Stock Plans and Share-Based Compensation

Under CSX's share-based compensation plans, awards consist of performance units, restricted stock units, restricted stock awards and stock options for management and stock grants for directors. Awards granted under the various programs are determined and approved by the Compensation Committee of the Board of Directors or, in certain circumstances, by the Chief Executive Officer for awards to management employees other than senior executives. The Board of Directors approves awards granted to CSX's non-management directors upon recommendation of the Governance Committee.

Share-based compensation expense for awards under share-based compensation plans and purchases made as part of the employee stock purchase plan is measured using the fair value of the award on the grant date and is recognized on a straight-line basis over the service period of the respective award. Forfeitures are recognized as they occur. Total pre-tax expense associated with share-based compensation and its related income tax benefit is shown in the table below. The year over year decrease in share-based compensation expense is primarily due to modifications to the terms of awards in the first and second quarters of 2017 (see Equity Award Modifications below).



	Fiscal Years
(Dollars in Millions)	2018		2017		2016
Share-Based Compensation Expense
Performance Units	$	28	$	49	$	17
Restricted Stock Units and Awards	6		15		11
Stock Options	13		22		7
Stock Awards for Directors	2		3		2
Employee Stock Purchase Plan	2		—		—
Total Share-based Compensation Expense	$	51	$	89	$	37
Income Tax Benefit	$	26	$	42	$	15

Long-term Incentive Plans

The CSX Long-term Incentive Plans (“LTIP”) were adopted under the 2010 CSX Stock and Incentive Award Plan. The objective of these plans is to motivate and reward certain employees for achieving and exceeding certain financial goals. Grants were made in performance units, with each unit being equivalent to one share of CSX common stock, and payouts will be made in CSX common stock. The payout range for participants will be between 0% and 200% of the target awards depending on Company performance against predetermined goals for each three-year cycle. In 2016, 2017 and 2018, target performance units were granted to certain employees under three separate LTIP plans covering three-year cycles: the 2016-2018 (“2016-2018 LTIP”), 2017-2019 (“2017-2019 LTIP”) and 2018-2020 (“2018-2020 LTIP”) plans.

NOTE 4. Stock Plans and Share-Based Compensation, continued

The key financial targets for the 2016-2018 and 2017-2019 plans are based on the achievement of goals related to both operating ratio and return on assets (tax-adjusted operating income divided by net property) excluding certain items as disclosed in the Company's financial statements. The three-year cumulative operating ratio and average return on assets over the performance period will each comprise 50% of the payout and are measured independently of the other. These plans state that payouts for certain executive officers are subject to downward adjustment by up to 30% based upon total shareholder return relative to specified comparable groups.

Payouts of performance units for the 2018-2020 plan will be based on the achievement of goals related to both operating ratio and free cash flow, in each case excluding non-recurring items as disclosed in the Company’s financial statements. The final year operating ratio and cumulative free cash flow over the plan period will each comprise 50% of the payout and will be measured independently of the other. For this plan, payouts for certain executive officers are subject to formulaic upward or downward adjustment by up to 25%, capped at an overall payout of 200%, based upon the Company’s total shareholder return relative to specified comparable groups over the performance period. The fair value of the performance units awarded during the year ended December 2018 was calculated using a Monte-Carlo simulation model with the following weighted-average assumptions:



Weighted-average assumptions used:	2018
Annual dividend yield	1.6	%
Risk-free interest rate	2.3	%
Annualized volatility	29.1	%
Expected life (in years)	2.9

Performance unit grant and vesting information is summarized as follows:



	Fiscal Years
	2018		2017		2016
Weighted-average grant date fair value	$	55.57	$	49.50	$	24.17
Fair value of units vested in fiscal year ending (in millions)	$	14	$	26	$	31

The performance unit activity related to the outstanding long-term incentive plans and corresponding fair value is summarized as follows:



	Performance Units Outstanding (in Thousands)		Weighted-Average Fair Value at Grant Date
Unvested at December 31, 2017	976		$	33.90
Granted	376		55.57
Forfeited	(43	)	43.09
Vested	(587	)	24.13
Unvested at December 31, 2018	722		$	52.58

NOTE 4. Stock Plans and Share-Based Compensation, continued

As of December 2018, there was $38 million of total unrecognized compensation cost related to performance units that is expected to be recognized over a weighted-average period of approximately two years.

Restricted Stock Grants

Restricted stock grants consist of units and awards, each equivalent to one share of CSX stock. Restricted stock units are issued along with corresponding LTIP plans and vest three years after the date of grant. Separately, restricted stock awards generally vest over an employment period of up to five years. Participants receive cash dividend equivalents on the unvested shares during the restriction period. These awards are time-based and not based upon CSX’s attainment of operational targets.

Restricted stock grant and vesting information is summarized as follows:



	Fiscal Years
	2018		2017		2016
Weighted-average grant date fair value	$	62.60	$	48.35	$	24.21
Fair value of units and awards vested during fiscal year ended (in millions)	$	9	$	8	$	14

The restricted stock activity related to the outstanding long-term incentive plans and other awards and corresponding fair value is summarized as follows:



	Restricted Stock Units and Awards Outstanding (in Thousands)		Weighted-Average Fair Value at Grant Date
Unvested at December 31, 2017	807		$	33.37
Granted	164		62.60
Forfeited	(23	)	42.12
Vested	(264	)	35.41
Unvested at December 31, 2018	684		$	39.30

As of December 2018, unrecognized compensation expense for these restricted stock units and awards was approximately $11 million, which will be expensed over a weighted-average remaining period of two years.

Stock Options

Stock options were granted in 2016, 2017 and 2018 along with the corresponding LTIP plans. Under this program, an employee receives an award that provides the opportunity in the future to purchase CSX shares at the closing market price of the stock on the date the award is granted (the strike price). The options become exercisable after a three-year vesting period and expire 10 years from the grant date if they are not exercised.

NOTE 4. Stock Plans and Share-Based Compensation, continued

The fair value of stock options granted was estimated as of the dates of grant using the Black-Scholes-Merton option model which uses the following assumptions: dividend yield, risk-free interest rate, annualized volatility and expected life. The annual dividend yield is based on the most recent quarterly CSX dividend payment annualized. The risk-free interest rate is based on U.S. Treasury yield curve in effect at the time of grant. The annualized volatility is based on historical volatility of daily CSX stock price returns over a 6.5 year look-back period ending on the grant date. The expected life is calculated using the safe harbor approach due to lack of historical data on CSX options, which is the midpoint between the vesting schedule (three year cliff) and contractual term (10 years).

In March 2017, the Company granted 9 million stock options to former CEO E. Hunter Harrison at a fair value of $12.88 per option. These options were granted with a ten-year term and an exercise price equal to the closing market price of the underlying stock on the date of grant. Upon his death in December 2017, all of Mr. Harrison's 9 million options were forfeited.

Assumptions and inputs used to estimate fair value of stock options are summarized as follows:



	Fiscal Years
	2018			2017			2016
Weighted-average grant date fair value	$	14.65		$	12.84		$	4.68

Stock options valuation assumptions:
Annual dividend yield	1.5		%	1.5		%	3.0		%
Risk-free interest rate	2.6		%	2.2		%	1.4		%
Annualized volatility	27.0		%	27.1		%	27.3		%
Expected life (in years)	6.5			6.3			6.5
Other pricing model inputs:
Weighted-average grant-date market price of CSX stock (strike price)	$	54.19		$	49.63		$	24.13

The stock option activity is summarized as follows:



	Stock Options Outstanding (in Thousands)		Weighted-Average Exercise Price		Weighted-Average Remaining Contractual Life (in Years)	Aggregate Intrinsic Value (in Millions)
Outstanding at December 31, 2017	4,163		$	29.52
Granted	1,009		54.19
Forfeited	(169	)	37.18
Exercised	(330	)	24.99
Outstanding at December 31, 2018	4,673		$	34.89	7.7	$	139
Exercisable at December 31, 2018	1,268		$	24.99	6.9	$	50

NOTE 4. Stock Plans and Share-Based Compensation, continued

Unrecognized compensation expense related to stock options as of December 2018 was $13 million and is expected to be recognized over a weighted-average period of approximately two years. The Company issues new shares upon stock option exercises.

Equity Award Modifications

In 2017, as part of an enhanced severance benefit under the management streamlining and realignment initiative discussed in Note 1, unvested performance units, restricted stock units and stock options for separated employees not eligible for retirement were permitted to vest on a pro-rata basis. Additionally, the terms of unvested equity awards for a former Chief Executive Officer, Michael J. Ward, and a former President, Clarence W. Gooden, were modified prior to their retirements on March 6, 2017 to permit prorated vesting through May 31, 2018.

The award modifications impacted approximately 75 employees and resulted in an increase to share-based compensation expense for revaluation of the affected awards of $39 million for the year ended December 31, 2017. The expense associated with these award modifications was included in the 2017 restructuring charge. No significant award modifications took place in 2018 or 2016.

Stock Awards for Directors

CSX’s non-management directors receive a base annual retainer of $100,000 to be paid quarterly in cash, unless the director chooses to defer the retainer in the form of cash or CSX common stock. Additionally, non-management directors receive an annual grant of common stock in the amount of approximately $150,000, with the number of shares to be granted based on the average closing price of CSX stock in the months of November, December and January. The independent non-executive Chairman also receives an annual grant of common stock in the amount of approximately $250,000, with the number of shares to be granted based on the average closing price of CSX stock in the months of November, December, and January.

Employee Stock Purchase Plan

In May 2018, shareholders approved the 2018 CSX Employee Stock Purchase Plan (“ESPP”) for the benefit of Company employees. The Company registered 4 million shares of common stock that may be issued pursuant to this plan. Under the ESPP, employees may contribute between 1% and 10% of base compensation, after-tax, to purchase up to $25,000 of CSX common stock per year at 85% of the closing market price on either the grant date or the last day of the six-month offering period, whichever is lower. No shares will be issued under the ESPP until first quarter 2019.