The main components of remuneration

The main components of remuneration comprise base salary, annual incentive arrangements, long-term share-based incentives and pension and life assurance benefits. Executive directors and senior executives are also entitled to a company car or car allowance, private medical insurance and financial counselling. James Guyette is entitled to a housing allowance and the costs of additional housing are met by the Company for Mike Terrett.

The committee considers that there should be a continuing emphasis on those elements of remuneration, such as annual and long-term incentives, which directly influence the performance of senior executives.

Base salaries
In determining the relative importance of these elements of remuneration, the committee believes that base salaries should be set at levels required to recruit and retain high quality senior executives and with reference to the levels in the relevant marketplace for companies of similar size, internationality and complexity. The committee has commissioned salary benchmarks from Deloitte LLP. The benchmarks have been prepared using their company size and complexity methodology which is based on these factors.

All salary increases must be justified on the basis of performance and are not automatic. Following the March 1 review, there will be no increases in the base salaries of executive directors for 2009. Other benefits are generally at the median of market practice.

Annual incentives
Executive directors and selected senior executives participate in the Annual Performance Related Award plan (APRA). For UK participants, APRA awards do not form part of pensionable earnings.

Target and maximum APRA bonus opportunity
Under APRA as operated in 2008, executive directors were eligible for awards in accordance with the table below:

	Target bonus as a % of salary) 1	Maximum bonus (as a % of salary)1
James Guyette	48	80
Sir John Rose	60	100
Andrew Shilston	48	80
Colin Smith	48	80
Mike Terrett	48	80

¹ It was possible for a bonus award to be increased by a further 20 per cent to reflect exceptional personal performance, and for 2008, an additional 25 per cent if the Group achieved a target reduction in operating costs.

APRA performance measures
The APRA performance measures set by the committee are based on the Group’s annual operating plans. For 2008, the measures for executive directors included underlying profit, average cash balance, cash flow, operating costs and individual contribution assessed with reference to the achievement of personal objectives and overall personal performance. The committee is mindful of corporate, environmental, social and governance risks when setting personal objectives. Forty per cent of any APRA bonus depends on personal performance.

A high proportion of the annual remuneration for executive directors is based on performance. For the Chief Executive, his 150 percent maximum bonus opportunity means that 60 per cent of his combined basic pay and bonus opportunity is directly related to annual financial and personal performance. In 2008, the level of achievement against the financial measures was sufficient to generate up to 56.25 per cent of the maximum bonus for individual participants subject to the achievement of their personal objectives.

Deferred APRA
One third of the value of APRA is currently delivered in the form of a deferred award of shares in the Company. A participant who is granted a deferred share award under APRA must normally continue to remain an employee of the Group for two years from the date of the award in order to retain the shares, although shares will be released early in certain circumstances including retirement or redundancy.

The value of any deferred share awards is derived from the annual bonus criteria and is therefore dependent on personal and business financial performance; the release of deferred share awards is not dependent on the achievement of any further performance conditions. This arrangement provides a strong link between performance and remuneration, promotes a culture of share ownership amongst the Group’s senior management and encourages decisions in the long-term interest of shareholders. The deferred share element operated for 2008 will result in share awards as described in the director’s emoluments table. Details of deferred shares held under the plan are shown in the table on the page 'share options'.

Changes to APRA for 2009
For 2009, APRA will change as follows:

• The opportunity to increase the bonus payable by 25 per cent for exceptional operating cost performance will be removed.
• Annual bonus opportunity levels will increase from 100 per cent to 135 per cent of salary for the Chief Executive and from 80 per cent to 125 per cent of salary for other executive directors.
• The percentage of APRA delivered in the form of a deferred award in the Company’s shares will increase from 33 per cent to 40 per cent. This further aligns the interests of executives with those of shareholders.
• In order to simplify APRA, the average cash balance measure will be removed. The cash flow measure in APRA and the Cash Flow Per Share measure in the Rolls-Royce Group plc Performance Share Plan will both remain.

Other annual incentives
The same targets as set for APRA are used for the All-Employee Bonus Scheme which typically enables all employees worldwide to receive a bonus of up to two week’s pay, based on corporate and business performance. Those executives participating in APRA are excluded from the All-Employee Bonus Scheme.

Rolls-Royce Group plc Performance Share Plan
The Rolls-Royce Group plc Performance Share Plan (PSP) is designed to reward and incentivise selected senior executives who can influence the long-term performance of the Group.

Under the rules of the PSP, selected executives are granted conditional share awards entitling them to a number of shares determined by reference to corporate performance over a three-year performance period. The measures of corporate performance are Cash Flow Per Share (CPS), Earnings Per Ordinary Share (EPS) and Total Shareholder Return (TSR). These measures are considered particularly important in generating shareholder value and are explained in more detail below. There is no retesting of the performance criteria and no automatic vesting in the event of a takeover. In the three-year period to December 31, 2008, the Company’s financial and TSR performance generated 80 per cent of the maximum number of shares under the rules of the plan.

Performance measures
No shares will be released from the PSP unless the growth in the Company’s EPS exceeds the UK retail price index by three per cent per year over the performance period.

The number of shares released (if any) will be determined in accordance with CPS targets, which will not be adjusted for inflation. CPS is calculated as cash flow after interest, taxation and capital expenditure, but before cost of business acquisitions or proceeds of disposals and payments to shareholders, divided by the weighted average number of shares in issue. Intermediate levels of performance attract pro rata releases. The Company’s TSR over the performance period will be compared with the TSR of the companies constituting the FTSE 100 index on the date of grant. This comparison will be carried out by an independent agency. If the Company’s TSR exceeds the median of that group of companies, the number of shares due to be released to an executive following achievement of the EPS and CPS targets will be increased by 25 per cent.

Shareholders have authorised the committee to set CPS performance targets for future grants provided that, in the committee’s reasonable judgement, the targets are no less challenging in the light of the Group's business circumstances and its internal forecasts than the targets for the initial grant in 2004 as approved by shareholders.

The following CPS targets apply to the grants to be made in 2009:

Aggregate CPS over three-year performance period	Percentage of maximum award released
40p	30
62p	100

The committee believes that these CPS targets are challenging and that the performance necessary to achieve awards towards the upper end of the range is stretching. They should not, therefore, be interpreted as providing guidance on the Group’s performance over the relevant period.

PSP award levels
The size of awards under the PSP are set taking into account competitive levels within the market place for UK companies of a similar size and complexity to the Group. In 2008, Sir John Rose received a conditional award of shares with a market value at the time of grant of 110 per cent of his annual salary. For other executive directors and business heads the grant was 80 per cent, and 65 per cent for other members of the Group Executive. As described above, the number of shares released is increased by 25 per cent if the Company’s TSR exceeds the median of the FTSE 100 Index.

For 2009, the number of conditional shares awarded under the PSP will increase from110 per cent to 120 per cent of salary for the Chief Executive and from 80 per cent to 100 per cent of salary for other executive directors. A further stretch will be incorporated such that if TSR performance exceeds the upper quartile of the FTSE 100 index, awards are increased by 50 per cent, with straight line vesting between median and upper quartile performance.

These increases are within the existing limits for the PSP (200 per cent of salary), approved by shareholders in 2004.

Share retention policy
The committee believes it is important that the interests of the executive directors should be closely aligned with those of shareholders. The deferred APRA award and the PSP provide considerable alignment. However, participants in the PSP are also required to retain at least one half of the number of after-tax shares released from the PSP, until their shareholding reaches the level of 1.5 multiplied by the value of the shares conditionally granted to them in their most recent PSP grant. When this level is reached, it must be retained until retirement or departure from the Company.

Executive share option plan
No options have been granted under the executive share option plan since the introduction of the PSP and the Company does not currently intend to make any further grants. The plan terminates in 2009.

All-employee share plans
The committee believes that share-based plans make a significant contribution to the close involvement and interest of all employees in the Group’s performance. Executive directors are eligible to participate in the Group’s all-employee share plans on the same terms as other employees. There are three main elements to these arrangements :

• the ShareSave Plan – a savings-related share option plan available to all employees. In the UK, this plan operates within UK tax legislation (including a requirement to finance the exercise of the option using the proceeds of a monthly savings contract) but the key principles are applied globally. The exercise of the option is not subject to the achievement of a performance target;
• the ‘Free Share’ element of the Share Incentive Plan (SIP), under which UK employees receive shares of up to the equivalent of one and a half week’s pay as part of the Company component of any bonus paid for 2008. The SIP attracts tax benefits for UK employees; and
• the ‘Partnership Share’ element of the SIP under which UK employees may make regular purchases of shares from pre-tax income.