Overview from John Connolly

Pensions are under the spotlight. The new pension regime, which comes into force on 6 April 2006, is causing companies and individuals to look carefully at pension policy and provision and they are likely to face some tough decisions. Until now pensions have been the missing link in executive remuneration. They are difficult to value, and comparisons of values are particularly problematic. Typically pensions have not really been considered as a fully integrated 'part of the package'. This is changing.

For many years executive directors participated in the wider company defined benefit plan, typically on more generous terms than most employees, and these plans tended to operate in very similar ways across companies. The introduction of the earnings cap in 1989 and the closure of many defined benefit plans has introduced greater diversity. When executive directors are appointed the pension provision is likely to be a key part of the negotiation on remuneration. But this has led to great variation in the level of pension provided to executive directors, even within the same company.

This lack of coherence has been largely ignored, due in part to a general lack of comprehensible disclosure relating to pension provision. This has made it difficult to identify the real value of a pension and to take this into account when reviewing the remuneration package and designing a coherent policy on total remuneration. Given the substantial values involved and an increased focus from shareholders, and from individuals, this cannot continue.

This is our first report specifically focusing on executive directors' pensions. In it we identify the types of pension arrangements currently in place and how these may evolve. More importantly, we have valued the pension benefits awarded to directors in a way which allows meaningful comparisons to be made across all types of arrangements. This means we can provide you with an indication of what current pensions are worth and the impact they have on the total remuneration of executives.

A proper review of the current and future role of pensions in the remuneration strategy is important to senior executives, remuneration committees and shareholders. This report provides you with information and insights around this important topic. We hope you find it interesting.

John Connolly
Senior Partner and Chief Executive 

1. Executive summary

1.1. The new environment

The Finance Act 2004 confirmed the Government's proposals to replace the existing eight different pension regimes with just one set of rules. The changes, originally proposed for 2005, will now apply to individuals who retire on or after 6 April 2006 (A-Day). Companies and employees therefore have an additional year to plan their long term strategy and develop arrangements to deal with the transition from the old regime to the new.

These changes will have a significant impact on executive directors and other highly remunerated employees and, while introducing greater individual choice and flexibility, will require companies and individuals to make some important decisions. The key features of the new regime are:

  • Contributions to registered plans are unrestricted irrespective of earnings. However, the employee's tax relief is normally limited to the lower of the annual allowance and relevant earnings for the year.
  • All schemes will be able to pay a tax-free lump sum of 25% of the value of the pension rights, subject to the lifetime allowance.
  • A recovery charge will apply to pension funds with a value at retirement in excess of the lifetime allowance. If the excess is taken as a pension, the charge is 25%. The pension income paid out of the remaining 75% is taxed at the individual's marginal income tax rate so a higher rate tax payer will pay 40% on the 75% making an overall tax rate of 55%. If the excess is taken as a lump sum the charge is 55% in all cases.
  • A charge of 40% on contributions to defined contribution plans or increases in benefits in defined benefit plans in excess of the annual allowance will be made.
  • Transitional arrangements will provide a degree of protection for pension rights built up before A-Day. 

Lifetime allowance

Annual allowance

2006/07

£1.5 million

2006/07

£215,000

2007/08

£1.6 million

2007/08

£225,000

2008/09

£1.65 million

2008/09

£235,000

2009/10

£1.75 million

2009/10

£245,000

2010/11

£1.8 million

2010/11

£255,000

Testing benefits against the lifetime allowance

The recovery charge is intended to tax the benefit of tax-free returns in excess of the lifetime limit within a registered scheme. The calculation of benefits depends on whether the pension scheme is defined benefit or defined contribution. If the scheme is defined contribution, the calculation is broadly equal to the value of the fund. The calculation of benefits under a defined benefit scheme is slightly more complex. A valuation factor of 20:1 is applied to the value of the pension when brought into payment (i.e. the fund value equivalent is deemed to be 20 times the annual pension amount).

Testing benefits against the annual allowance

The annual allowance is designed to protect against large payments being made into a tax privileged scheme. In the year of retirement, the annual allowance will not apply. 

For defined contribution schemes, the annual allowance will apply to contributions paid into the fund each tax year. For defined benefit schemes, the annual allowance will be tested against the increase in the accrued pension each year, measured by a 10:1 factor. 

Exceeding the annual allowance will often mean a tax charge applies both when contributions go into a plan and when benefits are taken out.

Unregistered arrangements

The new regime for registered schemes will not prevent unregistered arrangements from continuing, but these will no longer attract tax breaks. However, from April 2006 contributions to FURBS will neither be taxable on the employee nor tax deductible for the employer. Instead tax will be payable by employees on taking benefits, at which time employers will receive their tax deduction. From April 2004 tax on gains, and from 2006 tax on income within FURBS will no longer benefit from reduced tax rates, instead they will pay tax at the trust rate (32.5% for dividend income, 40% for other income and capital gains).

Transitional protection

There are two options to allow employees to protect the benefits they have accrued to date. The choice of protection method will be based on individual circumstances but it will be possible to register for both where benefits exceed the lifetime allowance at A-Day. 

Primary Protection – a member registers the capital value of their pre A-Day pension rights expressed as a percentage of the lifetime allowance (it must be more than 100%). On retirement the recovery charge is paid on pension funds where the value exceeds this percentage of the lifetime allowance at retirement.

Enhanced Protection – pre A-Day pension rights are totally ring-fenced. The employee must cease active membership of all registered schemes from A-Day, although defined benefits can continue to grow by reference to future pay increases and defined contribution plans may continue to receive investment returns within limits. This route is available to members with benefits both above and below the lifetime allowance at April 2006. The protection ceases if active membership resumes in any registered scheme. Where enhanced protection is lost primary protection will apply if registered.

1.2 A tax change or much more?

There is much debate about whether the new legislation is really just a tax change, or whether the impact will be much broader, and may indeed prove to be a catalyst for fundamental changes to the way executives are rewarded.

If it is just a tax change then it may be argued that the corporate response need only be minimal. Most employees will not be adversely affected by the new legislation and, after all, employers do not typically change their remuneration policies in order to compensate employees for changes in taxation. Following this argument, existing pension structures can be maintained with fairly simple changes to the delivery mechanisms (i.e. offering cash alternatives) where this can minimise any extra tax that would otherwise be triggered.

Many commentators suggest that this approach will prevail. However, companies are already starting to ask three fundamental questions:

  • Which members of the executive population will be affected by the lifetime limit? • What are the alternatives to pension beyond A-Day?
  • What will be the cost to the company and the level of benefit to the employee under these different alternatives?

It is the process of answering these questions which is likely to highlight the disparity in their current arrangements and which may prompt questions as to whether the status quo should, or can, continue.

Within most companies there will currently be a range of different arrangements for individuals depending on when they joined. Many companies have also introduced different arrangements for recent appointments and many of these will have been negotiated on an individual basis at the time of appointment. The new legislation will make these inconsistencies more apparent.

Waking up to reality

It might be expected that where a company provides a generous pension, the salaries might be below market average, or there might be less generous pension provision but higher potential incentive awards linked to performance. Our research does not support this theory. Executive directors with lower salaries tend to also have lower pension contributions and where the pension provision is at the lower end of market practice there is no evidence to suggest that this is being compensated for in the variable element of the package.

For example, for directors of FTSE 100 companies where the salaries are in the lowest quartile of market practice the median pension value is 25% of salary compared to 40% for directors where the salaries are in the top quartile of the market. And where the value of the pension provision is in the lowest quartile of market practice the incentive potential is around 380% of salary compared to 470% of salary where the pension provision is in the top quartile of the market.

It therefore appears that companies have not typically taken the pension value into account when determining the structure and quantum of remuneration arrangements. A lack of reliable data has meant that most remuneration committee members (and indeed individual directors) will not be aware of the difference in value of pension arrangements between companies, and indeed within the same company. Although there is much talk about taking a total remuneration approach, in reality this has usually included everything but pension, thereby leaving out an element which may typically be worth anywhere between 20% and 70% of salary, and sometimes more.

Companies may want to consider whether pension should form such a core benefit and what role post-retirement wealth building should have in the remuneration strategy. And there is evidence that pressure from shareholders may accelerate this debate. For example, the Association of British Insurers (ABI) has recently issued new guidelines which include the following:

"With impending changes to pensions taxation, Remuneration Committees should carefully consider what role will be continued to be played by additional pension accrual as against other forms of remuneration that might more clearly align with shareholder value creation. Companies are not responsible for compensating individuals for changes in personal tax liabilities".

We expect that over the next year the main focus will be on the transitional arrangements but we anticipate that the following five years will see a dramatic change in remuneration strategy and the composition of remuneration packages for executive directors.

Companies may change the way they see their role, from being a provider of postretirement security to a facilitator. Therefore we may see an increased emphasis on performance linked remuneration, with reduced pension but higher potential awards from incentive plans, allowing executives to further fund their retirement from the proceeds of these plans. It may be time to re-think the role of pensions at the executive level altogether.

2. Introduction

This report on the pension arrangements of executive directors in FTSE 350 companies is part of our series of reports on executive directors' remuneration. These reports are designed to provide comprehensive market data on the remuneration arrangements of executive directors in FTSE 350 companies.

Our main report, published in October 2004, provides detailed information on salaries and the design of short and long term incentive arrangements. By valuing these under various performance scenarios we provide detailed summaries of the potential total compensation available to directors and the balance between fixed and variable, short and long term, compensation.

This report fills in the missing part of this picture by providing an indication of the value of the pension benefits and the total remuneration available to directors.

What the report covers

The report is based on the information available in the annual reports and accounts of companies in the FTSE 350 as at 1 October 2004. This includes companies with financial year ends up to and including July 2004.

32 investment trusts have been excluded and therefore a total of 318 companies are included in the analyses. The list of companies included can be found in Appendix 1.

Although the level of disclosure required in the remuneration report on directors' pension arrangements is limited, particularly relating to company policy, it is possible to extract a significant amount of information from both the remuneration report and the notes to the accounts. This allows a range of analyses including:

  • the types of arrangements currently in place for executive directors, including provisions in place for executives affected by the earnings cap;
  • the types of arrangements that are likely to be offered to new appointments;
  • the value of the pension benefit; and
  • employee contributions.

In order to put pensions into the context of the total remuneration package, the report also contains analyses of total fixed remuneration (salary plus pension) and total remuneration (salary, pension and variable remuneration). A breakdown of the composition of the total remuneration package is also provided.

The methodology

It is not easy to identify the value of the pension benefit under a defined benefit plan and there are many ways in which this can be done. The principles on which we have based the method used in this report are:

  • Only information published in the remuneration report should be taken into account.
  • The approach should be logical and simple.

Most companies do not disclose details of the pension policy for executive directors. In many cases disclosure is limited to that required under the Directors' Remuneration Report Regulations 2002 and under the Listing Rules. This information includes the current and previous transfer value, the increase in transfer value, the accrued pension and the increase in accrued pension, all of which may be helpful in reaching a conclusion as to the value of the pension.

The methodology we have applied uses the current transfer value to derive the annual pension value as this avoids basing the value on information relating to the current year only, which may be influenced by unusual factors. It determines the value of one year's worth of pension accrual for each director, allowing for earnings growth up to retirement. 

Whilst there are some limitations in this approach, we believe that it provides a valuable indication of pension value across a broad spectrum of FTSE 350 companies and allows a meaningful comparison of the value of different types of pension.

Further details of the methodology used for valuing the pension benefit and long term incentive awards are provided in Section 3.

2.1 Main findings

Policy

  • It appears that only 41% of FTSE 100 and 32% of FTSE 250 companies are likely to offer defined benefit arrangements to new board appointments.

Current participation

  • 76% of directors in FTSE 100 and 55% of directors in FTSE 250 companies currently participate in a defined benefit plan, reflecting a gradual decrease over the past two years. 71% of these will be affected by the earnings cap and will have a variety of arrangements in place to deal with this.
  • Older directors are more likely to participate in defined benefit plans than younger. 71% of directors under the age of 50 in FTSE 100 companies and 55% in FTSE 250 companies participate in defined benefit plans, compared to 82% and 60% of directors over the age of 50 in FTSE 100 and FTSE 250 companies respectively. Directors under the age of 40 are far less likely to participate in defined benefit plans; although there are few directors below the age of 40 in FTSE 100 companies, this is more common in FTSE 250 companies and of these, only 42% participate in defined benefit plans.
  • Only 29% of directors in defined benefit plans are not affected by the earnings cap and therefore have 'uncapped' arrangements. This is more common in FTSE 100 companies and again there is a significant difference by age with only 6% of directors under 40 in uncapped arrangements compared to 38% of those over 50.

Value of pension benefit

  • Median level of company contribution – defined contribution plans.
  • Comparison of median defined benefit and defined contribution value by market capitalisation.

Earnings cap

  • Of those directors participating in defined benefit plans who are affected by the earnings cap, only 19% have no pension provision above the cap. This is more common in FTSE 250 companies and for younger executives. 38% of 'capped' directors under the age of 40 have no pension provision above the cap, compared to 20% of directors over the age of 50.
  • 28% of directors affected by the earnings cap have unfunded arrangements above the cap. This is considerably more common in FTSE 100 companies where unfunded arrangements are in place for 47% of directors compared to only 17% in FTSE 250 companies.
  • More commonly directors affected by the earnings cap will have funded unapproved arrangements (FURBS) or will receive a salary supplement or contribution to a personal pension plan. The value of these arrangements is typically between 20% and 45% of the salary above the earnings cap, with a median of 30% of salary above the cap.

Employee contributions

  • 61% of FTSE 100 companies operating defined benefit plans require the employee to contribute to the plan, compared to 69% of FTSE 250 companies.
  • Contributions range from less than 3% of salary to over 10% with a median of 5% of salary in FTSE 100 companies and 6% in FTSE 250 companies. 

3. Methodology 

Where information is provided on total fixed remuneration and total remuneration the basic salary levels for executive positions have been aged to 1 November 2004 by an average annual increase of 6%, based on the financial year of each company, ensuring that we present a useful guide to current remuneration levels.

The analyses are presented in several ways:

  • Position – we have categorised main board positions into two main groups – the top full time executive and other executive directors.
  • FTSE ranking as at October 2004 – the differences in pension practices between the FTSE 100 companies and the FTSE 250 companies are illustrated in many of the analyses. Throughout the report we have referred to these two groups as FTSE 100 and FTSE 250.
  • Company size – as measured by average market capitalisation over the period November 2003 to November 2004. For the purposes of analysis companies have been grouped together into market capitalisation bands.

3.1 Pension valuation

We have developed an objective methodology to determine the value of pension benefits awarded to directors participating in defined benefit plans for the purposes of comparing and benchmarking companies' pension policies using the information disclosed in company accounts.

Over recent years, there has been increased regulation concerning the disclosure of directors' pension benefits. As a result there is now much greater consistency in the information disclosed between different companies.

The pension data available consists of information on the level and change over the year in the accrued pension and the transfer value. Combined with the general information provided in the accounts in relation to the directors, such as age, past service and salary levels, we are able to derive an estimate of the value of the pension benefit earned over the year and the company's underlying pension policy.

There are a number of different ways to value and compare directors' pension benefits. Our methodology determines the value of one year's worth of pension accrual for each director, allowing for earnings growth up to retirement. The value derived is analogous to the charge required to operating profits under FRS17, as well as International Accounting Standards, in respect of the pension benefits earned in respect of company service over the year.

The transfer value disclosed is divided by accrued service (some companies disclose the years of pensionable service; where this is not disclosed we have used the number of completed years of service). This is increased to allow for expected future salary growth (adjusted by forecasted RPI) over the remaining years of service to normal retirement (where the normal retirement age is not disclosed we have assumed a standard age of 60). If the director is required to make a contribution this has been deducted.

Other ways of calculating the pension value include using the increase in accrued pension but this would base the value on the current year which may not reflect usual practice. Dividing the transfer value over the past years of service has the effect of smoothing out any large salary increases or changes in accrual rate over the period of service.

There are some disadvantages to using this method. For some individuals the derived value may be understating the real value of the pension benefit, for others it may be overstating it. However, in the absence of sufficient data for each individual director to enable the actual value to be derived, we believe that this methodology provides a consistent, simple and logical way of providing an indication of the value of the pension across all directors in FTSE 350 companies.

Where an executive is affected by the earnings cap we have added the contribution made during the year to additional funded arrangements, or payments made to personal pension plans or as salary supplements. Where there is an unfunded promise this is usually accounted for in the transfer values disclosed.

All contributions to pension plans have been valued on a pre-tax and national insurance basis. Where it has been reported that additional tax and national insurance gross-up amounts have been paid by a company in respect of pension contribution, these have been added to the value.

For defined contribution plans, contributions to personal pension plans or pension allowances made as additional salary, we have simply taken the contributions made by the company in the period.

3.2 Valuation of incentive and share awards

We have measured the potential gains that may be made from incentive plans by examining the plans in each individual company to determine the award that may be earned for ontarget performance, and for superior performance. In order to provide such analysis a number of assumptions have been made.

  • The potential gains that may be made from incentive plans have been measured over a three year period assuming a specified share price increase, allowing a comparison of the gains that may be made between companies with different types of incentive plan.
  • On-target (median) awards and superior (upper quartile) awards are accompanied by share price increases of 10% and 15% per annum respectively over three years. The share price growth assumptions are based on the average share price growth of the FTSE 350 companies over a series of rolling three year periods over the past ten years.
  • The analysis is based on overall company policy for main board directors, and not on individual award levels.
  • Where information regarding the maximum award that may be made under an incentive plan is not available, we have, where possible, inferred the relevant limit from practice over recent years. Where this proved impossible we have not included the company in the analysis.
  • It should also be noted that in some companies the plan limit is only used in exceptional circumstances. Where this is the case we have used typical practice.

Annual bonus plans

  • Where information is available we have based the analysis on the target and maximum award as stated. Typically the target award is 50% of the maximum award and therefore, where information relating to the target award is not available, we have assumed 50% of the maximum award. For superior performance we have assumed an award level between the target and maximum that may be earned.
  • Where there is a deferred element in the plan we have included the portion of the bonus made in cash in the annual element. The portion taken in deferred shares has again been valued on the basis of a 10% (for on-target performance) and 15% (for superior performance) share price increase per year, over the three year deferral period.
  • Where matching share awards are made if the participant is still in employment at the end of the deferred period these have been added to the deferred element.
  • If the matching shares are dependent on further performance conditions being met over the deferred period, then the final award that may be received has been determined depending on the conditions imposed. For example, if all matching shares would be awarded if EPS growth over the deferred period is equal to the increase in the Retail Price Index, or exceeds RPI growth plus 3% per annum, then we have assumed that on-target performance would result in all matching shares becoming available.
  • We have only included the matching award that would be made after a period of three years. If holding the original number of shares for a longer period of time would result in an increased number of additional shares, then only the number that would be available after three years has been included.

Performance share plans

  • Where information is available we have used the maximum initial award and the indicated level of award that would vest for median, or on-target, performance. Typically the proportion of the award that would vest for median performance is 25% to 30% of the maximum award and therefore, where information is not available on the level of vesting for median performance, we have taken 30% of the maximum.
  • Most commonly the maximum award will vest for upper quartile performance and therefore in most cases we have included the maximum award in the superior performance analyses. Where the maximum award only vests for performance in the top 10% or 20% of companies in a comparator group we have calculated the amount that would vest for upper quartile performance.
  • Some companies have a stated maximum but indicate that this will be used only in exceptional circumstances and awards will not generally be at this level. In these cases we have based our analysis upon the expected "maximum" level of award rather than the absolute limit. • A number of plans require part, or all, of the award to be retained for a period of time. We have not adjusted the potential value of the award to take this into account. We have also not made any adjustment for those plans where performance may be re-measured after a further period if the conditions are not met over the initial three year period.

Share option plans

  • We have examined the grant policy of each company and taken the annual grant size where stated. Where the size of grant is not available we have assumed that the maximum grant is phased over three years. The majority of companies now phase grants, rather than award them in one block, and therefore we have not made any adjustments for companies where grants may still be awarded in one block. Similarly we have taken the typical annual grant size for each company, rather than initial grants that may be made on appointment or promotion which may be larger than usual. Where annual grants are based on a multiple of earnings, we have taken this as basic salary plus annual bonus.
  • In many cases the performance conditions that must be met before options are exercisable are that EPS growth must be at least equal to RPI plus 3% or 4% per annum over a three year period. We have assumed that on-target performance would result in all of these options being exercisable. In order to recognise those plans where the EPS target is more stretching than this we have taken a proportion of the total grant to be exercisable at target performance. Where the proportion of options that are exercisable increases with the level of performance, we have made an assessment of what proportion of options would be exercisable for on-target and superior performance.
  • For super options the performance requirement is more stretching, usually requiring performance to be in the upper quartile of a comparator group. For these plans we have assumed that the options will only become exercisable for superior performance and therefore the value of these options is not included in the on-target analysis.

Other incentive plans

  • There are a few long term plans where the award is made at the end of the plan and not as a contingent share award made at the beginning of the performance cycle. For these plans we have calculated the value in the same way as for the performance share plans but with no adjustment made for share price growth over the period.

For each company the value of each element of the incentive plan has been determined using the above assumptions. Few companies operate all of the above plans, and so not all companies will have a value for each plan. For each company the value of all elements have been aggregated to produce the potential total incentive award, calculated as a percentage of salary, for target and superior performance.

Using the potential gains that may be made from incentive plans under certain performance conditions it is possible to calculate the total compensation package for the CEO and other main board directors.

For each element of the incentive package we have applied the percentages derived from the above analyses to the actual salary for the CEO and the other main board directors in each company.

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