4. Compensation components and system
4.1 Overview of compensation components
The table below provides an overview of the compensation components for the Board of Directors and the Management Board, with more details on both included later in the report:
4.2 Board of Directors compensation system
Role, responsibility and commitment
Sonova needs to be able to attract and retain members of the Board of Directors who are highly experienced and motivated to contribute their specific business expertise and perform a critical role in the strategic oversight of the company. Their compensation must enable this, while taking account of the way their contribution to Sonova’s success differs from that of the members of the Management Board.
Requirements – in terms of qualifications, skills, and experience – for directors of international listed companies are becoming ever more stringent. Sonova’s Board of Directors has the relevant and necessary skill set to ensure proper professional supervision, including international, industry, and subject specific experience.
The structure of fees paid reflects varying responsibilities, committee memberships, workloads and time commitments, so individual levels of pay are not the same. The Chairman of the Board of Directors, for example, devotes a substantial amount of his time to mandated duties, including leading the Board of Directors and committees, coordinating Board and committee meeting agendas and topics with committee chairs, and managing as well as contributing to and participating in committees. As NCC chairman, he takes the lead on topics such as Board and CEO evaluation, Board skill and competence definition and composition, new Board member recruitment and on-boarding, and participating in recruitment of Management Board members – as well as overseeing all compensation related matters.
The Chairman is also responsible for the continued development and adaptation of Sonova’s governance to meet regulatory and corporate requirements, preparing for and conducting the AGM, and overseeing the annual and compensation reports, as well as advising the CEO on key strategic, financial, HR, and operational matters. His role also encompasses third party interactions such as shareholder inquiries and requests about corporate governance and corporate responsibility as well as meetings with proxy advisors. His sound understanding of the company, developed over many years of service, is a unique and valuable qualification that we believe provides a substantial benefit to Sonova and its shareholders.
More details on the Board of Directors’ composition, diversity, competencies, evaluation, risk and compliance management, as well as corporate responsibility, can be found in the corporate governance report.
It is important that compensation components are structured to achieve a strong alignment with the interests of our shareholders. In line with best practice, a significant portion of the compensation for the Board of Directors consists of restricted shares; members of the Board of Directors receive no variable or performance-based compensation and are not eligible to participate in the occupational pension plan.
The compensation of members of the Board of Directors is defined in a regulation adopted by the Board of Directors; it consists of fixed compensation, namely a cash retainer and shares with a restriction period of five years and four months (Chairman of the Board of Directors) or four years and four months (all other members). In addition, members of the Board of Directors receive a committee fee (if applicable) and a travel allowance.
As announced in the compensation report for the 2018/19 financial year, the meeting attendance fee was discontinued during this reporting year and the cash retainer for the Chairman as well as the restricted shares for both the Chairman and the other Board members were reduced. The committee fees were increased in alignment with ever increasing requirements and the market, with the overall change resulting in a decrease of about 9% in the total compensation for the Board of Directors.
Compensation structure AGM 2019 to AGM 2020
The table above provides an overview of the normal compensation structure of the Board of Directors.
As outlined in the introduction to this compensation report, the compensation related short-term measures taken in response to the current COVID-19 related crisis include the Chairman of the Board of Directors ceding his cash retainer (net of social security contributions for the portion delivered in restricted shares) from April 2020 until the 2021 AGM. Additionally, the other members of the Board of Directors will waive 20 percent of their cash retainer and committee fees for the next term of office, from the 2020 AGM to the 2021 AGM.
The compensation of members of the Board of Directors is subject to mandatory employer social security contributions (AHV/ALV). These contributions are paid by Sonova and are disclosed in the compensation report in compliance with Sonova’s reporting obligations.
Sonova does not grant contractual severance payments to members of the Board of Directors, nor does Sonova make advance payments or grant loans to them.
Sonova Share Ownership Guidelines
To further align the interests of the Board of Directors with those of our shareholders, the Sonova share ownership guidelines require the members to hold a fixed value in shares.
Members of the Board of Directors are required to maintain a minimum shareholding equivalent to CHF 200,000. They have five months from the first grant of restricted shares to achieve 80 percent of the required shareholdings, and one year and five months from the same point in time to achieve the full required shareholdings. The requirements of the guidelines can be met through shareholdings in the form of the restricted shares awarded as part of compensation and, if applicable, through share purchases on the open market. Compliance with the shareholding requirement is reviewed annually by the NCC.
4.3 Management Board compensation system
The compensation of the Management Board (including the CEO) is defined in several regulations adopted by the Board of Directors and comprises:
- A fixed base salary
- A short-term cash incentive award (VCC)
- A long-term equity incentive award (EEAP); and
- Employee benefits, such as pension benefits, flat rate cash car allowance, expense allowance, relocation benefits for certain affected members, as well as social security contributions.
As outlined in the introduction to this compensation report, the compensation system of the Management Board is linked to the company’s strategy and business results, and aligns with the interests of our shareholders, rewarding performance in the context of the business and the market. The system has proven effective over many years; however, certain specific short-term adjustments are being made to ensure continued alignment during the current COVID-19 related crisis. These changes are summarized in the introduction and outlined under each element below.
The charts below illustrate the compensation mix excluding employee benefits at target for the CEO, Arnd Kaldowski, and the Management Board in the 2019/20 financial year:
The table on the next page provides an overview of the compensation components of the Management Board, with more details on the following pages. The ratio of the VCC and the EEAP as a percentage of the fixed base salary shown in the table on the next page can vary slightly year on year, depending on which component (if any) is adjusted as a result of the compensation review.
Compensation structure 2019/20 financial year
Fixed base salary
The fixed base salary ensures a recurrent payment in cash in regular instalments. The salary level is based on the scope and complexity of the position, market norms and benchmarks, and the individual’s profile in terms of experience and skills. Salary progression depends primarily on the individual’s performance, as well as on market developments and the economic environment.
As outlined in the introduction to this compensation report, the compensation related short-term measures taken in response to the current COVID-19 related crisis include a freeze on salary increases for the Management Board until later in the 2020/21 financial year. Additionally, the CEO will voluntarily forego 50 percent of his monthly base salary and each of the other Management Board members 20 percent of their monthly base salaries from April 2020 to September 2020.
Short-term cash incentive award (Variable Cash Compensation)
Sonova’s VCC aims at aligning a significant part of compensation to budget achievements in a given financial year. The VCC is an integral component of the compensation for members of the Management Board, defined as a percentage of the annual fixed base salary. At target, it amounts to 89% of fixed base salary for the CEO and up to 50% for the other members of the Management Board.
The Board of Directors normally determines annually the target performance level for each KPI for the following financial year, based on the recommendation of the NCC. The targets are generally set in such a way that on an adjusted base, substantial improvements from the previous financial year’s achievement are required, in line with the company’s ambitious mid- and long-term financial plans. Setting demanding and ambitious targets helps Sonova strive to deliver best-in-class performance and stay ahead of the market. Lower and upper performance thresholds are also set, below which the payout percentage is zero, and above which it is capped at 200%. Payout levels between the threshold, the target, and the maximum are calculated by linear interpolation.
The VCC for the Management Board is based on three categories of performance objectives: Group and/or business unit and individual performance objectives. The performance objectives that must be met to achieve the target VCC are mutually agreed at the beginning of the financial year.
Group performance objectives are based on the budget; the specific KPIs can include sales, EBITA, FCF, and EPS. Business unit performance objectives can include sales, EBITA, ASP, and OPEX of the respective business unit. These KPIs have been chosen because they are the key drivers for the long-term success of Sonova; they reward for expanding the business, gaining market share, and further increasing profitability through operating leverage.
In broad terms, the rationale for applying these particular Group and business unit performance indicators in determining the VCC is as follows: sales correlate with market success, EBITA reflects profitability, ASP tracks value add and price discipline, OPEX and FCF represent operational and capital efficiency respectively. As for the performance indicators linked to the external market, earnings per share is important to shareholders and for the determination of the share price.
Group and business unit performance objectives together are weighted at 80% of the overall VCC. The individual performance component is based on the achievement of individual objectives defined at the beginning of the financial year between the CEO and individual members of the Management Board – and, for the CEO, between the Board of Directors and the CEO. The total weight of the three to six individual performance objectives for each member of the Management Board is generally 20% of the overall VCC. The weight can be increased up to 40% for exceptional reasons, such as supporting key strategic initiatives.
This section and table provides an overview of the normal structure of the VCC.
As outlined in the introduction to this compensation report, the compensation related short-term measures taken in response to the current COVID-19 related crisis specify that 50 percent of the VCC payout for the 2019/20 financial year will be deferred to later in the 2020/21 financial year.
During these uncertain times, target setting for the VCC will need to be governed on a rolling basis to reflect rapidly changing market conditions in the 2020/21 financial year. While the KPIs will generally remain the same, the target weightings will reflect the primary focus on liquidity, costs and growth. This includes shifting all weightings for individual targets to financial targets for the time being. Additionally, the maximum VCC payout during the 2020/21 financial year will be capped at 100 percent for Management Board members.
Looking forward, in line with our strategy and to reflect Sonova’s corporate social responsibility and sustainable business approach, business relevant ESG targets will be more formally reflected in the VCC, even if not from the start of the 2020/21 financial year. Once business returns to normal, five percent each of the financial and individual targets – that is, 10% of the overall VCC targets for each member of the Management Board – will be linked to specific, tangible ESG related initiatives.
Long-term equity incentive award (Executive Equity Award Plan)
The purpose of the EEAP is to ensure long-term value creation for the company, alignment of the interests between shareholders and the members of the Management Board, and the long-term retention of talent at Sonova.
The EEAP is offered annually to the members of the Management Board. The Board of Directors determines the individual grant level to the members of the Management Board based on the recommendation of the CEO, and to the CEO based on the recommendation of the NCC. Generally, the grant date is on February 1st each year.
Under the EEAP, the CEO receives an equity compensation mix of 62.5% in options and 37.5% in PSUs and the other members of the Management Board are awarded 50% in options and 50% in PSUs.
A portion of the EEAP is allocated in the form of performance options: This reflects the growth-focused strategy and the desire to further strengthen the alignment of the Management Board compensation with our shareholders’ interests.
Options granted under the EEAP vest in four equal annual instalments over a period of 16–52 months, generally depending on ROCE achievement. The first tranche vests on June 1 of the year following the grant year (16 months after grant date). The exercise price of the options is the closing price of the Sonova share on the Swiss Stock Exchange (SIX Swiss Exchange) at the grant date, and the life of the options is 10 years (grants before the 2017/18 financial year: 7 years).
The fair value of the options is calculated at the grant date by a third party using the “Enhanced American Pricing Model.” Additional information is available in Note 7.4 to the consolidated financial statements. Re-pricing of any out-of-the-money options granted under the EEAP is prohibited.
For reference, the average vesting duration for options is 34 months. Options have usually been exercised approximately one and a half years after the vesting date. In this way options align management with shareholder interest, as value creation is only realized in the event of increasing share price (see section 5 for more information on the overall levels of the target achievements as well as other qualitative comments).
Vesting of option grants made under the EEAP to members of the Management Board generally uses ROCE as its performance criterion because it reflects multiple KPIs, including both the profitability of the company and the efficiency with which Sonova’s capital is being employed. The Board of Directors generally determines the target level of performance at which the options will vest in full and a minimum performance threshold below which there is no vesting. Payout levels on ROCE performance between the threshold and the target are determined by linear interpolation.
There is no provision for over-achievement; the proportion of options that can vest ranges from 0% to 100%.
With the option grant in February 2020 we have implemented an important change, in order to further foster long-term alignment to shareholders. Options are now subject to a five-year holding period from the grant date. During this period, even after the vesting date, options cannot be sold, pledged, assigned, transferred or otherwise disposed of.
Performance Share Units
The other portion of the EEAP is allocated in the form of PSUs: PSUs vest based on achieving relative Total Shareholder Return (rTSR). This external criterion, measured against a peer group of relevant companies, provides a performance assessment against these companies designed to incentivize members of the Management Board to achieve strong performance.
PSUs granted under the EEAP will cliff vest after three years and four months, depending on the rTSR achievement. Sonova’s TSR is measured against those of the SLI®1) constituents that remain in the index during a performance period of three years and two months from grant. The slightly shorter performance period provides sufficient time to test for performance and receive approval of the calculation prior to vesting. The SLI® was selected in order to compare Sonova´s performance to companies with a comparable geographic footprint, providing a relevant and challenging benchmark for Sonova’s value creation.
Depending on the rTSR performance ranking, the cliff vesting of PSUs is as follows:
- 20th percentile or below: no cliff vesting occurs and granted PSUs are forfeited
- 50th percentile: 100% of granted PSUs cliff vest
- 80th percentile or above: 200% of granted PSUs cliff vest (cap)
The number of shares allocated for each vested PSU between the 20th and 80th percentile is calculated by linear interpolation. As an additional performance alignment measure, if Sonova’s (absolute) TSR is negative over the performance period, the cliff vesting is capped at 100%.
The calculation of rTSR target achievement will be conducted using the average closing price for 90 trading days prior to grant and end of performance period respectively. The fair value of the PSUs is calculated at the grant date by a third party by using the “Monte Carlo Pricing Model.” Additional information is available in Note 7.4 to the consolidated financial statements.
As for the options, with the PSU grant in February 2020 we have implemented an important change, in order to further foster long-term alignment to shareholders. PSUs are now subject to a five-year holding period from the grant date. During this period, even after the vesting date, PSUs and underlying shares cannot be sold, pledged, assigned, transferred or otherwise disposed of.
- The Swiss Leader Index (SLI) includes the 30 largest and most liquid securities in the Swiss equity market
Summary of the EEAP instruments
This section and table provides an overview of the normal structure of the EEAP.
As outlined in the introduction to this compensation report describing the compensation related short-term measures taken in response to the current COVID-19 related crisis, the Board of Directors is convinced that the EEAP continues to fulfil its purpose of ensuring long-term value creation for Sonova and alignment of the interests with shareholders: The benefit for the Management Board members will only arise if the company performance and share price increases and outperforms peers. However, given the current crisis and its uncertainties, and after thorough consideration, the Board of Directors has decided to suspend the ROCE target for the portion of the EEAP delivered in options for the time being.
Termination of employment under the long-term equity incentive award (Executive Equity Award Plan)
In the event of termination of employment, unvested awards (options, RSUs, PSUs) are forfeited. Any applicable holding period for grants from 2020 onwards continues to apply, unless specifically provided otherwise below. Vested options can be exercised within a period of three months. Specific exceptions include:
- In case of death or disability, unvested options and RSUs vest immediately and unvested PSUs according to the regular vesting schedule. Any still applicable holding period lapses. The vested options are exercisable within a period of 12 months commencing on the date of death or termination.
- In case of retirement, the unvested options and RSUs with a vesting date during the calendar year of the employee’s retirement vest according to the regular vesting schedule. The holding period, if applicable, continues to apply. The vested options are exercisable for a period of 12 months from the latter of the date of expiry of the holding period or of retirement. Unvested equity grants with a vesting date after the calendar year of the employee’s retirement are forfeited without any compensation.
- For PSUs, in case of a qualified retirement as specified in the plan rules and subject to further requirements, any then unvested PSUs will vest on a pro-rata basis. However, the performance assessment will only be determined upon completion of the performance period.
- In case of a termination of employment by a participant or by Sonova (except for termination for cause) for Management Board members in office on April 1st, 2017 whose date of termination occurs between the grant date in 2018 and/or 2019 and May 31st, 2021 (transition period), any then unvested PSUs will vest on a pro-rata basis. However, the performance assessment will only be determined upon completion of the performance period.
- In the event of termination of employment by Sonova for cause all options, whether vested or not, and other unvested awards become null and void immediately. “Cause” means any act of fraud, embezzlement or dishonesty, unauthorized use or disclosure of confidential information or trade secrets of Sonova, or any other misconduct by the employee.
- In the event of termination of employment by Sonova following a change of control (“double trigger”), unvested equity grants vest immediately on a pro-rata basis considering the period from the grant date to the effective date of the change of control compared to the original period at target level, for options, and for PSUs based on actual achievement of the PSU performance conditions as of the date of occurrence of the change of control. Any still applicable holding period lapses on an employee’s date of termination. Vested options are exercisable for a period of 60 days commencing on an employee’s date of termination. This rule does not apply in the event of voluntary resignation by the employee following a change of control. In such case, equity grants are forfeited.
Disclosure of targets
Internal individual and/or financial targets under the VCC and the EEAP plans are generally considered sensitive information with the exception of information relating to rTSR for PSUs. Disclosing internal targets would allow confidential insight into our strategy and thus could create a competitive disadvantage for Sonova.
Therefore, after review and careful consideration during the reporting year, the decision was made not to disclose the specifics of the VCC and EEAP internal financial targets at the time of their setting, but to further increase transparency by disclosing target achievements and their respective payouts at the end of the relevant period. For the first time in this report, the specific target achievement for each KPI underlying the VCC is disclosed (see section 5.2 for more information related to the overall quantitative achievements). Similarly, the first PSU target achievement of rTSR occurring in the next reporting year will be disclosed.
As a general rule, on a comparable basis, substantial improvements against the previous year’s achievements are required in order to meet the growth targets, in line with the company’s ambitious strategic and financial plans and as communicated to the capital market.
However, given the impact of the current COVID-19 related crisis on our business, quarterly VCC targets will have to be set in the 2020/21 financial year and will be linked to the expected significantly reduced business volume.
Sonova Share Ownership Guidelines
To further align the interests of the Management Board with those of our shareholders, the Sonova share ownership guidelines require Management Board members to hold a minimum fixed value in shares equivalent to the following amounts:
- CEO: CHF 1,000,000
- Other members: CHF 200,000
They have three years and five months after receiving the first grant as Management Board member to build up the shareholding, with a required progression of one year and five months for a 12.5% achievement, and two years and five months for a 25% achievement. Only shares in the form of fully vested shares awarded as part of compensation and, if applicable, share purchases on the open market are counted. Compliance with the shareholding requirement is reviewed annually by the NCC.
As the Management Board is international in its nature, the members participate in the benefit plans available in the country of their employment contract. Benefits consist mainly of retirement, insurance, and healthcare plans that are designed to provide a reasonable level of protection for the employees and their dependents in respect to retirement income, healthcare provision, and coverage against the risk of disability or death.
Sonova maintains defined-contribution plans under the Swiss occupational pension regulations. Pension benefits are provided through the regular pension plan. Members of the Management Board who are under a Swiss employment contract are eligible for the same benefits as all other employees in Switzerland. Members of the Management Board who are under a foreign employment contract receive benefits in line with local current market practice.
The compensation of members of the Management Board who are under Swiss employment is subject to mandatory employer social security contributions (AHV/ALV).
The benefits and company contributions covered by Sonova are disclosed in the compensation report in compliance with Sonova’s reporting obligations.
The CEO and selected members of the Management Board are entitled to a flat rate cash car allowance as well as an expense allowance in line with the expense regulations applicable to all members of management in Switzerland, which is approved by the Swiss tax authorities.
Employment terms and conditions
As part of its commitment to good corporate governance, Sonova has a forfeiture provision in all employment agreements with the Management Board members. It provides for repayment of any compensation paid or granted prior to approval by the AGM if the proposed aggregate compensation of the members of the Management Board is not approved.
All members of the Management Board have permanent employment contracts with a notice period of a maximum of six months. The notice period for the CEO is 12 months.
Sonova does not grant contractual severance payments to members of the Management Board, nor does Sonova make advance payments or grant loans to them. There are no change of control provisions other than those highlighted in the EEAP termination provisions.
Sonova has introduced a claw-back provision allowing the company to reclaim any VCC payment, in part or in full, in the event of an accounting/financial restatement due to non-compliance with financial reporting requirements under the Swiss laws at the time of disclosure. This provision applies to all VCC payments for a period of three years following the financial year related to which the VCC payment has been made.
We believe that the five-year holding period under the EEAP represents an effective solution to mitigate any impact in the event of an accounting/financial restatement due to non-compliance with financial reporting requirements under the Swiss laws at the time of disclosure.