workspan, May 2004, Volume 47, Number 5

Feature

Severance and Change-in-Control Policies: Now Is the Time to Act
By Robert B. Jones, JD, CPA, CEBS, Aon Consulting

A recent survey found that employers aren’t doing enough to keep severance pay and change-in-control policies responsive to the realities of changing business strategies. Learn how compensation committees can add a neglected area of the total compensation package to their agendas.

While much has been written about the three-year recession and its effect on corporate business strategies, compensation strategies and the war for talent, there is not much information on the effects of the recession on severance and change-in-control policies.

Many have cringed as details are revealed about the litigation at Disney, which involves payments to former executive Michael Ovitz of $141 million for a little more than one year’s work. The Richard Grasso pay package at the New York Stock Exchange (NYSE) — which included some very rich severance provisions by anyone’s standards — is still grabbing front-page headlines. Jack Welch is another example. His executive perquisite package, which was framed in terms of a drawn-out severance/retirement/consultancy package, outraged many observers and caused GE to review the situation after the fact and make certain adjustments.

Executive recruiters are advising their executive placement candidates to negotiate severance upfront because the honeymoon may be short in an era of heightened attention to corporate performance and short-term results.

In light of all of this, what are employers doing to keep severance pay and change-in-control policies current and responsive to the realities of changing business strategies, the intensive scrutiny in the governance arena and the needs of the 2004 workforce?

Not enough, according to an October survey jointly conducted by WorldatWork and Aon Consulting. (See “About the Survey.") The survey found that 33 percent of surveyed respondents have not reviewed their severance plans in the past two years; 15 percent have not reviewed the plans since they were established. Similarly, a fairly high percentage of respondents (44 percent) have not conducted a formal review of their change-in-control policies since they were established. Eighty-six percent of respondents have no schedule for reviewing their change-in-control policies. Finally, while more than half of respondents (51 percent) have reviewed their top executives’ severance plan within the past 12 months or upon hire, a surprising 78 percent do not have a schedule for review of the top executive’s severance plan.

Yet, the three-year recession has caused severance and change-in-control plans to have widespread practical application: More than three-quarters of respondents (76 percent) have experienced a reduction in force in the past 24 months. Numerous shareholder proposals have recommended putting limits on severance packages for departing executives or permitting shareholders to vote on severance packages before they are paid.

Changes in the business environment, the pay packages of top executives and increasing governance requirements (imposed or recommended by Sarbanes-Oxley, the National Association of Corporate Directors, the U.S. Securities and Exchange Commission, the NYSE and Nasdaq) indicate that a review of the severance and change-in-control policies should be part of a regular schedule of formal review by compensation committees. This also is due in part to the fact that these policies can represent sizeable amounts of corporate assets. Finally, an equally important consideration is that the recently “quiet” mergers and acquisitions (M&A) market may be heating up again and severance and change-in-control policies may be more prevalent in the near future in certain economic sectors. (See “Survey Highlights.”)

Behind the Data
Several theories exist regarding why more attention hasn’t been paid to severance and change-in-control plans. First, corporate boards are deeply involved in hiring top executives. But once they’re hired and the honeymoon ends, inertia can set in and certain details of the pay package may not be reviewed on a timely basis. These issues may not capture as much attention and focus in the periodic board meeting as do the regularly scheduled and annual bonus awards, salary increases and equity compensation (stock option) awards that compensation committee members are required to oversee and approve. Corporate boards also are deeply involved in reviewing top executives’ performance, a practice that has accelerated since the passage of Sarbanes-Oxley.

Helping executives focus on the merits of a deal — rather than worrying about their jobs in the event they become redundant — is the rationale for making change-in-control policies meaningful. With a number of tasks to accomplish at every meeting and the agenda building over the past 18 months since Sarbanes-Oxley, compensation committee members or senior management may feel that the potential acquisition or merger situation just seems too far off to worry about now. This thinking can be dangerous. As illustrated by the recent offer that Comcast made for Disney, dramatic changes can occur very quickly.

A careful and periodic review of change-in-control and executive and employee severance policies can fall through the cracks. Emphasis should be placed on a careful review. The WorldatWork/Aon data reveals that, among those who reviewed their severance plans since they were established, 55 percent made no change. Similarly, for change-in-control policies, 42 percent made no change. One cannot help but wonder whether the reviews were thorough enough. In some cases, could a second opinion have been sought? The potential dollars on the table can be significant in these situations; seeking expert assistance as a best practice is usually needed to avoid excesses and to ensure the package is fully aligned with the business strategy.

What Should Employers Do?
First, compensation committees should examine their philosophies about severance and change-in-control. Is the employer acquisitive and likely to invoke change-in-control provisions readily, or is the company not seeking alliances or acquisitions, preferring to remain independent? What is the employer’s attitude about paying severance if a corporate raider causes redundancies among the headquarters’ office staff? Compensation committees should recognize that this problem might have several layers in the severance area: top executives, senior executives and managers, and all other employees.

Second, how does the employer want to communicate the policies? What are the compensation strategy and preferred methods for getting this done? The repercussions of communicating well or poorly can be significant in today’s litigious society.

Third, employers and their compensation committees should recognize the need to periodically review the company’s severance policies and change-in-control arrangements. This process should be built into the compensation committee’s calendar on a regular annual cycle. Theoretically, the process does not need to be thoroughly and exhaustively reviewed annually, but it should be an agenda item on the calendar each year so it is not forgotten or overlooked in subsequent years.

Fourth, much of the new governance focus is about process. Compensation committees should begin a process that includes a detailed annual review of severance and change-in-control policies. Some of the questions that should be asked include:

• How and with which vehicles does the company communicate the severance pay policies to employees?
  
• Does the severance policy rise to the level of an employee welfare benefit plan under the Employee Retirement Income Security Act (ERISA)?
  
• What is the maximum total dollar amount as a function of the base pay number that can inure to each tier of executives in the event of a change in control? (A surprising number of companies in our experience have never benchmarked their potential change-in-control/golden parachute liability in light of the golden parachutes under Internal Revenue Code Section 280G.)
  
• If an excess golden parachute payment exists, should the executive be grossed-up for the golden parachute tax? (This can be a large number by itself.)
  
• What happens under each of the following scenarios on a change-in-control?:
  
  • Voluntary resignation
  • Disability
  • Retirement
  • Non-renewal of contract by executive for good reason
  • Discharge without cause
  • Discharge with cause.

• How is “cause” defined?
  
• What types of triggers exist on the various programs, such as stock options or deferred compensation?:
  
  • “Double” — requires both a change-in-control and an executive to terminate
  • “Single” — less common, meaning only a change-in-control
  • “Modified single” — requiring the executive to say on with the company for a period to help during the transition.

As an example of details to be reviewed in this area, Golden Parachutes and Cushion Landings, published by The Corporate Library, includes a comprehensive look at current corporate policy and practice regarding termination payments, including a full assessment of the actions that could be taken to curb the excesses associated with executive severance. These best practices include:

• Reducing the length of executives’ contracts
• Not forgiving retention or other loans
• Not including incentive payments as part of severance benefits
• Vesting retirement benefits based solely on actual service (not additional deemed service)
• Terminating unvested stock options and other restricted equity awards (do not accelerate them)
• Not paying severance benefits to an executive at the same time as consultancy fees (a form of double-dipping)
• Not paying severance benefits to an executive at the same time as retirement benefits
• Ceasing or cutting back provision of office space, administrative support, corporate transportation, financial counseling and subsidized club memberships at the termination date.

Finally, periodically benchmark the severance levels for the three sectors against the peer group and appropriate competitors. This is critical, as the overspend on severance or change-in-control can be just as bad or worse than the overspend on a given executive’s total direct compensation — often as much as a million dollars or more over 10 years.

By following this suggested process, compensation committees can add a neglected — but important — area of the total compensation package to their agendas. The additional focus can help them more prudently manage corporate resources and perform job functions better and more responsively while ensuring that anomalies do not exist that might rise up to surprise the company in the form of costly litigation or shareholder angst.

About the Survey The purpose of the survey was to analyze and better understand the changing landscape of severance and change-in-control practices. A representative sample of 5,530 WorldatWork members received an e-mail invitation in early October. The survey closed after eight days with a total of 704 responses — a 13-percent response rate.

Survey Highlights Many companies’ severance structures are different for the CEO, executives and all other employees (36 percent). Nearly two in 10 companies (18 percent) have no severance plan at all. The trend of employers offering outplacement continues to gather momentum. Seventy-five percent of responding organizations provide outplacement benefits to all affected employees. Most companies rely on years of service as the basis for calculating the severance benefit (94 percent) for plans covering the largest number of employees (not the CEO). One week’s pay per year of service is the most common formula for severance payouts for plans covering the largest number of employees (not the CEO); however, two in 10 companies use two weeks’ pay per year of service. About half of surveyed organizations do not offer a COBRA subsidy, but three in 10 provide a complete subsidy, and two in 10 provide a partial subsidy. Executives commonly receive a lump sum payment of severance that equals at least 12 months of their monthly salary. A common thread is that 95 percent of the respondents have indicated that “years of service” is the basis for calculating severance benefits.

About the Author
Robert B. Jones, JD, CPA, CEBS, is a senior vice president and national director of U.S. Compensation Consulting for Aon Consulting and has been a WorldatWork member since 1996. He can be reached at robert_jones@aoncons.com or 610/834-2157.

© 2004 WorldatWork, 14040 N. Northsight Blvd., Scottsdale, AZ 85260 U.S.A.; 480/951-9191; Fax 480/483-8352; www.worldatwork.org; E-mail worldatwork@worldatwork.org