event-driven distribution triggersNo event-driven distribution triggers Amounts originally deferred before effective date Amounts originally deferred before effective date

grandfathered, grandfathered, ifif no further deferral under no further deferral under subsequent electionsubsequent election

General scope will have unintended consequencesGeneral scope will have unintended consequences— e.g., impact on SARs, RSUs, and SERPs likely to necessitate e.g., impact on SARs, RSUs, and SERPs likely to necessitate

administrative rulings to clarifyadministrative rulings to clarify

Other possible (probable) effects . . .Other possible (probable) effects . . .

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Investor Initiatives and VotingInvestor Initiatives and Voting

IN GENERALIN GENERAL

ISS (Institutional Shareholder Services)ISS (Institutional Shareholder Services) Glass Lewis & Co.Glass Lewis & Co. CalPERS (California Public Employee CalPERS (California Public Employee

Retirement System)Retirement System)— Significant to a lesser extent because of Significant to a lesser extent because of

perceived labor-oriented political agendaperceived labor-oriented political agenda

Initiatives by the following Initiatives by the following organizations are likely to be organizations are likely to be influential . . .influential . . .

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ISSISS

Oppose any proposed plan and committee member re-election ifOppose any proposed plan and committee member re-election if— CEO pay “disconnect” from sustained company performanceCEO pay “disconnect” from sustained company performance— More than 50% of CEO pay increase from equity awardsMore than 50% of CEO pay increase from equity awards— CEO participates in proposed planCEO participates in proposed plan

Disconnect if 1 and 3 year TSR is negative, but CEO’s total Disconnect if 1 and 3 year TSR is negative, but CEO’s total direct pay is above prior yeardirect pay is above prior year

Applies to Russell 3000, publicly traded 3 years, and CEO in Applies to Russell 3000, publicly traded 3 years, and CEO in place at least 2 yearsplace at least 2 years

New voting guidelines effective for New voting guidelines effective for annual meetings after 1/31/04 . . .annual meetings after 1/31/04 . . .

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GLASS LEWIS & CO.GLASS LEWIS & CO.Proxy advisory company, and direct Proxy advisory company, and direct competitor to ISS, formed in 2003competitor to ISS, formed in 2003 . . . . . . Equity compensation plans are evaluated based on qualitative and Equity compensation plans are evaluated based on qualitative and

quantitative reviewquantitative review— Qualitative review looks at plan administration, method and term of exercise, Qualitative review looks at plan administration, method and term of exercise,

repricing history, and other factorsrepricing history, and other factors— Qualitative review includes 20 different weighted analysesQualitative review includes 20 different weighted analyses

Employs a pay-for-performance model with assigned grades based on CEO Employs a pay-for-performance model with assigned grades based on CEO pay and performance relative to peer company median practicepay and performance relative to peer company median practice— No information provided on how information is used in developing voting No information provided on how information is used in developing voting

recommendationsrecommendations

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CALPERSCALPERS

Model to identify U.S. portfolio companies that are both high pay and low Model to identify U.S. portfolio companies that are both high pay and low performance, and are opening dialogue with these companies to get them to performance, and are opening dialogue with these companies to get them to change their practiceschange their practices

Want companies to develop executive compensation policies for shareholder Want companies to develop executive compensation policies for shareholder approvalapproval

— Include compensation philosophy; targeted mix of salary and incentives; Include compensation philosophy; targeted mix of salary and incentives; methodologies for alignment of employee and shareholder interest; and parameters methodologies for alignment of employee and shareholder interest; and parameters for employment contract provisions/severancefor employment contract provisions/severance

Advocate all equity compensation tied to performance criteria including options Advocate all equity compensation tied to performance criteria including options and restricted stockand restricted stock

They are working in close conjunction They are working in close conjunction with Glass Lewis & Co.with Glass Lewis & Co. . . . . . .

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CONCLUSION . . .CONCLUSION . . . Lead or followLead or follow Look beyond the dataLook beyond the data Understand new and proposed regulationsUnderstand new and proposed regulations Listen to shareholdersListen to shareholders

Documents

The Future of Executive Compensation George B. Paulin President & CEO, F.W. Cook & Co., Inc. October 6, 2004