LONG-TERM INCENTIVE EMPLOYEE COMPENSATION

The 2011 Omnibus Incentive Plan (2011 Incentive Plan) was approved by shareholders and established in May of 2011 to provide for the awarding of options on common shares and full value restricted common shares or units to employees and non-employee directors. The number of shares initially available for issuance to participants under the 2011 Incentive Plan was 4.6. The 2011 Incentive Plan replaced the ITT Amended and Restated 2003 Equity Incentive Plan (2003 Incentive Plan) on a prospective basis and no future grants will be made under the 2003 Incentive Plan. However, any shares remaining available for issuance under the 2003 Incentive Plan became available for grant under the 2011 Incentive Plan as of the date the 2011 Incentive Plan was approved by shareholders. In connection with the Distribution, and per the terms of the 2011 Incentive Plan, an equitable adjustment which preserved the intrinsic value of the awards after giving effect to the distribution of Exelis and Xylem was made (referred to as the Equitable Adjustment). As of December 31, 2013, 40.2 shares were available for future grants under the 2011 Incentive Plan. ITT makes shares available for the exercise of stock options or vesting of restricted shares or units by purchasing shares in the open market or by issuing shares from treasury stock.

Prior to 2013, our long-term incentive plan (LTIP) was comprised of three components: non-qualified stock options (NQOs), restricted stock units (RSUs), and a total shareholder return award (TSR). The majority of RSUs settle in shares; however RSUs granted to international employees are settled in cash. We account for NQOs and equity settled RSUs as equity-based compensation awards while cash-settled TSR awards granted prior to 2013 and cash settled RSUs are accounted for as liability-based awards. Beginning in 2013, we replaced the TSR component of our LTIP with a Performance Unit award component. Performance Unit (PSU) awards are based on both a relative total shareholder return metric as well as a return on invested capital (ROIC) metric, equally weighted, providing a balance between relative and absolute long-term performance. The PSU awards will settle in shares, dependent upon performance, following a three-year performance period to further align payouts with stock price performance. The PSU awards are accounted for as two distinct awards, an ROIC award and a TSR award. We account for NQOs, RSUs, ROIC awards, and share-settled TSR awards granted in 2013 as equity-based compensation awards.

Long-term incentive employee compensation costs are primarily recorded within general and administrative expenses, and are reduced by an estimated forfeiture rate. These costs impacted our consolidated results of operations as follows:



	2013		2012		2011
Share-based compensation expense, equity-based awards	$	13.3	$	12.9	$	23.3
Share-based compensation expense, liability-based awards	3.8		1.9		2.1
Total share-based compensation expense in operating income (loss)^(a)	$	17.1	$	14.8	$	25.4

(a)

Share-based compensation expense incurred during 2013, 2012, and 2011 includes $0.2, $0.5 and $4.7, respectively, classified as a transformation cost in the Consolidated Statements of Operations related to the modification of equity awards. Also, included in 2011 is $8.3 of accelerated expense recognition primarily related to the retirement of Steven R. Loranger, our former Chairman, President and Chief Executive Officer.

At December 31, 2013, there was $18.7 of total unrecognized compensation cost related to non-vested equity awards. This cost is expected to be recognized ratably over a weighted-average period of 2.1 years. Additionally, unrecognized compensation cost related to liability-based awards was $4.2, which is expected to be recognized ratably over a weighted-average period of 1.6 years.

Conversion and Cancellation of Outstanding Equity at Spin Date

In connection with the Distribution, ITT modified its outstanding equity awards on October 31, 2011 (the modification date). For equity awards issued through employee compensation arrangements, the awards were generally modified such that, following the Distribution, the employee only held equity in their future employer and the intrinsic value of the awards was preserved through the Equitable Adjustment. Awards held by members of the Board of Directors were modified so that the awardee continued to hold an award in each of the three companies following the Distribution.

As a result of the Equitable Adjustment, an option modification expense of $7.9 was recorded during 2011 for awards that were fully vested on the modification date. The option modification included $3.2 of expense allocated to discontinued operations for employees who transferred to Exelis or Xylem. In addition, $0.2 and $0.5 of incremental fair value was amortized during 2013 and 2012, respectively, for awards unvested on the modification date for employees who remained with ITT.

Pursuant to the completion of the Distribution on October 31, 2011, 1.2 stock options and 0.5 restricted equity awards held by the employees of Exelis and Xylem were converted to equity awards in the underlying common stock of their respective employer and were cancelled as ITT equity awards.

Non-Qualified Stock Options

Options generally vest over or at the conclusion of a three-year period and are exercisable in seven or ten-year periods, except in certain instances of death, retirement or disability. Options granted between 2004 and 2009 were awarded with a contractual term of seven years. Options granted prior to 2004 and after 2009 were awarded with a contractual term of ten years. The exercise price per share is the fair market value of the underlying common stock on the date each option is granted.

A summary of the status of our NQOs as of December 31, 2013, 2012 and 2011 and changes during the years then ended is presented below.



	2013				2012				2011
Stock Options	Shares		Weighted Average Exercise Price		Shares		Weighted Average Exercise Price		Shares			Weighted Average Exercise Price
Outstanding – January 1	4.3		$	18.46	8.0		$	16.70	3.7			$	85.08
Granted	0.4		26.82		0.4		22.80		0.3			115.36
Exercised	(1.9	)	17.37		(3.8	)	15.35		(0.7	)		76.27
Cancelled or expired	(0.1	)	16.15		(0.3	)	17.21		(1.3	)	^(b)	92.76
Outstanding on Distribution Date before Equitable Adjustment	—		—		—		—		2.0			88.52
Outstanding on Distribution Date after Equitable Adjustment	—		—		—		—		8.0			16.18
November/December 2011 Activity:
Granted	—		—		—		—		0.7			20.28
Exercised	—		—		—		—		(0.7	)		13.87
Outstanding – December 31	2.7		$	20.46	4.3		$	18.46	8.0			$	16.70
Options exercisable – December 31	1.5		$	18.34	2.9		$	17.10	6.3			$	16.03


(b)	Includes 1.2 shares cancelled in connection with the Distribution of Exelis and Xylem, with a corresponding weighted average exercise price of $92.20.

The aggregate intrinsic value of options exercised (which is the amount by which the stock price exceeded the exercise price of the options on the date of exercise) during 2013, 2012 and 2011 was $26.3, $24.7 and $29.8, respectively.

The amount of cash received from the exercise of stock options was $34.8, $58.0 and $61.6 for 2013, 2012 and 2011, respectively. The income tax benefit realized during 2013, 2012 and 2011 associated with stock option exercises and lapses of restricted stock was $13.4, $11.0 and $16.7, respectively. We classify the cash flows attributable to excess tax benefits arising from stock option exercises and restricted stock lapses as a financing activity. Excess tax benefits arising from stock option exercises and restricted stock lapses were $8.7, $6.4 and $7.2 for 2013, 2012 and 2011, respectively. The following table summarizes information about ITT’s stock options at December 31, 2013:



	Options Outstanding						Options Exercisable
Range of Exercise Prices	Number	Weighted Average Remaining Contractual Life (in years)	Weighted Average Exercise Price		Aggregate Intrinsic Value		Number	Weighted Average Remaining Contractual Life (in years)	Weighted Average Exercise Price		Aggregate Intrinsic Value
$12-$15	0.5	1.1	$	13.19	$	14.0	0.5	1.1	$	13.19	$	14.0
$15-$20	0.4	4.5	19.92		9.7		0.4	4.5	19.92		9.7
$20-$25	1.4	7.1	21.39		31.9		0.6	6.1	20.94		15.0
$25-$30	0.4	9.2	26.82		5.8		—	—	—		—
	2.7	6.0	$	20.46	$	61.4	1.5	4.2	$	18.34	$	38.7

The aggregate intrinsic value in the preceding table represents the total pre-tax intrinsic value, based on ITT’s closing stock price of $43.42 as of December 31, 2013, which would have been received by the option holders had all option holders exercised their options as of that date. There was no options “out-of-the-money” as of December 31, 2013.

As of December 31, 2013, the total number of stock options expected to vest (including those that have already vested) was 2.6. These stock options have a weighted-average exercise price of $20.37, an aggregate intrinsic value of $60.6 and a weighted-average remaining contractual life of 5.1 years.

The fair value of each option grant was estimated on the date of grant using the binomial lattice pricing model which incorporates multiple and variable assumptions over time, including assumptions such as employee exercise patterns, stock price volatility and changes in dividends. The following are weighted-average assumptions for 2013, 2012 and 2011:



	2013			2012			November 7, 2011 Grants			2011 Grants Before Distribution
Dividend yield	1.5		%	1.6		%	1.8		%	1.7		%
Expected volatility	29.9		%	34.1		%	39.3		%	24.7		%
Expected life (in years)	6.4			6.9			7.0			7.0
Risk-free rates	1.1		%	1.4		%	1.5		%	3.1		%
Weighted-average grant date fair value	$	6.62		$	6.71		$	6.97		$	29.70

Expected volatilities for option grants prior to the Distribution were based on ITT’s stock price history, including implied volatilities from traded options on our stock. Expected volatilities for option grants subsequent to the Distribution were based on a peer average of historical and implied volatility. ITT uses historical data to estimate option exercise and employee termination behavior within the valuation model. Option characteristics are considered separately for valuation purposes. We utilized two employee groups for option grant valuation purposes for periods prior to the distribution and have utilized one group for all subsequent option grant valuations. The expected life represents an estimate of the period of time options are expected to remain outstanding. The expected life provided above represents the weighted average of expected behavior for certain groups of employees who have historically exhibited different behavior. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of option grant.

Restricted Stock Units and Performance Units

Beginning in 2011, the Compensation Committee of the Board of Directors elected to grant RSUs to employees, as opposed to restricted stock awards (RSAs) which were awarded in periods prior to 2011. The Committee decided to grant RSUs rather than RSAs in 2011 because RSUs provide a consistent tax treatment for domestic and international employees. RSUs provide the same economic risk or reward as RSAs, but recipients do not have voting rights and do not receive cash dividends during the restriction period. Dividend equivalents on RSUs, which are subject to forfeiture, are accrued and paid in cash upon vesting of the RSU, which typically occurs three years from the date of grant. If an employee retires or is terminated other than for cause, a pro rata portion of the RSU may vest. The fair value of restricted stock awards and restricted stock units is determined using the closing price of the Company’s common stock on date of grant.

The fair value of the ROIC awards was based on the closing price of ITT common stock on the date of grant less the present value of expected dividend payments during the vesting period. A dividend yield of 1.49% was assumed based on ITT's annualized dividend payment of $0.40 per share and the March 5, 2013 closing stock price of $26.76. The fair value of the ROIC award is fixed on the grant date; however, a probability assessment is performed each reporting period to estimate the likelihood of achieving the ROIC targets and the amount of compensation to be recognized. The ROIC award payout is subject to a payout factor which includes a maximum and minimum payout.

The fair value of the TSR award was measured using a Monte Carlo simulation, measuring potential total shareholder return for ITT relative to the other companies in the S&P 400 Capital Goods Index (the TSR Performance Group). The expected volatility of ITT's stock price was based on the historical volatility of a peer group while expected volatility for the other companies in the TSR Performance Group was based on their own stock price history. All volatility and correlation measures were based on three years of daily historical price data through March 5, 2013, corresponding to the three-year performance period of the award. The TSR award payout is subject to a multiplier which includes a maximum and minimum payout. As the grant date occurred after the beginning of the performance period, actual TSR performance between the beginning of the performance period (December 2012 average closing stock price) and the grant date was reflected in the valuation. A dividend yield of 1.49% was assumed based on ITT's annualized dividend payment of $0.40 per share and the March 5, 2013 closing stock price of $26.76

The table below provides a rollforward of outstanding RSUs, PSUs, and RSAs for each of the years ended December 31, 2013, 2012 and 2011.



	2013				2012				2011
Restricted Stock and Performance Units	Shares		Weighted Average Grant Date Fair Value		Shares		Weighted Average Grant Date Fair Value		Shares			Weighted Average Grant Date Fair Value
Outstanding – January 1	1.2		$	21.06	1.4		$	18.55	0.9			$	89.70
Granted	0.6		28.16		0.4		22.56		0.3			115.18
Lapsed	(0.4	)	20.25		(0.5	)	15.21		(0.3	)		99.53
Canceled	(0.1	)	22.68		(0.1	)	20.58		(0.6	)	^(c)	95.30
Outstanding on Distribution Date before equitable adjustment	—		—		—		—		0.3			93.42
Outstanding on Distribution Date after equitable adjustment	—		—		—		—		1.0			17.94
November/December 2011 Activity:
Granted	—		—		—		—		0.4			20.27
Outstanding – December 31	1.3		$	24.17	1.2		$	21.06	1.4			$	18.55


(c)	Includes a total of 0.5 RSUs and RSAs canceled in connection with the Distribution of Exelis and Xylem, with a corresponding weighted average grant date fair value of $95.14.

The table below provides the number of the outstanding equity settled RSUs, PSU's, RSA's and cash settled RSUs as of December 31, 2013, 2012 and 2011.



	2013	2012	2011
Equity settled RSUs	1.0	0.9	0.8
Cash settled RSUs	0.1	0.1	0.1
PSUs	0.2	—	—
RSAs	—	0.2	0.5

As of December 31, 2013, the total number of RSUs and PSUs expected to vest was 0.9 and 0.3, respectively. The number of PSUs expected to vest is based on current performance estimates.

Total Shareholder Return Awards

The TSR award plan is a performance-based cash award incentive program provided to key employees of ITT. TSR awards, granted prior to 2013, are accounted for as liability-based awards. The fair value of outstanding awards is determined at the conclusion of the three-year performance period by measuring ITT’s total shareholder return percentage against the total shareholder return performance of other stocks generally comprising the S&P 400 Capital Goods Index. We reassess the fair value of our TSR awards at the end of each reporting period using actual total shareholder return data over the performance period to date as well as a Monte Carlo simulation for potential future price movements. Payment, if any, typically occurs during the first quarter of each year and is based on the TSR performance comparison measured against targets established at the time of the award. No payments were made during either 2013, 2012, or 2011 under the TSR award plan. The estimated TSR liability as of December 31, 2013 is $3.8.

In connection with the Distribution, a proportionate number of outstanding TSR awards vested corresponding to the percentage of time passed between original grant date and October 31, 2011 (the vested portion). The fair value of the vested portion on October 31, 2011 was nil, as the performance factor for each TSR grant was below the minimum threshold. The unvested portion of TSR awards (the percent of time remaining between October 31, 2011 and the awards originally stated vesting date) were modified depending on the year of grant. The unvested portion of the 2010 and 2011 TSR awards were modified through the granting of RSU awards with a grant date fair value equal to the unvested portion at target. The replacement RSU awards maintain the vesting date established in the original TSR award agreement. No compensation expense was recognized in connection with these modifications as the incremental fair value resulting from the modification pertains to the unvested portion of the original TSR award. The deferred compensation cost of $2.2, as of the modification date, was recognized straight-line over the remaining vesting periods which concluded on December 31, 2013.