Directors' remuneration report

The directors’ remuneration report is presented to shareholders by the Board. The report complies with Regulation 11 and Schedule 8 of the Large and Medium-Sized Companies and Groups (Accounts and Reports) Regulations 2008 (the Regulations). A resolution will be put to shareholders at the Annual General Meeting on 22 November 2011 inviting them to approve this report.

Remuneration policy and arrangements

The Remuneration Committee

Responsibilities of the Committee include making recommendations to the Board on the Group’s executive remuneration policy and determining, on behalf of the Board, specific remuneration packages for the executive directors and Chairman. In doing so, the Committee takes into account pay and employment conditions elsewhere in the Company and operates within agreed terms of reference which are available for inspection on the Company’s website. The Company complied with the provisions of the UK Corporate Governance Code relating to directors’ remuneration throughout the financial year except as is disclosed in the Corporate governance statement.

The Committee met five times in the past year to consider and agree, amongst other matters,

• Annual Incentive Plan performance and payments for the financial year ended 31 July 2010
• Annual Incentive Plan structure and performance targets for the financial year ended 31 July 2011
• Framework of executive total remuneration
• Principles to govern the Annual Incentive Plan for the financial year ending 31 July 2012
• Committee terms of reference
• Structure of the directors’ remuneration report for the financial year ended 31 July 2011.

In 2010/11 the Committee consisted of:

• Stuart Chambers (Chairman of the Committee)
• Bruno Angelici
• Donald Brydon
• David Challen
• Anne Quinn
• Kevin Tebbit

Each member’s attendance at meetings held during the year is set out in the Corporate governance statement.

Mr Brydon is absent when his own remuneration as Chairman of the Company is under consideration. The Chief Executive attends meetings of the Committee by invitation; he is absent when his own remuneration is under consideration.

During the year, the Committee received material assistance and advice from the Chief Executive and the HR Director (who is also Secretary to the Committee). The Committee and the Company also received advice from Kepler Associates, the Committee’s independent remuneration adviser, and Freshfields Bruckhaus Deringer LLP. Kepler does not provide any other services to the Group. Freshfields Bruckhaus Deringer LLP was appointed by the Company to advise the Group on various legal matters during the year.

Remuneration policy

The Committee applies a remuneration policy which has at its core the following objectives:

• to align the interests of executives with those of shareholders
• to focus on top-line growth, margin improvement and capital discipline
• to link a significant proportion of remuneration to financial and individual performance, both in the short term and long term
• to provide strong linkage between remuneration and performance
• to ensure total remuneration is market-competitive and helps attract and retain executives of the highest calibre.

It is the Company’s policy to take into account the pay and conditions of employees throughout the Group when determining directors’ remuneration. During the year, the Committee received a paper from the Group HR Director and noted the pay policy applicable in the Group's main areas of operation in determining the remuneration of the Board, including the Executive Directors.

Remuneration arrangements

The remuneration of senior executives balances fixed, variable, short-term and long-term remuneration, and is reviewed each year on a total remuneration basis to ensure that executives continue to be appropriately incentivised to achieve the Group’s objectives.

For 2010/11, executive directors’ remuneration comprised basic salary, benefits in kind, annual bonus and pension benefits. In addition, executive directors and senior executives participate in share-based incentive schemes, which in 2010/11 included the Smiths Group Sharesave Scheme, the Smiths Group Co-Investment Plan (CIP), the Smiths Group 2008 Value Sharing Plan and the 2010 Smiths Group Value Sharing Plan (VSP).

Elements of remuneration

The main elements of remuneration for executive directors in 2010/11 are summarised below:

The following charts illustrate the proportions of the 2010/11 remuneration packages comprising fixed (i.e. base salary) and variable elements of pay, assuming target annual bonus and expected values of long-term incentives. For 2010/11, c. 70% of the fair value of executive directors’ total remuneration was performance related.

Base salary and benefits

The Chief Executive's salary has been frozen since 2007/08. Salaries have been reviewed annually, taking into account the size and nature of the role, individual performance and experience, the relative performance of the Company, remuneration policy within the Company and salaries at comparator companies. Salaries are benchmarked against comparable roles at other FTSE100 companies of similar market capitalisation, revenues and complexity to Smiths. The salaries for all participants in the Value Sharing Plan, including the Chief Executive, remained frozen at their 2007/08 levels for 2010/11. The Committee has taken these matters into account and determined that the Chief Executive will receive a modest increase in annual base salary for 2011/12 as set out in the table below;

Benefits for Mr Bowman include a car allowance and health insurance.

Mr Turner receives health insurance but does not receive a car allowance.

Annual bonus

Executive directors are eligible to participate in an annual bonus plan based on a combination of corporate financial goals (Group EPS and cash conversion) and individual performance. The maximum annual bonus opportunity for the Chief Executive is 180% of salary and for the Finance Director is 125% of salary. Of any bonus earned, 50% is compulsorily deferred into Smiths shares under the rules of the CIP. The table below summarises the structure of the 2010/11 annual bonus plan and the awards receivable for performance in 2010/11.

2010/11 annual bonus outcome as a percentage of salary earned in 2010/11

No changes are proposed to the annual bonus plan for 2011/12

Co-Investment Plan (CIP)

Executive directors and selected senior executives are required to invest 50% of any net bonus earned in Smiths shares. Invested amounts are eligible for a 2-for-1 matching share award after three years (based on the pre-tax amount of deferred bonus in question), subject to continued employment in the Group and the Company’s average return on capital employed (ROCE) over the performance period exceeding the Company’s weighted average cost of capital (WACC), which the Committee regards as appropriately reflecting the operating efficiency of the Company.

Matching share awards vest in full if ROCE exceeds WACC by an average margin of at least 3% a year; a 1-for-1 matching share award vests if ROCE is between WACC+1% and WACC+3% p.a. Dividends accrue on matching shares that vest. The Committee reviews these targets prior to the start of each award cycle to ensure they remain appropriately stretching.

For 2007/08 and earlier years, executive directors and selected senior executives were able to invest up to 100% of any net bonus earned (or if greater, 25% of salary) in Smiths shares. Invested amounts were eligible for a 1-for-1 matching share award after three years (based on the pre-tax amount of salary or deferred bonus in question) subject to continued employment in the Group and the Company’s average ROCE over the performance period exceeding the Company’s WACC over the same period by an average margin of at least 1% p.a.

Value Sharing Plans (VSPs)

Details of Group and divisional VSPs are set out in this section. The 2008 VSPs are one-off plans approved by shareholders in 2008, and the 2010 VSPs, which are intended to operate annually, were approved by shareholders at the 2010 AGM. The VSPs are long-term incentive plans that were designed to reinforce Smiths' strategy of focusing on shareholder value creation at the Group and divisional levels.

2008 Group VSP

Awards made under the Group VSP reward selected senior executives (including the CEO) with a pre-determined number of shares for every £5m of value created above a hurdle over the three-year and four-year performance periods from 1 August 2008.

One-third of the award will depend on the growth, over each performance period, in Smiths market capitalisation plus net equity cash-flows to shareholders (i.e. dividends plus share buybacks less share issues) over and above the median total shareholder return of the FTSE 100 companies (excluding financial services companies).

The remaining two-thirds of each award will be determined by the growth, over each performance period, in adjusted Profit Before Tax (PBT) (from a baseline PBT of £338.6m in 2007/08) multiplied by a fixed multiple of 12.0 plus net equity cash-flows to shareholders over and above a cost of equity hurdle return of 9.5% a year.

No retesting of either performance condition is permitted.

In line with the commitment made to shareholders at the time, no subsequent grants were made under the 2008 VSPs during the financial years ended 31 July 2009 and 31 July 2010. In 2010, the Committee reviewed the Group’s long-term incentive arrangements. The Committee felt that the broad structure of the VSP remained appropriate going forward, and shareholders approved a new VSP at the 2010 AGM. Under this 2010 VSP, grants will be made annually (with the opportunity reduced by approximately two‑thirds to reflect the proposed frequency of grants and following an assessment of the market competitiveness of the fair value of the total package) and will vest after three years.

2010 Group VSP

Messrs Bowman and Turner are participants in the 2010 Group VSP, which rewards executive directors and selected senior executives with a pre-determined number of shares for every £5m of value created above a hurdle over a three-year performance period.

On 17 December 2010 Mr Bowman was granted an award under which he will be entitled to receive 800 Smiths Group shares for each £5m of surplus value created. On the same date, Mr Turner was granted an award under which he will be entitled to receive 320 Smiths Group shares for each £5m of surplus value created.

– TSR Element

30% of the award will depend on the three year growth in Smiths market capitalisation plus net equity cash-flows to shareholders (i.e. dividends plus share buybacks less share issues) over and above the median total shareholder return of the FTSE 100 companies (excluding financial services companies).

Participants will only be entitled to a vesting of shares under the TSR Element if the Committee is satisfied that this is justified by the underlying financial performance of the Company over the performance period.

– Earnings Element

The remaining 70% of the award will be determined by the three year growth in adjusted Profit Before Tax (PBT) (from a baseline PBT of £432.7m in 2009/10) multiplied by a fixed multiple of 10.1 (representing the ratio of Smiths market capitalisation at the start of the performance period to the baseline PBT) plus net equity cash-flows to shareholders over and above a cost of equity hurdle return of 8.5% a year. The Committee determined this hurdle rate of return to be sufficiently challenging, whilst taking into account the substantial fall in the risk free rate over the two years since the grant of the 2008 VSP, and its impact on the Group’s cost of equity.

The Committee may reduce the payout of the Earnings Element if an acquisition results in a material reduction in return on invested capital.

No retesting of either performance condition is permitted.

Performance measure selection

The Remuneration Committee believes that the combination of relative TSR and PBT continues to provide the best balance between internal line-of-sight and shareholder alignment, between absolute and relative performance and between internal and external perspectives. PBT is considered the best internal measure of Smiths financial performance as it is highly visible internally and regularly monitored and reported. Relative TSR provides strong alignment with shareholders and the FTSE 100 index (excluding financial services companies) continues to be considered a relevant and robust indicator of the relative value created by Smiths management for its shareholders.

2010 Divisional VSPs

In addition to the 2010 Group VSP, the Committee also implemented revised divisional plans for each of the five divisions (Smiths Detection, Smiths Medical, John Crane, Smiths Interconnect and Flex-Tek). These plans continue to be along the same lines as the Group VSP, helping focus the most senior divisional executives on maximising the value of their divisions and returning surplus cash to the Group.

Leaving and change-of-control provisions

The treatment of awards on leaving or a change of control is the same for both the 2008 and 2010 VSPs. For bad leavers , awards lapse. In the event of ill health, permanent disability or death, awards would be pro-rated for time and the performance period would run its normal course (except on death where the performance period would be curtailed). For other leavers, the treatment of awards remains subject to Committee discretion.

In the event of a change of control, performance would be measured over the period from grant to change of control. As the plan is based on increasing value over time faster than a benchmark, the curtailing of the performance period naturally reduces the value of the plan and in such circumstances there is no need for additional time pro-rating.

The Committee retains discretion to vary these approaches if it deems it appropriate to do so.

2011 Long-Term Incentive Plan

The Remuneration Committee reviews the Company’s executive long-term incentive arrangements annually in order to reflect developments in best practice and in light of the Group’s objectives and priorities. The 2008 VSPs involved a one-off award granted in July 2008, maturing in two tranches following announcement of results for the 2010/11 and 2011/12 financial years. The 2010 VSP was intended to operate annually, with awards vesting after three years. The initial awards under the 2010 VSP were made in December 2010.

Although the resolution for the adoption of the 2010 VSPs was strongly supported by shareholders at the 2010 AGM, (88% of shares voted supported the Resolution) we have since received feedback from shareholders and from the ABI expressing concern about share plans along the lines of the VSP, particularly in relation to the uncapped nature of the awards under the plan and especially in circumstances where the company intends to operate such plans on an annual basis rather than in exceptional circumstances. As a consequence the Remuneration Committee has decided, after careful consideration to seek the approval of shareholders for the implementation of a new LTIP, which is a conventional share plan under which an award over a fixed number of shares will vest if a demanding performance condition is met. The Committee is satisfied that the proposed LTIP is closely aligned with market practice. If the LTIP is approved by shareholders at the AGM, the first LTIP awards will be made in November 2011.

The main features of the proposed scheme would be:

• Annual grants vesting after three years
• Vesting conditions for 2011/12 awards based 50% on earnings growth, 30% on TSR vs FTSE100 (excluding financial services) and 20% on cash conversion.

Further details on the proposed scheme can be found in the Notice of AGM.

2004 Performance Share Plan (PSP)

No awards have been made under the PSP to executive directors or other participants in the VSP since 2007/08 and none will be made to these executives in 2011/12. Following the end of the performance period of the 2007 PSP cycle in December 2010, no directors hold outstanding awards under the PSP.

Sharesave Scheme

The Smiths Group Sharesave Scheme, which is open to all UK employees with at least 12 months’ service, is subject to UK legislation as to the maximum amount that can be saved. Participants save a fixed sum of up to £250 a month for three or five years and may use the sum generated by their savings contracts to exercise options to acquire shares which are usually granted at a 20% discount to the market price.

Share ownership guidelines

It is the Committee’s policy that executive directors should, over time, acquire a shareholding with a value equal to at least one and a half years’ gross salary (two years’ gross salary for the Chief Executive) and retain at least 50% of any net vested share awards (after sales to meet tax liabilities) until those values are achieved.

Share scheme dilution limits

The Company follows the guidelines laid down by the Association of British Insurers. These restrict the issue of new shares under all the Company’s share schemes in any 10-year period to 10% of the issued ordinary share capital and under the Company’s discretionary schemes to 5% in any 10-year period. As at 31 July 2011, the headroom available under these limits was 5.4% and 1.5%, respectively (excluding the conditional share awards granted under the 2008 and 2010 VSPs).

Pension

The Company operates pension arrangements for executive directors. In the case of Mr Bowman, the Company pays a monthly salary supplement (worth 42% of salary per annum), as approved by the Committee, to enable him to make his own pension provision. In the case of Mr Turner, the Company pays a monthly salary supplement (worth 25% of salary per annum), as approved by the Committee, to enable him to make his own pension provision. Details of the salary supplements are set out in the tables under Remuneration.

Five-year historical TSR performance

The following graph shows the Company’s total shareholder return (TSR) performance over the past five years compared to the FTSE 100 Index. The FTSE 100 Index, of which the Company has been a member throughout the period, has been selected to reflect the TSR performance of other leading UK-listed companies. The values of hypothetical £100 investments in the FTSE 100 Index and Smiths Group plc shares (after adjustment for the Return of Cash in June 2007) were £121 and £153 respectively.

Remuneration

The total remuneration of directors, excluding the value of shares to which certain directors may become entitled under the Value Sharing Plan, Performance Share Plan and Co‑Investment Plan and pension allowances, was as follows:

The emoluments of the directors are set out below:

1. Peter Turner’s total emoluments for 2010 are for a part year, covering the period from his appointment on 19 April 2010 until the end of the 2010 financial year on 31 July 2010.

2. Bruno Angelici's total emoluments for 2010 are for a part year, covering the period from his appointment on 1 July 2010 until the end of the 2010 financial year on 31 July 2010.

3. In the 2004 Performance Share Plan 67% of the award was linked to growth in adjusted EPS. The calculation of adjusted EPS growth included changes in the pension interest credit (PIC), a large line item which reflects changes in market interest rates on (largely historical) pension liabilities, and is not considered by the Board to be a proportionate reflection of current management performance. The 2007 PSP scheme vested in 2010. The 2007 base figure for the pension interest credit was £34 million but fell to £2 million in 2010. It is now common practice to exclude PIC from adjusted EPS growth calculations for LTIPs and, whilst at Smiths its impact has been broadly neutral over the life of the scheme for the majority of participants, its inclusion appeared to the Committee to have been inequitable for five participants who held awards granted in 2007 but did not receive grants prior to 2007. To address this inequity the Remuneration Committee approved ex gratia payments for these participants. For the Chief Executive this resulted in a lower number of shares vesting with a difference in value of £280,000. In recognition of this inequity the Remuneration Committee approved part payments for these participants. For the Chief Executive this figure was £200,000. Going forward, pension interest credit is excluded from the calculation of adjusted EPS in both the base period and the performance period for the Value Sharing Plans.

Director’s pension entitlements

No director accrues annual pension under a defined benefit arrangement.

Directors’ interests in the Company’s shares

These interests include beneficial interests of the directors and their families in the Company’s shares held in trusts and holdings through nominee companies. None of the directors has disclosed any non-beneficial interests in the Company’s shares.

The Company has not been notified of any changes to the holdings of the current directors, their families and any connected persons between 1 August and 26 September 2011.

Service contracts

The Company’s policy is that executive directors are normally employed on terms which include a one-year rolling period of notice and provision for the payment of a predetermined sum in the event of termination of employment in certain circumstances (but excluding circumstances where the Company is entitled to dismiss without compensation).

Mr Bowman

Mr Bowman is employed under a service contract with the Company dated 15 November 2007 and effective from 10 December 2007. The service contract was for an indefinite term expressed to end automatically on his anticipated normal retirement date (age 60). On 26th September 2011 the Nominations Committee agreed to amend this contract to remove the reference to normal retirement age. As before it may be terminated by 12 months’ notice given by the Company or six months’ notice given by Mr Bowman. The Company may elect to terminate the contract by making a payment in lieu of notice equal to 150% of Mr Bowman’s basic salary, this being a genuine pre-estimate of Mr Bowman’s entitlement in respect of the unserved notice period, to cover:

1. salary;

2. annual pension contribution by the Company (42% of base salary);

3. the annual cost to the Company of providing all other benefits to which Mr Bowman is entitled under his contract, but excluding bonus.

In this event, the contract provides that Mr Bowman’s bonus entitlement for the financial year in which termination occurs and for the unserved notice period will be the subject of a separate, good faith discussion between Mr Bowman and the Chairman; the contract also specifies that Mr Bowman would in this case be treated as a good leaver for the purposes of relevant share plans. In certain constructive dismissal events, Mr Bowman is entitled to resign and be treated in the manner set out above.

Mr Turner

Mr Turner is employed under a service contract with the Company dated 23 March 2010 and effective from 19 April 2010. It provides for a rolling one year notice period given by the Company or six months’ notice given by Mr Turner. In the event of termination by the Company (other than for cause), the Board is required to consider what sum should be payable as compensation to Mr Turner. In doing so, the Board shall take into account a number of specific matters, including Mr Turner’s personal circumstance, the financial performance of Smiths Group, applicable corporate governance best practice, the likelihood of Mr Turner obtaining alternative employment, and various other matters relating to Mr Turner’s financial loss. The amount of compensation, as so determined, will not be less than 12 months’ basic salary.

External appointments

Subject to the overriding requirements of the Company, the Committee is prepared to allow executive directors to accept external appointments where it considers that such appointments will contribute to the director’s breadth of knowledge and experience. Directors are permitted to retain fees associated with such appointments.

Chairman and non-executive directors

The Chairman and the non-executive directors serve the Company under letters of appointment and do not have contracts of service or contracts for services. Except where appointed at a general meeting, directors stand for election by shareholders at the first Annual General Meeting (AGM) following appointment and then stand for re-election at every third AGM (or such earlier AGM as the Board may determine) thereafter (under Article 49). The Board has resolved that all directors who are willing to continue in office will stand for re-election by the shareholders each year at the AGM. Either party can terminate on one month’s written notice and no compensation is payable in the event of an appointment being terminated early. The dates of their original appointment were as follows:

* subject to the director's re-appointment annually at each Annual General Meeting

The Board of Directors, excluding Remuneration Committee members, is responsible for recommending the remuneration of the non-executive directors with the exception of the Chairman, whose remuneration is determined by the Remuneration Committee. The fees payable to the non-executive directors were last increased with effect from 1 August 2009 and for the full year 2010/11 comprised the following:

* The fee payable to the Senior Independent Director is not paid to Mr Challen in addition to that paid for his chairmanship of the Audit Committee

The fees payable to the non-executive directors will remain frozen at this level for the full year 2011/12.

The Chairman and the non-executive directors are not eligible for bonuses or participation in share schemes and no pension allowances are made on their behalf.

Auditable part

The directors’ remuneration tables and accompanying notes; the directors’ pensions allowances and accompanying notes; and the directors’ share options and awards table have been audited.

The Directors’ remuneration report has been approved by the Board and signed on its behalf by:

S.J. Chambers

27 September 2011 

Directors' share option and long-term share plans

Value sharing plans

Key
PSP The Smiths Group Performance Share Plan

CIP The Smiths Group Co-Investment Plan

SAYE The Smiths Group Sharesave Scheme

VSP 2008 The Smiths Group Value Sharing Plan

VSP 2010 The Smiths Group 2010 Value Sharing Plan

* Thevesting dates shown above in respect of awards made under VSP 2008, VSP 2010 and CIP aresubject to the relevant performance test being passed.

** The expiry dates shown above apply in normal circumstances. No expiry date is shown if the option or award was exercised or vested or lapsed prior to 26 September 2011

*** Market price of a Smiths share at date of grant (if different from exercise price). The exercise price of an option under the SAYE is set at 20% less than the mid-market closing price of a Smiths share on the business day preceding the day on which employees are invited to participate in the grant.

# Actual sale price on date of exercise option or vesting of award.

Performance tests
A PSP Earnings Per Share (EPS) growth test

B PSP Total Shareholder Return (TSR) rank test

C CIP Return on Capital Employed (ROCE) test

D Surplus Shareholder Value - VSP 2008 TSR Test

E Surplus Internal Value - VSP 2008 PBT Test

F Surplus Shareholder Value - VSP 2010 TSR Test

G Surplus Internal Value - VSP 2010 PBT Test

- There are no performance criteria for SAYE.

Notes
The high and low market prices of the ordinary shares during the period 1 August 2010 to 31 July 2011 were 1450p and 1087p respectively.

The mid-market closing price on 31 July 2010 was 1116p and on 31 July 2011 was 1135p.

The mid-market closing prices of a Smiths share on the dates of awards made to directors in the 2010/11 financial year was 1240p (for the CIP Awards) and 1235p (for the VSP 2010 Awards).

The option over 2,750 shares granted to and held by directors under SAYE at 31 July 2011 was granted at an exercise price below the market price of a Smiths Group share on 26 September 2011 (922p).

None of the options or awards listed above was subject to any payment on grant.

Options and awards which lapsed or partially lapsed during the financial year ended 31 July 2011 are indicated in the tables above by a double hash mark (##): no other options or awards held by any director lapsed during the period 1 August 2010 to 31 July 2011.

No other Director held any options over the Company's shares during the period 1 August 2010 to 31 July 2011.

No options or awards have been granted to or exercised by directors or have lapsed during the period 1 August to 26 September 2011.

At 31 July 2011 the trustee of the Employee Share Trust held 855 shares (none of the directors had an interest in these shares at 31 July 2011). The market value of the shares held by the trustee on 31 July 2011 was £9,704 and dividends of approximately £296 were waived in the year in respect of the shares held by the trustee during the year.

Special provisions permit early exercise of options and vesting of awards in the event of retirement, redundancy, death, etc.

PSP awards granted in 2007

Smiths' TSR over the performance period for the 2007 PSP awards (24 October 2007 to 24 October 2010) ranked 16th in the comparator group of FTSE 100 companies (excluding financial services companies), a level of performance equivalent to the 78th percentile. Based on the vesting schedule under which 25% of the TSR element of the award (being one third of the total award) would vest at median and 100% of the element would vest at 75% or above, the TSR element of the 2007 awards vested in full. Smiths' EPS growth over the performance period was 9.1% p.a. Based on the vesting schedule under which 25% of the EPS element of an award (being two-thirds of the total award) would vest if EPS growth was 5% p.a. and 100% of the element would vest if EPS growth was 12% p.a., 68.5% of the EPS element of the 2007 awards vested and 31.5% lapsed. Overall, 79% of the 2007 PSP Awards vested.

CIP awards granted in 2007

Smiths' ROCE over the performance period for the 2007 CIP awards (1 August 2007 to 31 July2010) exceeded the Company's weighted average costs of capital (WACC) over the period by more than 1% p.a. Accordingly the 2007 CIP Awards vested in full.