Compensation of the Board of Management

Objectives

The compensation system for the Board of Management of Covestro AG is designed to facilitate a long-term increase in the company’s value and responsible corporate governance. Furthermore, we aim to position Covestro as an attractive employer in the competition for highly qualified executives, and ensure statutory and regulatory compliance. Board of Management compensation is in line with the basic principles of the compensation structure for managerial employees in the Covestro Group.

The appropriateness of the system and the compensation level are regularly reviewed by the Supervisory Board, which then makes any necessary adjustments. To this end, Covestro is compared with DAX and MDAX companies to determine, in particular, whether Covestro’s relative position within this group of companies in terms of revenue, employees and market capitalization is in line with the relative positioning of Board of Management compensation.

Compensation structure

The compensation comprises a non-performance-related component, an annual incentive and a long-term stock-based component. The Covestro Group’s compensation structure, based on average total annual compensation for a Board of Management member at 100% target attainment, is as follows:

Board of Management Compensation Structure (German Commercial Code)¹

The non-performance-related compensation comprises the fixed annual compensation, which reflects the responsibilities and performance of the Board of Management members, along with fringe benefits. The performance-related compensation comprises a short-term variable component, which depends on the attainment of the corporate performance targets and on the long-term variable compensation, the stock-based compensation program Prisma. This is linked directly to changes in Covestro’s share price.

The members of the Board of Management also receive pension entitlements for themselves and their surviving dependents. Furthermore, Covestro AG has purchased insurance for the members of the Board of Management to cover their personal liability arising from their service on the Board of Management. This includes a deductible that is in line with the GCGC recommendation.

Non-performance-related components

Fixed annual compensation

The level of the non-performance-related, fixed annual compensation for members of the Board of Management takes into account the functions and responsibilities assigned to them as well as market conditions. The fixed compensation is regularly reviewed by the Supervisory Board in light of factors such as the consumer price index and adjusted if necessary. It is paid out in 12 monthly installments.

Fringe benefits

Fringe benefits mainly comprise a company car (limited to the term of existing vehicle leases) or a vehicle allowance, use of the company carpool, payments toward the cost of security equipment, and reimbursement of the cost of annual health screening examinations. They are reported at cost or the amount of the pecuniary advantage gained.

Performance-related components

Short-term variable compensation

The target value of the short-term variable compensation is 100% of the fixed annual compensation. This amount is adjusted in line with the company’s success.

In fiscal year 2016, the Group-wide Covestro Profit Sharing Plan (Covestro PSP) was introduced, which also applies to the members of the Board of Management. It consists of a short-term variable compensation based solely on the company’s success. The system is based on the same performance indicators used to manage the company. The payout is based on performance in the areas of growth (core volume growth), liquidity (free operating cash flow, FOCF,) and profitability (return on capital employed, ROCE), with each counting for one third. In 2015, the Supervisory Board defined the global values for the threshold, 100% achievement and the maximum amount for each performance indicator, which are applied for the last time in fiscal 2018.

The figures for the upcoming years were adjusted for the Covestro PSP. The values below are applicable to the three-year period from 2019 to 2021.

For each individual KPI, the payout can be between zero (failure to meet minimum requirements) and three times the target value; however, the maximum payout for all three components combined is limited to 250% of the target value. The maximum payout is therefore 2.5 times the fixed annual compensation.

Components of Short-Term Variable Compensation

Long-term compensation

Aspire

The Board of Management members in office since 2015 are still formally participating in the final ongoing performance period (2015–2018 tranche) of the Bayer Group’s “Aspire” long-term stock-based compensation program. The payments made under this program are based on the Aspire Target Opportunity, which is a contractually agreed percentage of fixed annual compensation. Depending on the performance of Bayer stock, both in absolute terms and relative to the EURO STOXX 50^® benchmark index, participants are granted an award between 0% and 300% of their individual Aspire Target Opportunity at the end of the respective performance period.

In order to break the link between the payout and the development of Bayer’s share price, which can no longer be materially influenced by the members of the Board of Management, the Supervisory Board decided in 2015 that the average price of Bayer stock and the benchmark index calculated from the closing prices for the last 30 trading days of 2015 would be used as the closing price for all current tranches and that the payout amount would be frozen accordingly. As a result, there will be no payout for the 2015–2018 tranche otherwise due in January 2019, because the relevant average price as of year end 2015 remained below the hurdle. The target value for the 2015–2018 tranche was reduced to 8/12 of the full value (pro rata for the period from January to August 2015). This was compensated for by increasing the target value for the first tranche of Covestro’s own Prisma long-term compensation program launched in 2016 by 4/12.

Prisma

The members of the Board of Management are eligible to participate in the Prisma compensation program as long as they remain in the service of the Covestro Group and acquire for their own account and hold Covestro shares according to defined policies. This program is based on a target opportunity set at 130% of the fixed annual compensation. When a member of the Board of Management retires, current tranches may be shortened, thus reducing their value.

The payout is determined by calculating two factors: the total shareholder return (TSR) factor is the return generated by a stock expressed as a percentage (total of the final price of the share and all dividends distributed per share during the performance period divided by the initial price). The outperformance factor is based on the performance of Covestro stock during the performance period relative to the performance of the STOXX^® Europe 600 Chemicals index. It is determined by expressing the difference between the performance of Covestro stock and that of the index as a percentage. The factor is greater than 100% (less than 100%) if Covestro’s stock outperforms (underperforms) the index.

The Prisma target opportunity of each participant is multiplied by the TSR factor and the outperformance factor to arrive at the total distribution figure. The total distribution is limited to no more than 200% of the target opportunity. The maximum payout is therefore 260% of the fixed annual compensation. If Covestro’s shares were to significantly underperform the index (e.g. if the price of the stock went down while the index increased in value), the outperformance factor could amount to zero. As a result, there would be no payout.

Prisma Performance Periods

Other stock-based compensation

In his capacity as subgroup CEO within the Bayer Group, Patrick Thomas received a split payout of the short-term variable compensation (short-term incentive, STI) for the period prior to fiscal unity from October 2013 to December 2014. Part of the STI was paid out in the form of virtual Bayer shares with a three-year lock-up period. The payout of the STI tranche for fiscal 2013 of the entitlements based on virtual Bayer shares took place in 2017. The payout of the STI tranche for fiscal 2014 took place in 2018. The payout amount for both tranches was “frozen” on the basis of the stock price as of December 31, 2015.

Pension entitlements (retirement and surviving dependents’ pensions)

The members of the Board of Management are entitled to receive a lifelong company pension after leaving the Covestro Group, though generally not before the age of 62. This pension is paid out in the form of a monthly life annuity.

The arrangements for surviving dependents basically provide for a widow’s pension amounting to 60% of the member’s pension entitlement, and an orphan’s pension amounting to 12% of the member’s pension entitlement for each child.

The annual pension entitlement is based on contributions. From September 1, 2015, onward, Covestro has provided a hypothetical contribution amounting to as much as 33% of the respective fixed compensation each year. This percentage comprises a 6% basic contribution and a matching contribution of up to 27% – three times the member’s maximum personal contribution of 9%. The total annual contribution is converted into a pension module according to the annuity table for the applicable tariff of the Rheinische Pensionskasse VVaG pension fund. The annual pension entitlement upon retirement is the total amount of the accumulated pension modules including an investment bonus, which is determined annually by the representatives’ meeting of the Rheinische Pensionskasse VVaG and approved by the German Financial Supervisory Authority.

In the case of fixed compensation up to the annual income threshold, the Board of Management members, like all entitled employees, remain subject to the rules governing the basic company pension and are regular participants in the relevant pension plan.

Dr. Klaus Schäfer has been granted, in addition, a vested entitlement to a fixed annual pension of €126,750.

The actual pension entitlement cannot be precisely determined in advance. It depends on the development of the member’s compensation, the number of years of service on the Board of Management and the return on the assets of the Rheinische Pensionskasse VVaG.

Certain assets are administered under a contractual trust agreement (CTA), providing additional insolvency protection for pension entitlements resulting from direct commitments for the members of the Board of Management in Germany.

As a rule, future pension payments are adjusted by at least 1% per year. Depending on the pension obligation, an additional adjustment may be made if the investment bonus of the Rheinische Pensionskasse VVaG or the consumer price index exceeds 1% per year.

Cap on compensation

The individual performance-related components are capped at the grant date. To comply with the recommendation of the German Corporate Governance Code, a cap has also been agreed for the compensation as a whole. In 2018, the Supervisory Board resolved to include company pension expenditures above and beyond the components already taken into account (fixed annual compensation and variable components) in calculating total target compensation, i.e. the total compensation of a Board of Management member in the case of 100% target attainment.

The cap was set at 1.9 times the respective target compensation. This value was chosen to ensure that compensation will not have to be reduced even if both short-term and long-term compensation reach the maximum possible cap. In the event of such a scenario, it can therefore be expected that the total compensation accrued will not exceed the permitted cap, even when fringe benefits are added, the amount of which cannot be precisely determined in advance. A sample calculation is presented below using the compensation of the Chair of the Board of Management serving as of December 31, 2018:

Benefits upon termination of service on the Board of Management

Post-contractual noncompete agreements

Post-contractual noncompete agreements exist with the members of the Board of Management, providing for compensatory payments to be made by the company for the duration of these agreements (maximum of two years). The compensatory payment amounts to 100% of the average fixed compensation in the 12 months preceding termination of service.

Change of control

Agreements exist with the members of the Board of Management providing for severance payments to be made in certain circumstances in the event of a change in control. The amount of the severance payments, including any ancillary benefits, in the case of early termination of service on the Board of Management as a result of a change in control is limited to the value of three years’ compensation in line with the recommendation in Section 4.2.3 of the German Corporate Governance Code. Such payments do not exceed the compensation payable for the remaining term of the service contract.

Early termination of service on the Board of Management

The amount of the payments, including any ancillary benefits, made upon early termination of service on the Board of Management is limited to the value of two years’ compensation in line with the recommendation in Section 4.2.3 of the German Corporate Governance Code.

Unfitness for work

In the event of temporary unfitness for work, members of the Board of Management continue to receive the contractually agreed compensation. Covestro AG may terminate the service contract early if the member has been continuously unfit for work for at least 18 months and is likely to be permanently incapable of fully performing his or her duties (permanent incapacity to work). A disability pension is paid in the event of contract termination before the age of 60 due to permanent incapacity to work. The amount of this disability pension corresponds to the entitlement accrued on the date of contract termination, taking into account a fictitious period of service between that date and the member’s 55th birthday where applicable.

Compensation of the Board of Management for the fiscal year

The following paragraphs report the compensation of the Board of Management of Covestro AG for the fiscal year 2018. The members of the Board of Management of Covestro AG are the same as the members of the Board of Management of Covestro Deutschland AG, which became a subsidiary of Covestro AG on September 1, 2015. Compensation is not paid for the members’ work on the Board of Management of Covestro Deutschland AG.

As of May 31, 2018, the Supervisory Board initiated early termination of Patrick Thomas’ Board of Management contract by mutual agreement. The outstanding remuneration amount was stipulated in the context of a termination agreement, which categorized him as if he had worked until the regular expiration date of the contract (September 30, 2018). Accordingly, he received the pro-rated fixed compensation for the period from June to September 2018 in the form of a one-time lump-sum payment amounting to €390 thousand, which was paid out at the end of May 2018. For 2018, a target value of €877 thousand was established as short-term variable compensation under the Covestro PSP (equivalent to a pro-rated amount for nine out of 12 months) and will be paid out on the regular payout date at the end of April 2019 in accordance with the Covestro PSP regulations. The claims arising from the 2016–2019 and 2017–2020 tranches of the Prisma long-term compensation program remain unaffected. A target value of €1,140 thousand was determined for the 2018–2021 tranche (equivalent to a pro-rated amount for 9 out of 12 months). All Prisma tranches will be paid out according to the applicable plan regulations on the respective regular payout date.

In the 2018 reporting period, the aggregate compensation for the members of the Board of Management of Covestro AG totaled €14,337 thousand comprising €4,468 thousand in non-performance-related components and €9,869 thousand in performance-related components.

The following table shows the total compensation of the individual members of the Board of Management who served in 2018 according to the German Commercial Code and DRS 17.

Fixed annual compensation

The fixed compensation of Board of Management members was increased as of January 1, 2018, based on the change in the previous year’s consumer price index (1.68% from November 2016 to October 2017).

The fixed compensation of all members of the Board of Management in the reporting period totaled €2,501 thousand.

The fringe benefits for the reporting year 2018 include costs totaling €1,696 thousand in variable compensation paid to Dr. Thomas Toepfer in lieu of compensation from his previous employer to which he was no longer entitled.

Short-term variable compensation

In 2018, the short-term variable compensation for all the members of the Board of Management totaled €6,309 thousand after deduction of the solidarity contribution. The solidarity contribution is made by all employees of the companies covered by the respective agreements with the employee representatives to help safeguard jobs at the German sites. For the 2018 reporting period, the contribution amounted to 0.18% of each member’s Covestro PSP award. By resolution of the Supervisory Board, this contribution is also withheld from the Board of Management.

Long-term compensation (Aspire and Prisma)

The total compensation according to the German Commercial Code includes long-term stock-based compensation (Prisma) with a fair value when granted of €3,560 thousand.

In accordance with IFRSs, grants of stock-based compensation with a four-year performance period are therefore expensed at their respective fair values over four years starting with the grant year. The associated expense is a part of compensation according to IFRSs. According to IFRSs, the change in the value of existing entitlements under ongoing tranches granted in prior years must be reported as stock-based compensation. As explained above, however, because the payout amount of all remaining Aspire tranches was frozen based on the 2015 closing price, no change in value occurred under these tranches in the reporting year.

As of December 31, 2018, provisions of €7,203 thousand (December 31, 2017: €7,076 thousand) had been established for long-term compensation payable to members of the Board of Management; former members of the Board of Management accounted for €4,273 thousand (December 31, 2017: €1,491 thousand) of this figure.

Pension entitlements

The pension service cost recognized for the members of the Board of Management in the reporting year was €966 thousand (previous year: €756 thousand) according to the German Commercial Code, while the current service cost for pension entitlements recognized according to IFRSs was €1,434 thousand (previous year: €1,132 thousand).

Pension obligations are shown in the following table.

The pension service cost differs on account of the different principles applied in measuring the settlement value of pension obligations in accordance with the German Commercial Code and the present value of defined benefit pension obligations in accordance with IFRSs.

Disclosures pursuant to the recommendations of the German Corporate Governance Code

The following tables show the compensation and fringe benefits paid for the 2018 reporting period or the prior-year period, including the minimum and maximum achievable variable compensation, and the allocation of compensation for the reporting period or the prior-year period in the line with the recommendations in the February 7, 2017, version of the German Corporate Governance Code.

In 2018, the former Management Board member Frank H. Lutz received a payment of €186 thousand for the 2014-2017 tranche of the long-term compensation program Aspire.