Compensation of the Board of Management

Objectives

The compensation system for Covestro AG’s Board of Management remains largely unchanged from the version approved by the Annual General Meeting on May 3, 2016. It is aligned with the corporate strategy and is designed to facilitate a long-term increase in the company’s value and responsible corporate governance. We aim to position Covestro as an attractive employer in the competition for highly qualified executives, and, at the same time, ensure statutory and regulatory compliance. Board of Management compensation is in line with the basic principles of the compensation structure and, as a principle, is structured uniformly for the Board of Management as well as for other executives, including managerial employees, in the Covestro Group.

The appropriateness of the system and the compensation level of the Board of Management are regularly reviewed by the Supervisory Board, which then makes any necessary adjustments. The Supervisory Board used the services of an independent, third-party compensation consultant to determine appropriateness. As a rule, adjustments are in line with the increase in the consumer price index in Germany. If the need for a larger adjustment is ascertained, this is discussed in detail by the Human Resources Committee in view of the appropriate background information, and a resolution is proposed to the Supervisory Board as a whole. Covestro’s peer group comprises the companies listed on the DAX and MDAX (not including banks and insurance companies due to limited comparability). Covestro is compared to these companies to determine, in particular, whether Covestro’s relative position within this group in terms of revenue, employees and market capitalization is in line with the relative positioning of Board of Management compensation. The Supervisory Board then votes on the proposed adjustment.

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 a liability insurance for the members of the Board of Management to cover their legally required 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. It is paid out in 12 monthly installments.

Fringe benefits

Fringe benefits mainly comprise company cars (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. Due to her family’s place of residence in England and her Indian citizenship, Sucheta Govil also receives assistance from an external advisor in preparing her tax returns. Fringe benefits 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 performance.

In fiscal 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 business performance. 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 2018, 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 three-year period from 2019 to 2021. Between these values, linear interpolation is used to determine the payout.

For each individual performance indicator, 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

If a Board of Management member’s term begins or ends in the middle of a fiscal year, their PSP entitlement is prorated based on calendar days. The PSP entitlement for the fiscal year in which a Board of Management member leaves the company is forfeited in the event the member steps down (unless this occurs for good cause for which the member is not responsible) and in cases where the Board of Management member is terminated by the company for good cause.

The Supervisory Board is entitled to reduce the PSP payout to below the calculated amount or resolve to eliminate it entirely to the extent that target attainment falls far short of expectations (e.g., when the Covestro Group’s ROCE comes in below the WACC), or if an incident occurs at one of Covestro’s plants resulting in death or a large-scale discharge of chemicals that affects the surrounding areas.

Long-term compensation

Prisma

The members of the Board of Management are eligible to participate in the Prisma compensation program as long as they are employed by the Covestro Group and fulfill the share ownership guidelines applicable to them. 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.

If a Board of Management member’s term begins or ends in the middle of the first year of a performance period, their Prisma claim is prorated based on calendar days in that year. Tranches awarded for previous years remain in effect if members leave the company. Prisma claims for the tranches still in effect when a Board of Management member leaves the company are forfeited in the event the member steps down (unless this occurs for good cause for which the member is not responsible) and in cases where the Board of Management member is terminated by the company for good cause.

Prisma Performance Periods

Share ownership guidelines

The members of the Board of Management are contractually obligated to acquire Covestro shares equivalent to half of the Prisma target value (65% of the fixed compensation) on their own account within three years of their initial appointment and to hold these shares for the duration of their service on the Board of Management. This obligation is expected to be increased to 100% of the fixed compensation in future contract extensions. Sucheta Govil is already subject to this increased commitment.

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 each year amounting to as much as 33% of the respective fixed compensation beyond the annual income threshold in the statutory pension plan. 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 contributed to 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 GCGC, 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 of the individual components in the case of 100% target attainment of the variable components.

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, 2019.

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 GCGC. 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 GCGC.

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, plus, where applicable, a fictitious period of service from that date to the member’s 55th birthday where applicable.

Compensation of the Board of Management for the fiscal year

The following section reports the compensation of the Board of Management of Covestro AG for fiscal 2019. 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.

In the 2019 reporting period, the aggregate compensation for the members of the Board of Management of Covestro AG amounted to €6,274 thousand (previous year: €14,337 thousand). This amount comprised €3,001 thousand (previous year: €4,468 thousand) in non-performance-related components and €3,273 thousand (previous year: €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 2019 and/or 2018 according to the HGB.

Fixed annual compensation

The fixed compensation of Board of Management members was increased as of January 1, 2019, based on the change in the previous year’s consumer price index (1.90% from November 2017 to October 2018). The need for an additional adjustment for Dr. Klaus Schäfer was identified by the Supervisory Board, because his fixed compensation was significantly lower relative to that of the other Board of Management members in the relevant peer market group.

The fixed compensation of all members of the Board of Management in the 2019 reporting period totaled €2,771 thousand (previous year: €2,501 thousand).

Short-term variable compensation

In 2019, the short-term variable compensation for all Board of Management members totaled €549 thousand after deduction of the solidarity contribution (previous year: €6,309 thousand). This was based on a payout of 20.2% of the respective target value whose calculation is presented in the table below. The solidarity contribution is made by all employees of the companies covered by the respective agreements with the employee representtatives to help safeguard jobs at the German sites. For the 2019 reporting period, the contribution amounted to 2.1% of each employee’s Covestro PSP award. By resolution of the Supervisory Board, this contribution is also withheld from the Board of Management.

Long-term compensation (Prisma)

The total compensation according to the HGB includes long-term stock-based compensation (Prisma) with a fair value when granted of €2,724 thousand (previous year: €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. In addition, 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 of December 31, 2019, provisions of €10,570 thousand (December 31, 2018: €7,203 thousand) had been accrued for long-term compensation payable to members of the Board of Management; former members of the Board of Management accounted for €6,027 thousand (December 31, 2018: €4,273 thousand) of this figure.

Pension obligations

The pension service cost recognized for the members of the Board of Management in the reporting year was €956 thousand (previous year: €966 thousand) according to the HGB, while the current service cost for pension entitlements recognized according to IFRSs was €1,351 thousand (previous year: €1,434 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 HGB 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 reporting period (2019) 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 line with the recommendations of the GCGC in the February 7, 2017, version.

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.