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IBM Notice of 2008 Annual Meeting and Proxy Statement

2007 Compensation Discussion and Analysis

Section 1: Executive compensation summary—why we pay what we do

Trust and personal responsibility in all relationships—relationships with clients, partners, communities, fellow IBMers, and investors—is a core value at IBM. Investors should have as much trust in the integrity of a company’s executive compensation process as clients do in the quality of its products. A breach of either constitutes an unacceptable risk. As a part of maintaining this trust, we well understand the need for our investors to know how compensation decisions are made. We have put tremendous effort and rigor into our own executive compensation processes over many years, continually updating them to meet new voluntary criteria as well as official requirements from the SEC.

As we did last year, we are publishing this guide to executive pay at IBM, which will, we hope, make the process accessible and comprehensible not only to professional fund managers and to institutional investor groups, but to millions of individual investors.

Investors—IBM’s owners—want senior leaders to run the Company in a way that protects and grows their investment over the long term. This is no simple task at any company, and at a company as large and complex as IBM, it is a particularly exciting leadership challenge. IBM holds a unique identity, based on talent, brand, global operating footprint, the size and scope of our business overall and the size of each of our individual lines of business. Unlike those few other companies of comparable size and scale that tend to operate as holding companies of component businesses, we operate as an integrated entity across a number of significant business lines, most large enough to be among the Fortune 150 biggest companies if they were stand-alone businesses. Our unique, integrated model delivers great value to our investors and our clients, yet demands a senior leadership team of unusual depth, agility and experience.

To that end, IBM’s executive compensation practices are designed specifically to:

  • Ensure that the interests of IBM’s leaders are closely aligned with those of our investors and owners;
  • Attract and retain highly qualified senior leaders who can drive a global enterprise to succeed in today’s competitive marketplace;
  • Motivate our leaders to deliver high business performance;
  • Differentiate compensation so that it varies based on individual and team performance; and
  • Balance rewards for these demanding roles between short-term results and the long-term strategic decisions needed to ensure sustained business performance over time.

With these goals in mind, IBM executives earn their compensation based on performance over three time frames:

1. Current—Salary and annual incentives that reflect actions and results over 12 months;

2. Longer-term—A long-term incentive plan that reflects results over a minimum of three years, helping to ensure that current results remain sustainable; and

3. Full Career—Deferrals, retention payments and retirement accumulations help ensure today’s leaders stay with IBM until their working careers end.

Compensation elements for senior leaders

On average, 86% of IBM’s senior leaders’ annual compensation is “at risk”—which means it varies year to year based on business results, with the remainder coming from salary. With this much pay “at risk”, the Company ensures that the interests of senior executives are aligned with stockholders.

Current Year’s Performance: Salary and Annual Incentives
Salary. Senior leaders at IBM receive a small percentage of their overall compensation in salary. In 2007, for example, Chairman and CEO Sam Palmisano earned 10% of his compensation in salary, and the rest of the senior team earned an average of 14%.

Annual Incentive. Senior leaders are incented through a program that sets performance targets based on their role and scope. Actual payments are driven by business performance against revenue growth, net income, and cash flow targets and individual performance, as reflected in the Personal Business Commitment review process described under “How Compensation Decisions Are Made.” Top performers earn the greatest payouts; median performers earn much smaller amounts; and the lowest performers earn no incentive payments at all. Over the past four years, these results-based payouts for individual leaders have ranged from 0.7 times target to a high of 1.66 times target. In 2007, the annual incentive earned by the Chairman and CEO represented 33% of his total compensation; incentives achieved by the rest of the senior team averaged 20% of their total compensation. Additional information about the Annual Incentive Program is outlined in Section 2 of this CD&A, “Setting Performance Targets for Incentive Compensation”.

Team Incentive. When Mr. Palmisano became CEO in 2002, he asked the Board of Directors to take a portion of the incentive funding (approximately $ 3 million) to help create a pool for rewarding teamwork by his most senior leaders. This was done to reinforce IBM’s strategy of integration across the Company, with awards based on how well the EVP and SVPs lead efforts to deliver integrated value to IBM’s clients worldwide. Every year, an amount ranging from $ 0 to $ 250,000 is awarded and paid equally to each member of the senior team. The Chairman and CEO does not receive a team incentive. Since inception, payments to the senior team have ranged from $ 100,000 to $ 220,000; the maximum award has not yet been earned. In 2007, this team incentive represented an average of 5% of total compensation for the EVP and SVPs.

Other Compensation. At IBM, additional programs that are restricted to senior executive participation amount to less than 1% of total compensation on average. Programs are limited to services with a direct bearing on productivity.

Longer-Term Performance: Long Term Incentive Plan
Long-term incentive plans (LTIP) have been a focal point for much of the discussion over executive compensation in the past several years. Well-designed LTIPs ensure that senior leaders hold a competitive stake in their company’s financial future. At the same time, the size of the awards reflects the value that the company and, ultimately, its investors place on the individual executive at the time. Any gain the executives realize in the long run from the program depends on what they and their colleagues do to drive the financial performance of the company. Under IBM’s LTIP, senior leaders may receive certain grants of IBM equity, as explained below.

Performance Share Unit (PSU) Grants. This portion of the LTIP focuses senior leaders on delivering business performance over the next three years against two key financial metrics which drive long-term stockholder value—earnings per share and cash flow. Through this program, senior leaders are eligible to earn a target number of shares of IBM stock at the end of a three-year performance period. The award pays out at the end of the three years depending on how well the Company performed against targets set at the beginning of the three-year period. The payouts are made in shares of stock, so the value goes up or down based on stock price performance from the beginning of the grant. Additional information about PSUs is set forth in Section 2 of this CD&A, “Setting Targets for Incentive Compensation”.

Over the past seven years, program payouts have ranged from a low of 54% to a high of 147% of the target number of shares. In 2007, the potential value of performance share grants, assuming future performance at target, represented 40% of the Chairman and CEO’s total compensation and 42% for the EVP and SVPs.

The IBM Integration & Values Team (I&VT) consists of approximately 300 executives charged with working beyond the scope of their regular job responsibilities to drive growth through integration and demonstrating IBM’s values. The Chairman and CEO may grant members of this group additional performance shares for delivering extraordinary results. The Chairman and CEO, EVP and SVPs are not eligible for these I&VT awards.

Other Stock-Based Grants. Another portion of the LTIP provides for stock-based grants to focus senior leaders on delivering performance that increases the value of the Company through growth of IBM’s stock price over the long term. Senior leaders may receive these grants in the form of stock options, restricted stock, restricted stock units or any combination. The grants vest—become available for sale or exercise—over time, typically over either three or four years. Until vested, the grants have no value, except that dividend equivalents are paid on restricted stock units granted prior to January 1, 2008. For restricted stock units awarded after December 31, 2007, dividend equivalents will not be paid. Executives awarded these grants typically hold them for extended periods, and have up to 10 years to convert stock option awards to cash or shares. The planned value of the annual other stock-based awards granted in 2007 represented 17% of the Chairman and CEO’s total compensation and, on average, 19% for the EVP and SVPs.

In 2007, market-priced stock options were awarded to executives, including some named executive officers, who chose to participate in an IBM stock investment program. Under this program, which has since been discontinued, executives could invest 5, 10 or 15% of their annual incentive plan payout in IBM stock equivalents and receive IBM stock options, under the terms of the IBM Long Term Performance Plan, valued at two times their investment.

The values of the awards granted in 2007 are shown in the Grants of Plan-Based Awards Table. The 2007 expense associated with all outstanding awards, including grants made in 2007 and prior years, is shown in the 2007 Summary Compensation Table.

Full Career Performance: Retention, Pension and Savings
Retention of our key leaders for a full career is an important element of our total compensation strategy. This is accomplished through a combination of retention payments and retirement plans.

Retention Stock-Based Grants & Cash Awards. Periodically, Chairman and CEO Palmisano reviews outstanding stock-based awards for the members of his senior leadership team and other key executives. Depending on individual performance and the competitive environment for senior executive leadership talent, he may recommend that the Compensation Committee approve individual Retention Awards, in the form of restricted stock units or cash, for certain executives. The restricted stock unit grants typically vest at the end of five years and the cash awards have a clawback (i.e., repayment clause) if an executive leaves IBM before a specified date. These awards make it more difficult for other companies to recruit IBM’s top talent.

Closed Retention Plan. In 1995, IBM created a new plan to help retain, for their full careers, the caliber of senior leaders needed to turn the Company around, preserve its long-term viability, and position it for growth in the future. To discourage these leaders from joining competitors, benefits would be forfeited if leaders left IBM prior to the end of a full career, typically age 60. The approach worked, as evidenced by the Company’s historic turnaround in the late 1990s, and its current position of market leadership. Thirteen of the Company’s top 16 executives, including four of the named executive officers, were with IBM and eligible for the Retention Plan when it was introduced and remain with the Company today. Because its original purpose had been met, the plan was closed to new participants in 2004. Future accruals under the plan stopped on December 31, 2007, and the Retention Plan will not be replaced by any other plan.

Pension. Prior to 2008, IBM’s senior executives and other IBM employees in the U.S. participated in pension plans. Future accruals under the pension plans stopped on December 31, 2007. The amount of the pension benefit under these plans is based on pay and service and determined by the same formulas for executives and non-executives.

Savings. The money that U.S. executives save through the Savings Plan, as for all U.S. employees, is eligible for a Company match that in 2007 equaled 50% of the first 6% of eligible pay that they save through the plan for those hired before January 1, 2005, and 100% of the first 6% saved for those hired after December 31, 2004. As announced in early 2006, effective January 1, 2008, the provisions of the Savings Plan were changed, and it was renamed the 401(k) Plus Plan, becoming the only retirement program available to IBM’s U.S. employees for future accruals.

In the U.S., the Department of Labor and Internal Revenue Service also permit company executives to defer, on a nonqualified basis, receipt of compensation they earn. This also allows IBM to delay paying these obligations and, until they come due and are paid, IBM retains the cash for operating purposes. In simple terms, this deferred compensation is money earned in the past, but not yet paid out. Executives choose investment options for their accounts from the same investment options available to all employees through the 401(k) plan. IBM does not pay guaranteed, above-market or preferential earnings on deferred compensation. The value of these account balances, then, can go up or down depending on market performance. For executives with long and successful careers at a single company, the deferrals can accumulate to sizeable amounts over time.

As shown in the table below, the current value of Chairman and CEO Palmisano’s account, made up of money he earned during the past 12 years that the program has been available, is now worth approximately $ 39 million. During that time, Mr. Palmisano could have chosen not to defer, taken these funds from IBM and put them in other investment vehicles. Had he done so, these numbers would not appear here. The table below shows the deferral elections and accumulated balances (including investment returns) that are owed to the Chairman and CEO from his prior years’ earned compensation. Before he was named Chairman and CEO in January 2003, Mr. Palmisano had invested approximately $ 8 million of his compensation in the account. When Mr. Palmisano retires, the value of his deferrals will be paid to him in five equal installments over five years.

Ten-Year History of Chairman and CEO Deferred Compensation (Nonqualified)

Year Deferrals IBM Match Year End Balance
1998 $ 207,525 $ 29,587 $ 948,401
1999 299,500 41,250 1,512,020
2000 1,280,125 45,088 2,525,162
2001 1,311,185 68,400 4,782,542
2002 5,021,815 130,600 8,796,332
2003 2,272,900 178,700 12,979,815
2004 6,020,881 208,600 20,935,482
2005 5,000,050 202,050 23,993,254
2006 5,729,377 205,350 34,942,721
2007 750,000 150,000 39,274,203

How compensation decisions are made

At any level, compensation reflects an employee’s value to the business—market value of skills, individual contribution and business results. To be sure we appropriately assess the value of senior leaders, IBM follows an evaluation process, described here in some detail:

1. Making Commitments

At the beginning of each year, all IBM employees, including Chairman and CEO Palmisano and the other senior leaders, make a Personal Business Commitment (PBC) of the goals, both qualitative and quantitative, they seek to achieve that year in support of the business. These commitments are reviewed and approved by each individual’s manager. Chairman and CEO Palmisano’s commitments are reviewed directly by the Board of Directors.

2. Determining Executive Vice President (EVP) and Senior Vice President (SVP) Compensation

Evaluation of Results by the Chairman and CEO
Throughout the year, employees assess their progress against their PBCs. At year end, employees at all levels, including executives, work with their managers to evaluate their own results—not only with regard to their stated goals, but in relation to how well their peers and the entire Company performed.

The self-assessments of the EVP and SVPs are reviewed by the Senior Vice President of Human Resources (SVP HR) and Chairman and CEO Palmisano, who evaluate the information, along with the following:

  • Comparisons to market compensation levels for cash compensation and total direct compensation;
  • Potential for future roles within IBM; and
  • Total compensation levels relative to internal peers before and after any recommendations.

Following this in-depth review and in consultation with the SVP HR, Mr. Palmisano makes compensation recommendations to the Board’s Compensation Committee based on his evaluation of each senior manager’s performance and expectations for the coming year.

Evaluation of results by the Compensation Committee
The Compensation Committee decides whether to approve or adjust the Chairman and CEO’s recommendations for the members of his team.

The Committee evaluates all of the factors considered by the Chairman and CEO and reviews compensation summaries for each senior leader that tally the dollar value of all compensation and related programs, including salary, annual incentive, long-term compensation, deferred compensation, retention payments and pension benefits.

3. Determining Chairman and CEO Compensation—Research, Recommendations and Review

IBM’s SVP HR works directly with the chair of the Compensation Committee to provide a decision-making framework for use in making a recommendation for the Chairman and CEO’s total compensation. This framework includes the Chairman and CEO’s evaluation of how well he believes he performed against his commitments in the year, with an assessment of his performance against the Company’s stated strategic objectives. In addition to the above, the Committee also reviews an analysis of IBM’s total performance over the past year and a competitive benchmark analysis furnished by the Committee’s outside consultant (Towers Perrin).

The Compensation Committee also separately reviews relevant information and arrives at its recommendation for the Chairman and CEO’s total compensation. In this work, they are assisted by the Compensation Committee’s outside consultant.

The final pay recommendation for the Chairman and CEO is presented to the independent directors on IBM’s Board for further review, discussion and final approval. This process is followed every year.

4. Ensuring Competitive Pay—Approach to Benchmarking

IBM participates in several executive compensation benchmarking surveys that provide detail on levels of salary, target annual incentives and long-term incentives, the relative mix of short- and long-term incentives, and mix of cash and stock-based pay. We include in these surveys a broad range of key information technology companies, given the battle for talent that exists in our industry and to help us identify trends in the industry. We also include companies outside our industry, with stature, size and complexity that approximate our own, in recognition of the fact that competition for senior management talent is not limited to our industry. The companies used in the benchmarking surveys for 2007 and 2008 compensation decisions are listed below. The Committee reviews and approves this list annually. These surveys are supplemented by input from the Compensation Committee’s outside consultant on factors such as recent market trends.

AIG EDS PepsiCo
Altria Group Ford Pfizer
Apple General Electric Procter & Gamble
AT&T General Motors Sprint
Bank of America Hewlett-Packard Sun Microsystems
Boeing Honeywell Texas Instruments
Chevron Intel United Technologies
Cisco Systems Johnson & Johnson Verizon
Citigroup Lenovo Walt Disney
Dell Lockheed Martin Wells Fargo
Dow Microsoft Xerox
DuPont Motorola  

The data from these surveys and related sources form the primary external view of the market, and the Company’s philosophy is to generally target the median of the market for cash and total compensation for IBM job roles compared to jobs of similar size and complexity at comparable companies. For individual compensation decisions, the information is used together with an internal view of longer-term potential and individual performance relative to other executives. For the Company’s senior level executives, the Compensation Committee also takes into account long-term retention objectives, recognizing that their skills and experience are highly sought after by other companies and, in particular, by the Company’s competitors.

5. Compensation Committee Consultant

The Committee currently retains a Managing Director of Towers Perrin as its outside compensation consultant to advise the Committee on market practices and the specific IBM policies and programs. This Managing Director does not perform any work for the Company. The consultant’s work for the Committee includes data analyses, market assessments, and preparation of related reports. The work done by Towers Perrin for the Committee is documented in a formal scope of work and contract which is executed by the consultant and the Committee.

Chairman and CEO compensation decisions for 2007 and 2008

The Compensation Committee made decisions for the Chairman and CEO’s 2007 and 2008 compensation following the process described above and using the pay components shown above. The Compensation Committee noted the following as key points regarding the Chairman and CEO’s performance against his Personal Business Commitments for 2007:

  • Achieved very strong financial performance including record revenue, profit, cash flow and earnings per share (EPS)
  • Improved overall client satisfaction and quality of delivery
  • Continued to drive IBM to be the leading globally integrated enterprise
  • Invested and developed leaders in high growth countries, which combined, grew revenue more than 20% in 2007
  • Returned significant capital to stockholders through $ 18.8 billion in share buyback and $ 2.1 billion in dividends
  • Increased IBM’s leading market position in served software and services
  • Strengthened services business, generating the strongest services revenue performance since 2003, and posting double-digit growth in services pre-tax profit
  • Drove strong financial performance through the acquisition strategy and excellence in integration execution
  • Continued leadership in technology and innovation earning more U.S. patents than any other company for the 15th consecutive year

The Committee considered these results and recommended that Mr. Palmisano receive $ 5,800,000 in annual incentive for his 2007 performance.

The Committee worked with its outside consultant (Towers Perrin) to review Mr. Palmisano’s base salary, annual incentive target and long-term incentive award value using a framework of competitive benchmark analysis, Company performance and Mr. Palmisano’s personal performance. Based on this review, the Committee recommended that Mr. Palmisano’s base salary and target annual incentive for 2008 remain at $ 1,800,000 and $ 5,000,000, respectively.

The Committee recommended a 2008 long-term incentive award comprised entirely of 2008-2010 Performance Share Units valued at $ 11,000,000. The 2007 award was valued at $ 10,000,000 and consisted of $ 7,000,000 in Performance Share Units and $ 3,000,000 in restricted stock units. The 2008 grant will be made on May 8, 2008. The Committee chose the long-term incentive value to improve Mr. Palmisano’s position relative to competitive benchmarks and to signal the Committee’s desire for him to continue his focus on taking the steps necessary to position the Company for long-term success.

The Committee’s recommendations were approved by the independent directors on IBM’s Board.

EVP and SVP compensation decisions for 2007 and 2008

The Compensation Committee also made decisions for each of the executive officers following the process described above and using a mix of the components shown above. The Compensation Committee noted the following as key points for each of the other named executive officers:

Mark Loughridge, Senior Vice President and Chief Financial Officer

  • Returned substantial capital to stockholders by creating a more efficient balance sheet, preserving U.S. cash levels and positioning future non-U.S. cash flows to service debt
  • Exceeded Net Income and EPS objectives
  • Exceeded Cash Flow objectives, while avoiding losses due to sub-prime mortgages
  • Developed long-term EPS roadmap to 2010 to enhance investor understanding of financial model
  • Managed IBM’s portfolio, including the Printer Systems divestiture and execution of 12 strategic acquisitions

Following IBM’s practice, the recommendations for Mr. Loughridge’s compensation were ratified by the independent directors on IBM’s Board.

Steve Mills, Senior Vice President and Group Executive, Software Group

  • Achieved financial performance in line with market
  • Grew middleware brands faster than market
  • Integrated acquisitions effectively, exceeding profit objectives and retaining key talent
  • Introduced new development practices for greater global integration and efficiency
  • Continued to strengthen IBM’s brand with respect to market-leading software products and services

Mike Daniels, Senior Vice President, Global Technology Services

  • Significantly increased revenue, net income and profit of GTS business
  • Focused on building a culture of services excellence resulting in improved client satisfaction
  • Completed strategic transformation of the GTS business model including global standardization of products/services
  • Accelerated growth rate vs. prior years
  • Expanded use of channels to increase sales

Doug Elix, Senior Vice President and Group Executive, Sales and Distribution

  • Achieved performance objectives in high growth markets
  • Held market share
  • Increased client satisfaction
  • Improved growth in key mature markets—Japan and Germany
  • Provided leadership to improve overall sales management process and focus on client value
  • Identified organizational structure and key leaders to drive performance in new growth markets

Based on these results and following the process outlined above, the Compensation Committee approved the following 2007 annual incentive payments for these named executive officers:

2007 Incentive Payouts
Name Annual Incentive Team Incentive

M. Loughridge $ 1,168,750 $ 220,000
S.A. Mills 850,700 220,000
M.E. Daniels 1,066,400 220,000
D.T. Elix 1,045,000 220,000

The team incentive payment reflected Chairman and CEO Palmisano’s assessment of the performance of his entire senior leadership team and their success in working together to integrate across business units to deliver strong 2007 business results.

The Committee also approved these 2008 base salary, target annual incentive and stock-based grants under the Long-Term Performance Plan:

2008 Cash 2008 Long-Term Incentive Awards
Name Salary Rate (Effective June 1, 2008) Annual Incentive Target Restricted Stock Units(1) Performance Share Units(1)

(1) Restricted stock units (RSUs) and performance share units (PSUs) will be granted on May 8, 2008. The actual number of RSUs and PSUs granted on this date will be determined by dividing the value shown above by a predetermined, formulaic planning price for the second quarter 2008. The PSUs will vest in 2011 and the RSUs will vest 1/3 in 2009, 1/3 in 2010, and 1/3 in 2011.

M. Loughridge $ 720,000 $ 975,000 $ 1,050,000 $ 2,450,000
S.A. Mills 695,000 940,000 900,000 2,100,000
M.E. Daniels 665,000 900,000 900,000 2,100,000
D.T. Elix 775,000 1,045,000 0 0

Senior leaders—personal stake in IBM’s future

Investors want the leaders of their companies to act like owners. That alignment, we have found, works best when senior leaders have meaningful portions of their personal holdings invested in the stock of their company. This is why IBM sets significant stock ownership requirements for the Company’s top 60 senior leaders, including the Chairman and CEO.

Of this group, the Chairman and CEO, EVP and SVPs are all required to own IBM stock or equivalents worth three times their individual target cash compensation (their base salary plus the incentive payment they would earn if they hit their performance targets) within five years of hire or promotion. As a group, the Chairman and CEO, EVP and 14 SVPs own 1.45 million shares or equivalents valued at approximately $ 156 million as of December 31, 2007. Approximately 40 other senior leaders are required to hold shares worth one time their target cash compensation within five years of hire or promotion.

All of these approximately 60 leaders who have been in place for at least five years have met or exceeded their personal IBM ownership requirements. In fact, this group currently holds, on average, nearly four times more IBM stock or equivalents than the Company requires.

IBM meeting market standards for executive compensation

We recognize that the issue of executive pay is critical to stockholders and to members of the public whose hopes for the future rest substantially on trust in the conduct of those who run our corporations. Simply put, those who profit disproportionately to the value they create for stockholders and society, or the value they provide to clients, are breaking faith with all who would do business with them, and all who would risk their hard-earned savings in the future of an enterprise.

We have provided the information in these pages precisely because IBM works to keep that faith. We know that striking a balance between stockholders’ concept of fairness and the incentives needed to attract and retain a stellar executive team will always require sound judgment and careful thought. Business, markets, and people are too dynamic for mere formulaic solutions. The numbers can be best understood when the process behind them is transparent.

IBM’s business has always been to help our clients succeed through innovative solutions. Our stockholders deserve no less. We welcome this discussion.

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