March 30, 2007

 

Dear Shareholder:

 

You are cordially invited to attend the Annual Meeting of Shareholders of Puget Energy, Inc., (Puget Energy) on May 4, 2007 beginning at 10:00 a.m. at the Puget Sound Energy Corporate Campus, 10885 N.E. 4th Street, in Bellevue, Washington 98004. You will find a map with directions on the back page of this proxy statement. Enclosed is our 2006 annual report for your review.

 

Details of the business to be conducted at the meeting are given in the attached Notice of Annual Meeting of Shareholders and Proxy Statement. Only common stock shareholders of record at the close of business on March 2, 2007 are entitled to vote at the meeting.

 

Whether or not you plan to attend the annual meeting, it is important that your shares be represented and voted. Therefore, I urge you to promptly vote and submit your proxy by telephone, via the Internet or by signing, dating and returning the enclosed proxy card in the envelope provided.

 

We will provide live coverage of the annual meeting from the Investors section of the Puget Energy website at www.pugetenergy.com.  Replay of the annual meeting of shareholders will be available in the Investors section of the website for those of you that are unable to attend.

 

We appreciate your continued interest in Puget Energy and look forward to seeing you at the meeting.

 

Sincerely,

 

Stephen P. Reynolds

Chairman, President and Chief Executive Officer

 

Notice of Annual Meeting of Shareholders
Friday, May 4, 2007 at 10:00 a.m.

 

Puget Sound Energy Auditorium
10885 N.E. 4th Street
Bellevue, Washington 98004

 

Dear Shareholder:

 

The Annual Meeting of Shareholders of Puget Energy, Inc. will be held at the Puget Sound Energy Auditorium, located on the Puget Sound Energy Corporate Campus, 10885 N.E. 4th Street, Bellevue, Washington on Friday May 4, 2007, beginning at 10:00 a.m. for the following purposes:

 

 

Only common stock shareholders of record at the close of business on March 2, 2007 will be entitled to vote.

 

Your vote is important.  Regardless of the number of shares you own, please vote as soon as possible. You may vote your proxy by telephone, via the Internet, or by signing, dating and returning the enclosed proxy card in the envelope provided. You will find instructions on the enclosed proxy card.

 

If your shares are registered in the name of a brokerage firm or trustee and you plan to attend the meeting in person, please bring a letter, account statement or other evidence of your beneficial ownership to the meeting.

 

By Order of the Board of Directors

 

James W. Eldredge

Corporate Secretary

 

March 30, 2007

Bellevue, Washington

 

TABLE OF CONTENTS

 

PUGET ENERGY, INC.

 

This proxy statement is being furnished to you by the Board of Directors of Puget Energy, Inc. (Puget Energy) to solicit proxies for use at its Annual Meeting of Shareholders. The meeting will be held at the Puget Sound Energy Auditorium, located on the Puget Sound Energy Corporate Campus, 10885 N.E. 4th Street, Bellevue, Washington beginning at 10:00 a.m. on May 4, 2007. This proxy statement, proxy card and our 2006 Annual Report are being mailed to shareholders beginning on or about March 30, 2007.

 

The mailing address of Puget Energy’s principal executive offices is Puget Energy, Inc., 10885 N.E. 4th Street, P.O. Box 97034, Bellevue, Washington 98009-9734.

 

 

 

 

 

 

 

We are not aware of any other matter to be presented for action at the Annual Meeting.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ten directors currently constitute the Company’s Board of Directors, which is divided into three classes. Class I consists of four directors, Class II of three directors and Class III of three directors. Generally, one class of directors is elected each year to a three-year term. The members of Puget Energy’s Board of Directors and Board Committees are the same as the members of PSE’s Board of Directors and Board Committees.

 

Directors are elected to hold office until their successors are elected and qualified, or until resignation or removal in the manner provided in our Bylaws. On June 29, 2006, the Board of Directors appointed George W. Watson as a Class II director. The appointment of Mr. Watson was recommended by the Governance and Public Affairs Committee. The Governance and Public Affairs Committee established the experience and expertise criteria and retained a third party search firm to identify potential candidates, including Mr. Watson. Washington law and the Bylaws of the Company provide that the term of a director appointed to fill a vacancy expires at the next annual meeting of shareholders at which directors are elected. Accordingly, Mr. Watson has been nominated for election at the Annual Meeting. At the Annual Meeting, the shareholders will elect four Class I directors to serve for a term of three years expiring on the date of the 2010 Annual Meeting and one Class II director to serve a term of one year expiring on the date of the 2008 Annual Meeting.

 

Currently, the Company’s Corporate Governance Guidelines require any nominee in an uncontested election who receives a greater number of votes “withheld” or votes “against” than votes “for” their election to tender their resignation to the Board of Directors within five business days of the certification of the election. The Governance and Public Affairs Committee will then consider the resignation offer and make a recommendation to the full Board of Directors. Within 90 days of submission of the director’s resignation, the independent members of the Board will

decide whether to accept the resignation, reject the resignation, or elect to delay acceptance for a specified period of time to address underlying shareholder concerns, recruit a new director or for any other reasons the Board considers appropriate. The Company will disclose the Board’s decision within four business days in a filing with the Securities and Exchange Commission (SEC), providing a full explanation of its process and the factors considered or, if the Board is unable to make a decision in that timeframe, it will promptly disclose the reasons. This policy will apply to the elections at the Annual Meeting. If Proposal 2 is approved at the Annual Meeting, a majority voting standard will apply in uncontested elections in the future as more fully described under “Proposal 2 — Approval of Amendments to the Company’s Articles of Incorporation to Adopt a Majority Vote Standard in Uncontested Elections of Puget Energy, Inc. Directors.”

 

Class I Nominees Standing for Election — Terms Expiring in 2010

 

Phyllis J. Campbell, age 55, was appointed the Lead Independent Director of the Boards of Puget Energy and PSE in May of 2005. She has been President and Chief Executive Officer of The Seattle Foundation (charitable foundation) since 2003. Prior to that, she was Chair of the Community Board of U.S. Bank, Washington from 2001 to 2003 and President of U.S. Bank, Washington (financial institution) from 1993 to 2001. Ms. Campbell has been a director of Puget Energy since its incorporation in 1999 and of PSE since 1993. She also serves as a director of Nordstrom, Inc., Alaska Air Group, Inc. and Joshua Green Corporation (privately held).

 

Stephen E. Frank, age 65, served as Chairman, President and Chief Executive Officer of Southern California Edison (regulated utility) from 1995 until his retirement in January 2002. Prior to that, he was President and Chief Operating Officer of Florida Power and Light Company from 1990 to 1995. Mr. Frank has been a director of Puget Energy and PSE since 2003. He also serves as a director of Associated Electric & Gas Insurance Services, Northrop Grumman Corp., Intermec, Inc., and Washington Mutual, Inc.

 

Dr. Kenneth P. Mortimer, age 69, is President Emeritus of the University of Hawaii and Western Washington University. He is also Chancellor Emeritus of the University of Hawaii at Manoa. He is also Senior Associate of the National Center for Higher Education Management Systems. Dr. Mortimer holds a Ph.D. degree from the University of California at Berkeley and an MBA from the Wharton School of the University of Pennsylvania. Dr. Mortimer has been a director of Puget Energy and PSE since 2001.

 

Stephen P. Reynolds, age 59, has been Chairman, President and Chief Executive Officer of Puget Energy and PSE since May 2005, and was President and Chief Executive Officer from January 2002 to April 2005. Mr. Reynolds has been a director of Puget Energy and PSE since 2002. Mr. Reynolds also serves as a director of Intermec, Inc.

 

Class II Nominee Standing for Election — Term Expiring in 2008

 

George W. Watson, age 59, has been President and CEO of CriticalControl Solutions Corp. a firm offering document imaging and workflow management software to governmental and energy sector clients, located in Alberta, Canada since 2003. Previously, he was an executive with TransCanada Pipelines, Ltd., an energy company, from 1990 to 1999, where he served as president and CEO from 1993 to 1999. He has been a director of Puget Energy and PSE since June 2006. He also serves on the boards of CriticalControl Solutions Corp., Canadian Spirit Resources, Inc., Teekay Shipping LNG LLP and Badger Daylighting Income Fund.

 

The Board of Directors recommends that you vote FOR Proposal 1 —
the election of each of the nominees listed herein.

 

Class II Terms — Expiring in 2008

 

William S. Ayer, age 52, has been Chairman, President and Chief Executive Officer of Alaska Airlines, Inc. and Alaska Air Group (air transportation) since 2003. He served as Alaska Airlines’ President and Chief Operating Officer from November 1997 to January 2002, and as Chief Executive Officer from January 2002 to February 2003. Prior to that, he served as Sr. Vice President Operations for Horizon Air, an Alaska Airlines affiliate. Mr. Ayer has been a director of Puget Energy and PSE since 2005.

 

Sally G. Narodick, age 61, is retired President of Narodick Consulting, which specialized in strategic planning for the educational technology industry. She retired as Chief Executive Officer of Apex Learning Inc., a venture-backed Internet distance learning company, in 2000. Previously, she served as a Consultant on Strategic Planning for Educational Technology software for IBM Corporation. Ms. Narodick has been a director of Puget Energy since its incorporation in 1999 and of PSE since 1989. Ms. Narodick also serves as a director of Cray, Inc., Penford Corporation, SumTotal Systems, Inc. and Solutia Inc.

 

Class III — Terms Expiring in 2009

 

Craig W. Cole, age 57, has been President and Chief Executive Officer of Brown & Cole Stores, LLC (retail grocery) since 1989. Mr. Cole has served as a director of Puget Energy and PSE since December 1999. In addition, he serves as a director of the National Food Marketing Institute and as a Regent of the University of Washington.

 

Tomio Moriguchi, age 71, has served as Chairman and Chief Executive Officer of Uwajimaya, Inc. (food and merchandise distributor) since December 1994. Mr. Moriguchi has been a director of Puget Energy since its incorporation in 1999 and of PSE since 1988. Mr. Moriguchi also serves as President of the Board of North American Post Publishing, Inc.

 

Herbert B. Simon, age 63, has been a member of Simon Johnson, L.L.C. (real estate and venture capital projects investment company located in Tacoma, Washington) and its predecessor company since 1985. Mr. Simon has served as a director of Puget Energy and PSE since March 2006. In addition, Mr. Simon serves as a Regent of the University of Washington.

 

Independence of the Board

 

The Board has reviewed the relationships between Puget Energy (and its subsidiaries) and each of its directors and has determined that all of the directors, other than Stephen P. Reynolds, Puget Energy’s Chairman, President and Chief Executive Officer (CEO), are independent under the NYSE corporate governance listing standards and Puget Energy’s Corporate Governance Guidelines, which are available at Puget Energy’s website, www.pugetenergy.com, by clicking on the section Corporate Governance. In making these determinations, the Board has established a categorical standard that a director’s independence is not impaired solely as a result of the director, or a company for which the director or an immediate family member of the director serves as an executive officer, making payments to PSE for power or natural gas provided by PSE at rates fixed in conformity with law or governmental authority, unless such payments would automatically disqualify the director under the NYSE’s corporate governance listing standards. The Board has also established a categorical standard that a director’s independence is not impaired if a director is a director, employee or executive officer of another company that makes payments to or receives payments from Puget Energy, PSE, or any of their affiliates, for property or services in an amount which is less than the greater of $1 million or one percent of such other company’s consolidated gross revenues, determined for the most recent fiscal year. These categorical standards will not apply, however, to the extent that Puget Energy would be required to disclose an arrangement as a related person transaction pursuant to Item 404 of Regulation S-K.

 

In making its independence determinations, the Board considered all relationships between its directors and Puget Energy (and its subsidiaries), including some that are not required to be disclosed in this proxy statement as related-person transactions. Messrs. Ayer, Cole, Moriguchi and Simon serve as directors or officers of, or otherwise

have a financial interest in, entities that make payments to PSE for energy services provided to those entities at tariff rates established by the Washington Utilities and Transportation Commission. These transactions fall within the first categorical independence standard described above. In addition, PSE has entered into transactions with entities for whom Messrs. Cole, Frank and Simon serve as directors or officers, or in which they otherwise have a financial interest, that involve amounts that are less than the greater of $1 million or 1% of those entities’ consolidated gross revenues. These transactions fall within the second categorical standard described above. PSE has also made a charitable contribution to an entity for which Ms. Narodick served as director. Because these relationships either fall within the Board’s categorical independence standards or involve an amount that is not material to Puget Energy or the other entity, the Board has concluded that none of these relationships impair the independence of the applicable directors.

 

Board Attendance

 

The Puget Energy Board of Directors met eight times during 2006. Under the Company’s Corporate Governance Guidelines, each director is encouraged to attend Puget Energy’s regularly scheduled annual meeting of shareholders. All directors as of May 9, 2006 attended the 2006 Annual Meeting of Shareholders of Puget Energy. No director attended fewer than 92% of the aggregate of those meetings and the meetings of the Board Committees on which he or she served.

 

Executive Sessions

 

Non-management directors meet in executive session on a regular basis, generally on the same date as each scheduled Board meeting. Because the Chairman of the Board is a member of management, the Lead Independent Director, who is not a member of management, presides over the executive sessions. Shareholders may communicate with the non-management directors of the Board through the procedures described under the section of this proxy statement, “Shareholder Communications with the Board.”

 

Committees of the Board of Directors

 

The Puget Energy Board of Directors has established Audit, Compensation and Leadership Development, Governance and Public Affairs and Securities Pricing Committees, which meet in addition to regular Board meetings. The Audit, Compensation and Leadership Development, and Governance and Public Affairs Committees are composed of three or more directors, as determined by the Board, each of whom meet the independence requirements in the Company’s Corporate Governance Guidelines. The membership of the committees as of February 7, 2007 and a brief statement of their principal responsibilities are as follows:

 

The chair of each committee discussed below serves as the presiding director during executive sessions of that committee.

 

Audit Committee

 

The Audit Committee assists the full Board in oversight of:

 

 

In addition, the Audit Committee has ultimate authority and responsibility to select, evaluate and, where appropriate, replace the independent auditor. Each member of the Audit Committee is an independent director under SEC rules and NYSE listing standards. The Board has determined that Ms. Narodick, Mr. Frank and Mr. Watson meet the definition of “audit committee financial expert” under SEC rules. The Audit Committee met five times during 2006.

 

Compensation and Leadership Development Committee

 

The Compensation and Leadership Development Committee acts on behalf of the Board of Directors to establish and oversee the Company’s executive compensation programs. The committee must have at least three members, each of whom is an independent director under the rules of the Company’s Corporate Governance Guidelines and the NYSE. The Compensation and Leadership Development Committee met four times during 2006.

 

The committee’s responsibilities are detailed in its charter posted on the Company’s website at www.pugetenergy.com, and can be accessed by clicking on the sections: Corporate Governance; Committee Composition and Charter; Compensation and Leadership Development Committee. These responsibilities are to:

 

 

 

 

The Committee establishes all elements of compensation for the Chairman, President and CEO, including any special compensation and benefits, and reviews and approves the Chairman, President and CEO’s recommendations regarding all elements of compensation for the other executive officers. The Committee directly engages an independent executive compensation consultant, Towers Perrin. At the request and direction of the Committee, Towers Perrin provides market trend analysis and best practices, assesses individual pay elements and total pay, and reviews and advises the Committee on recommendations prepared by management. In addition, with respect to the Chief Executive Officer, the consultant provides input and guidance to the Committee on its compensation recommendations.

 

The agenda for meetings of the Compensation and Leadership Development Committee is determined by its Chairman with the assistance of the Company’s Vice President of Human Resources and the Chairman, President and CEO. Committee meetings are regularly attended by the Chairman, President and CEO and by the Vice President of Human Resources. At each meeting, the Committee meets in executive session. The Compensation Committee’s Chairman reports the Committee’s recommendations on executive compensation to the Board. Independent advisors and the Company’s Human Resources department support the Compensation Committee in its duties and, along with the Chairman, President and CEO, may be delegated authority to fulfill certain administrative duties regarding the compensation programs. The Committee has authority under its charter to retain, approve fees for and terminate advisors, consultants and agents as it deems necessary to assist in the fulfillment of its responsibilities. The Committee reviews the total fees paid to outside consultants by the Company to ensure that the consultant maintains objectivity and independence when rendering advice to the committee.

 

Governance and Public Affairs Committee

 

The purpose of the Governance and Public Affairs Committee is to:

 

 

The Committee has engaged Towers Perrin to serve as its independent compensation consultant with respect to the compensation and benefits of directors.

 

Each member of the Governance and Public Affairs Committee is independent under NYSE listing standards. The Governance and Public Affairs Committee met five times during 2006.

 

Securities Pricing Committee

 

The purpose of the Securities Pricing Committee is to:

 

 

Members need not be “independent” directors as defined by the NYSE. The Securities Pricing Committee met twice in 2006.

 

Transactions with Related Persons

 

Our Board of Directors has adopted a written policy for the review and approval or ratification of related person transactions. Under the policy, our directors and executive officers are expected to disclose to our Chief Compliance

Officer the material facts of any transaction that could be considered a related person transaction promptly upon gaining knowledge of the transaction. A related person transaction is generally defined as any transaction required to be disclosed under Item 404(a) of Regulation S-K, the SEC’s related person transaction disclosure rule.

 

Any transaction reported to the Chief Compliance Officer will be reviewed according to the following procedures:

 

 

When determining whether to approve or ratify a related person transaction, the Chair of the Audit Committee or the Audit Committee, as applicable, will review relevant facts regarding the related person transaction, including:

 

 

If any related person transaction is not approved or ratified, the Committee may take such action as it may deem necessary or desirable in the best interests of the Company and its shareholders.

 

There were no related person transactions required to be disclosed pursuant to Item 404(a) of Regulation S-K in fiscal year 2006.

 

The Governance and Public Affairs Committee is responsible for the identification, review, selection and recommendation to the Board of candidates for director nominees, including the development of policies and procedures to assist in the performance of these responsibilities. The Committee reviews with the Board the requisite skills and characteristics for Board nominees and composition and the specific considerations relating to individual director candidates. Upon the Committee’s recommendation, the Board recommends the Board nominees to the shareholders for election.

 

Director candidates may be recommended or suggested by a current director, a member of senior management or a shareholder. In addition, the Governance and Public Affairs Committee has authority to retain search firms to identify director candidates. In the event of any shareholder recommendations, the Governance and Public Affairs Committee will screen and evaluate the persons recommended in the same manner as other candidates. A director candidate should be referred to the Chair of the Governance and Public Affairs Committee for consideration by the Committee, which may then recommend the director candidate to the Board for its consideration, if deemed appropriate. A shareholder wishing to recommend a director candidate for consideration by the Committee should submit their suggestions in writing to the Chair of the Governance and Public Affairs Committee, c/o the Corporate Secretary, providing the candidate’s name, biographical data and other relevant information. Shareholders who intend to nominate a director for election at the 2008 Annual Meeting of Shareholders must provide advance written notice of such nomination to the Corporate Secretary in the manner described below under “Shareholder Proposals — Advance Notice Procedures for Director Nominations and Other Business.” In the event there is a vacancy on the Board, the Governance and Public Affairs Committee will initiate the effort to identify appropriate director candidates.

 

The Board has adopted Director Recruiting and Selection Criteria as set out in Exhibit A to the Governance and Public Affairs Committee Charter, which is available on the Company’s website at www.pugetenergy.com by clicking on the sections, Corporate Governance, Committee Composition and Charter, Compensation and Leadership Development Committee. In accordance with the Selection Criteria, the Governance and Public Affairs Committee and the Board, as appropriate, will review the following considerations, among others, in their evaluation of candidates for Board nomination: personal and professional ethics; commitment to fulfill the duties of the Board; financial expertise; industry knowledge; training and experience in public policy and governmental affairs; regional knowledge and contacts; ethnic, gender, professional, and philosophical diversity; and other relevant qualifications. A director candidate’s ability to devote adequate time to Board and Board Committee activities is also considered. Pursuant to Puget Energy’s Corporate Governance Guidelines, directors are expected to tender their resignation prior to the annual shareholders meeting following their 72nd birthday, though a director may stand for reelection even though the retirement policy would prevent him or her from completing a full three year term. In addition, without specific approval from the Board, no director may serve on more than five public company Boards (including service on the Puget Energy/PSE boards, which are counted together as one board). The Committee periodically reviews with the Board the appropriate process for, and the considerations to be made in, the evaluation of director candidates.

 

The following table sets forth information regarding compensation for each of the Company’s nonemployeee directors for 2006. As described in further detail below, the Company’s nonemployee director compensation program in 2006 consisted of quarterly retainer fees of $15,000 at least two-thirds of which is payable in Puget Energy stock, with the balance payable in cash. Additional quarterly retainer amounts associated with serving as lead director, chairing Board committees and serving on the Audit Committee, and meeting fees are paid in cash. Directors may defer their cash or stock fees into deferred stock units.

 

 

DIRECTOR COMPENSATION FOR FISCAL YEAR 2006

 

 

 

 

Nonemployee Director Compensation Program.  The Board believes that the level of nonemployee director compensation should be based on Board and committee responsibilities and be competitive with comparable companies. In addition, the Board believes that a significant portion of nonemployee director compensation should align director interests with the long-term interests of shareholders.

 

Nonemployee directors were compensated in 2006 by:

 

 

Nonemployee directors were paid the following additional cash quarterly retainer fees in 2006:

 

 

On February 28, 2007, the Governance and Public Affairs Committee completed a review of compensation for nonemployee directors, including a review of director compensation practices of comparable utility companies. As a result of this review, the Committee recommended and the Board of Directors approved the program on March 1, 2007 to increase the base cash quarterly retainer fee to $20,000, increase the fee for attendance at Board and committee meetings to $1,600 and for attendance at telephonic meetings lasting 60 minutes or less to $800, and reduce the additional cash quarterly retainer fee for the lead independent director to $3,750. The other elements of

the director compensation program described above remain the same. The changes to the program became effective March 1, 2007.

 

To facilitate the stock ownership guidelines described below, 100% of the quarterly retainer fee is paid in the form of Puget Energy shares until a director owns a number of Puget Energy shares equal in value to two years of retainer fees.

 

After meeting this ownership requirement, a portion of the base quarterly retainer for a fiscal quarter is payable in shares of Puget Energy stock. Under the terms of our Nonemployee Director Plan and Board policies as currently in effect, the number of shares is determined by dividing two-thirds of the base quarterly retainer by the fair market value of Puget Energy stock for the last business day of a fiscal quarter. For this purpose, fair market value for a single trading day is the average of the high and low trading prices for Puget Energy stock as reported by the NYSE.

 

All quarterly retainer and meeting attendance fees are paid on the last business day of March, June, September and December. Nonemployee directors are reimbursed for actual travel and out-of-pocket expenses incurred in connection with their services. Directors who also serve as employees of the Company do not receive compensation for their service on the Board or any committees.

 

Nonemployee directors are eligible to participate in our matching gift program on the same terms as all Puget Energy employees. Under this program, we will match up to a total of $300 a year in contributions by a director to non-profit organizations with an IRS 501(c)(3) tax exempt status that are located in and serve the people of PSE’s service territory in Washington State.

 

Deferral of Compensation.  Nonemployee directors may defer receipt of all or a part of their quarterly retainer fees that are required to be paid in Puget Energy stock into unfunded deferred stock unit accounts under our Nonemployee Director Plan. Deferred stock units earn the equivalent of dividends, which are credited as additional deferred stock units. Nonemployee directors do not have the right to vote or transfer the deferred stock units. Deferred stock units will be distributed as shares of Puget Energy stock after retirement or other termination of Board service.

 

Nonemployee directors may also elect to defer all or a part of their fees payable in cash under our Deferred Compensation Plan for Nonemployee Directors. Nonemployee directors may allocate these deferrals into one or more “measurement funds,” which currently include an interest crediting fund, an equity index fund, a bond index fund and a Puget Energy stock fund. Nonemployee directors are permitted to make changes in measurement fund allocations quarterly. Amounts allocated to the Puget Energy stock fund are treated as deferred stock units that will earn the equivalent of dividends, which are credited as additional deferred stock units. Nonemployee directors do not have the right to vote or transfer the deferred stock units. Amounts deferred will be paid at the time elected by the nonemployee director, which must be at least three years after the date of deferral. Amounts allocated to the Puget Energy stock fund are payable only in Puget Energy stock. Other accounts are payable in cash.

 

Director Compensation Review Practices.  The Governance and Public Affairs Committee is responsible for annually reviewing the Company’s nonemployee director compensation practices in relation to comparable companies. Any changes to be made to nonemployee director compensation practices must be recommended by the Governance and Public Affairs Committee for approval by the full Board. See “Governance and Public Affairs Committee” for a description of the committee’s processes and procedures for considering and determining director compensation.

 

Director Stock Ownership Guidelines.  The Board believes that nonemployee directors should have a financial stake in the Company. The Board has adopted stock ownership guidelines for nonemployee directors. The guidelines call for the Company to pay the base quarterly retainer in the form of Puget Energy stock until a director owns shares equal in value to the ownership target. Directors and officers of the Company are not allowed to own derivatives of Puget Energy stock, nor are they allowed to own shares in margin accounts.

 

The following table shows the number of shares of common stock beneficially owned on February 15, 2007 by each director and nominee, by each executive officer named in the Summary Compensation table, by the directors and executive officers of Puget Energy as a group, and by each person or group that Puget Energy knows owns more than 5% of Puget Energy’s common stock. Puget Energy considers executive officers of PSE to be executive officers of Puget Energy. No director or executive officer owns more than 1% of the outstanding shares of common stock. Franklin Resources, Inc. and its affiliates of San Mateo California beneficially own approximately 9.5% of Puget Energy common stock. Lord, Abbett & Co. LLC of Jersey City, New Jersey beneficially owns approximately 5.7% of Puget Energy common stock. NWQ Investment Management Company, LLC of Los Angeles, California beneficially owns approximately 5.4% of Puget Energy common stock. Percentage of beneficial ownership is based on 116,723,205 shares outstanding as of February 21, 2007.

 

Beneficial Ownership Table

 

 

 

 

 

Section 16(a) Beneficial Ownership Reporting Compliance

 

Section 16(a) of the Securities Exchange Act of 1934 requires the directors and officers of Puget Energy and PSE to file reports of ownership and changes in ownership with respect to the equity securities of the Companies with the SEC. To our knowledge, based on our review of the reports furnished to Puget Energy in 2006 and written representations that no other reports were required, all directors and officers of Puget Energy who are subject to the Section 16 reporting requirements filed the required reports on a timely basis in 2006, except for one Form 4 relating to a single transaction which was inadvertently filed four business days late for Mr. Reynolds, Chairman, President and CEO. The filing which was due on February 17, 2006, related to the acquisition of 4,335 Puget Energy phantom share units with a transaction date of February 15, 2006 and an acquisition price of $21.04 per unit.

 

The Company has updated the Executive Compensation section of the proxy to comply with rules the SEC adopted in 2006. The new rules require company proxy statements to further disclose existing compensation practices and to include additional narrative and tabular disclosure. In response, the Company has expanded explanations of historical compensation and the cost of that compensation for our named executive officers, as well as expanded information concerning director compensation.

 

This section provides information about the compensation program in place for the Company’s named executive officers — the CEO, Chief Financial Officer and the three other most highly compensated executive officers for 2006. It includes information about the overall objectives of our compensation program and each element of compensation the Company provides.

 

Compensation Program Objectives

 

The Company’s executive compensation program has two main objectives:

 

 

The following is a discussion of the specific strategies used to accomplish each of these objectives, including Committee and management actions to implement these strategies.

 

 

 

Several factors are critical to attracting and retaining executives for the Company. One is ensuring that total pay opportunity is competitive with similar companies so that new executives will want to join the Company and current executives are not hired away. As described below in the discussion of Compensation Pay Elements (Review of Pay Element Competitiveness), the Committee annually compares executive pay to external market data from similar

companies in our industry. Individual pay adjustments are reviewed to see how they position the executive in relation to the median of market pay, while also considering the executive’s recent performance and experience level. The Company may choose to pay an individual above median level of market pay when our executive has a role with greater responsibility than the best comparison job or when our executive’s experience and performance exceed those typically found in the market. The Committee determines the pay level for Mr. Reynolds, the Chairman, President and CEO, and reviews and approves Mr. Reynolds’ recommendations for pay levels of the other executives.

 

Another critical factor to motivating our executives, as well as attracting and retaining them, is to provide incentive compensation for meeting and exceeding target levels of annual and long-term goals. Our “pay for performance” strategy connects individual, team, and Company performance with an executive’s pay. We believe the executives who will most successfully lead the Company are motivated by the possibility for individual financial gain and by the satisfaction of individual and team accomplishment. By establishing goals, monitoring results, and providing payments and recognition for accomplishment of results, the Company focuses executives on actions that will improve the Company and enhance shareholder value.

 

A final critical factor in attracting, motivating and retaining executives is providing them with retirement income based upon annual salary and actual bonus paid, as well as tenure. We recognize that executives choose to work for the Company from a variety of other alternative organizations, and one financial goal of employees is to provide a secure future for themselves and their families. The Committee reviews the design of retirement programs provided by competing companies and provides benefits that are commensurate with those of its competitors.

 

 

In addition to rewarding performance that meets or exceeds goals, our annual and long-term incentives help executives focus on the priorities of our shareholders and customers. Both the annual incentive plan and the long-term incentive plan measure and reward the Company’s performance on Service Quality Indices (SQIs). These reporting measures were developed in collaboration with the Company’s regulator and provide customers with a report card on the Company’s customer service and reliability. In fact, we provide an annual accounting on these 11 measures to our customers each year. Additional key measures used for determining incentives are Earnings Per Share (EPS) in the annual incentive plan and Relative Total Shareholder Return (Relative TSR) in the long-term incentive plan. EPS and Relative TSR are important shareholder performance measures, but they also indicate to our customers that the Company will have the financial strength needed for long-term sustainability.

 

 

The Chairman, President and CEO leads the talent reviews and succession planning through meetings with his executive team. Each executive conducts talent reviews of senior employees who have high potential for assuming greater responsibility in the Company. The talent reviews include evaluations prepared within the Company and by external organizational development consultants. The Committee annually reviews these assessments of executive readiness, the plans for development of the Company’s key executives, and progress made on these succession plans. The Committee directly participates in discussion of succession plans for the position of Chairman, President and CEO.

 

 

 

When Company results are above expectations, total direct compensation is higher than our target of the 50th percentile. If results are below expectations, total direct compensation is lower than this targeted level. As described above as “pay for performance,” the Company’s variable pay program helps focus executives and creates a record of their results. When the performance of the executive team and all employees is better than planned,

customers and shareholders benefit. Customers receive good customer service and reliable energy supplies at the least cost. Shareholders have the opportunity to receive dividends and increases in the value of their investment. By keeping a significant portion of pay at risk, the Company will not pay for results unless they are achieved. This is also why the Company targets the median pay of the market when performance goals are met, but will pay higher when performance exceeds targets.

 

Compensation Program Elements

 

This section continues the detailed discussion of the Company’s compensation program by identifying the elements of the program and examining how these elements function and why the Committee chooses to include the items in the compensation program.

 

The Company’s compensation policies encompass a mix of base salary, annual and long-term incentive compensation, health and welfare benefits, retirement programs, and a small number of perquisites. The Company also provides certain change in control benefits to executives. The total package is designed to provide participants with appropriate incentives that are competitive with the comparator group and achieve current operational performance and customer service goals as well as the long-term objective of enhancing shareholder value. The Company does not have a specific policy regarding the mix of cash and non-cash compensation elements, but arrives at a mix of pay by setting each compensation element relative to market comparators. The Company delivers compensation through cash and stock-based programs, because cash provides liquidity for employees while stock increases the connection to shareholders. Long-term performance-based incentives are designed to comprise the largest portion of each executive’s incentive pay. As an example, the mix of annual salary and annual and long-term incentive targets for the Chairman, President and CEO in 2006, if all annual and long-term performance goals were achieved, was 29% annual salary, 22% target annual incentive, and 49% target long-term incentive. Annually the Committee reviews total compensation opportunity and actual total compensation received over the prior years by each officer in the form of a tally sheet. This review helps inform the Committee’s decisions on plan designs by allowing the Committee to review overall pay received in relation to Company results.

 

Review of Pay Element Competitiveness

 

In making compensation decisions on base salary, annual and long-term incentive programs, management prepares comprehensive surveys of pay for review by the Committee and the Committee’s outside executive pay consultant, Towers Perrin. The surveys summarize data provided by the Towers Perrin Energy Services survey for a selection of utility and other companies that are most similar in scope and size to Puget Energy. For the review of compensation pay levels and practices in 2006, we included the following utility companies that were all of similar scope (generally $2 billion — $5 billion revenue and $4 billion — $10 billion asset size for 2005) and also participated in the Towers Perrin Energy Services survey:

 

 

Base Salary

 

Base salaries are generally targeted at the 50th percentile for the comparator group. Actual salaries vary by individual and depend on additional factors, such as expertise, individual performance achievement, level of experience and level of contribution relative to others in the organization.

 

Generally, base salaries for executives are administered on a subjective, individual basis by the Committee using as a guideline, median salary levels of a select group of electric and combination gas and electric companies

and other comparable companies from the group above, as well as internal equity among executives. We recognize that it is necessary to provide executives with a portion of total compensation that is delivered each month and provides a balance to other pay elements that are more at risk.

 

Base Salary Adjustments

 

The Committee reviewed Mr. Reynolds’ performance and based on his results and market comparison, his base salary for 2006 was increased from $750,000 per year to $775,000, a 3.3% increase. For the other named executives, Mr. Reynolds evaluated their performance during 2005 and recommended increases to the Committee based on individual performance. The recommended increases were similar to the range of salary increases awarded to all employees. The Committee reviewed market comparisons and found the proposed increases appropriate. These increases were: Mr. Valdman, a 4% increase to $364,000; Ms. O’Connor, a 3.2% increase to $289,000; Ms. McLain, a 3.0% increase to $273,000, and Mr. Markell, a 3.3% increase to $268,000.

 

Annual Incentive Compensation

 

In addition to reviewing base salaries paid by our market comparator group, we also review annual incentive payments through an annual review of total cash compensation (base salaries plus incentives). Total cash compensation is targeted at the 50th percentile of total compensation for the industry comparator group if the Company’s annual performance goals are achieved at target. If performance goals significantly exceed target, total cash compensation can approach the 75th percentile.

 

All PSE employees, including executive officers, participate in an annual incentive program. The plan is designed to provide financial incentives to executives for achieving desired annual operating results while meeting the Company’s service quality commitment to customers. The 2006 plan had a funding level based on Earnings Per Share (EPS) and attainment of Service Quality Indices (SQIs). The Committee can adjust earnings per share used in annual incentive calculation to exclude nonrecurring items that are outside the normal course of business for the year. Individual awards were based 70% on Company EPS results and 30% on performance against team and individual goals. Individual goals were developed from the overall corporate goals for 2006:

 

 

For 2006, a threshold level of $1.38 EPS (Puget Sound Energy utility EPS) and 5 out of 11 SQI performance was required before any incentives could be paid. In order for target level annual incentives to be paid, the Company needed to achieve EPS of $1.47/share and meet 10 out of 11 SQIs. Actual performance for 2006 was better than the target level for EPS, but below target for SQI achievement. Utility EPS was $1.52, and SQI achievement was 9 out of 11, leading to a funding level of 105.75% (117.5% x 90% = 105.75%).

 

For 2006, the target incentives for this plan varied by executive officer: The target for Mr. Reynolds was 75% of base salary, for Mr. Valdman, 60% of base salary, and the targets for Ms. O’Connor, Ms. McLain, and Mr. Markell were 45% of base salary. The maximum incentive for exceptional performance in this plan is twice the target incentive.

 

For 2006, the performance goals for the named executives of PSE included EPS performance and other specified operational goals. The targets for Messrs. Reynolds, Valdman and Markell and for Ms. O’Connor and

Ms. McLain were based 70% on EPS performance and based 30% team or individual goals. Based on the combination of financial results and operational goals, incentive awards were funded at 105.75% of target, and after considering performance on individual and team goals, the following amounts were paid: Mr. Reynolds, $614,672; Mr. Valdman, $230,958; Ms. O’Connor, $137,528; Ms. McLain, $129,914 and Mr. Markell, $127,534.

 

Long-Term Incentive Compensation

 

Total direct compensation (base salary, annual incentive and long-term incentives) opportunities are designed to be competitive with market practices, generally targeting the 50th percentile. The Puget Energy 2005 Long Term Incentive Plan (LTIP), approved by shareholders in 2005, provides for several forms of multi-year incentive grants, both equity and cash-based awards. Even though the LTIP provides many types of awards, the Company’s use of the plan typically divides into two types of grants — annual grants of Performance Shares and Performance-Based Restricted Stock to all eligible employees, and new employment grants to newly hired executives. The Company does not use stock options frequently, even though permitted under the LTIP, because the Committee believes that performance shares and performance-based restricted stock generally have better incentive value for executives in a utility industry company.

 

The Company’s most common use of the LTIP is for annual grants to eligible plan participants. The Committee has been using Performance Shares since the LTIP was initially approved by shareholders in 1995. As part of ongoing reviews of the effectiveness of the LTIP program, Performance Share measures and features of the plan have been modified occasionally. In 2006, based on a review of competitive practice of utility companies and the Committee’s objectives, the Committee revised its long-term incentive program and granted PSE executives and key employees a mixture of Performance Share grants and Performance-Based Restricted Stock grants. The total value of long-term incentive compensation awards is consistent with prior years. The Performance-Based Restricted Stock was introduced to provide a balance to the Performance Share program.

 

 

The Committee establishes the number of LTIP shares that will be paid to each plan participant by evaluating the market comparator group’s actual payment and forecast target payment of long-term incentive awards and based on the participant’s level of responsibility. The Committee generally does not consider previously granted awards or the level of accrued value from prior programs when granting annual incentive awards or making new LTIP grants of performance shares and performance-based restricted stock. Each year’s grant is primarily viewed in the context of the compensation opportunity needed in that year to maintain the Company’s competitive position relative to the comparator group. Target Performance Share awards are calculated based on a percentage of annual salary, and are translated into a target number of shares using the average of the month ending stock prices from the three months prior to the start of the performance period. Targets are 170% of base salary for Mr. Reynolds, 110% for Mr. Valdman and 95% for Ms. O’Connor, Ms. McLain and Mr. Markell. The Company’s use of Performance Shares also includes a feature termed “banking” which is an evaluation of the interim performance of the grant at the end of the first and second years of the performance period. If Company performance up to that point in the grant qualifies

for payment, then a portion of shares will be credited to the participant in the form of restricted stock units that will be paid at the end of the performance period, provided the participant continues employment until that time.

 

The points below summarize the performance measures and design of the LTIP grants that are currently outstanding and those which completed during 2006.

 

 

New employment grants are the other typical type of grant from the LTIP and are made to attract an executive to the Company, and often are also used to replace value the candidate would forfeit from similar awards by moving to the Company. New employment grants are usually in the form of restricted stock, performance shares, or in one recent case, non-qualified stock options. Of the current named executives, three received new employment grants from the LTIP when they joined the Company. Mr. Markell received pro-rata grants of Performance Shares for Performance Share cycles that were outstanding when he joined in 2002. Mr. Valdman received a restricted stock grant and pro-rata grants of Performance Shares. Mr. Reynolds received a restricted stock grant and two grants of non-qualified stock options.

 

Timing of Grants

 

The Committee approves LTIP grants in the first quarter of the year at the regular meeting of the Committee, which typically is within a month after the Company has publicly released a report of its annual earnings. Due to administrative requirements, the Committee may make the effective date of grants up to five business days after the date of Committee action. The Committee may also make grants of stock options or stock appreciation rights to selected executive officers in appropriate circumstances. These circumstances would generally include the hiring of new executives or the need to retain current executive officers. The Company’s policy for pricing stock options is to establish the grant price as the fair market value of Puget Energy stock on the date that the Committee approves the grant of stock options. The LTIP defines fair market value as the average of the high and low price for Puget Energy stock on the date of grant. The options granted at employment for Mr. Reynolds were priced on January 8, 2002, the date that the Committee approved Mr. Reynolds as President and CEO. There have been no option grants to executives since these January 8, 2002 employment option grants.

 

Stock Ownership

 

The Company has established stock ownership guidelines to be achieved over a five-year period for PSE officers and key managers. For executives, holding a certain amount of stock relative to their current income helps to strengthen their alignment to shareholders. The guidelines range from five times base salary for the Chairman, President and CEO to two times base salary for the named executive officers to 50% of base salary for other key employees. Directly owned shares, share equivalents in the deferred compensation plan, and contingent shares in the LTIP that are forecast to be paid, count towards meeting the stock ownership guidelines. The Company has determined that as of December 31, 2006, all of the Named Executive Officers meet or exceed their guidelines. Officers and Directors of the Company are not allowed to own derivatives of Puget Energy stock, nor are they allowed to own shares in margin accounts.

 

Impact of Accounting and Tax Treatment of Compensation

 

The accounting treatment of compensation generally has not been a factor in determining the amounts of compensation for our executive officers. However, the Company considers the accounting impact of various program designs to balance the potential cost to the Company with the benefit/value to the executive. The Company considers the tax impact of long-term incentive compensation awards, and therefore to the extent practical, strives to deliver pay that qualifies under IRS section 162(m) as performance-based to obtain a corporate tax deduction. Under 162(m), the Company may not deduct compensation expense for the named executives if that expense is over one million dollars, except that performance-based pay is excluded from the total pay applying to 162(m). Our LTIP grants of performance-based restricted stock and performance shares are designed to meet the performance-based qualification and therefore are fully tax deductible. Only Mr. Reynolds has pay that normally exceeds the one million dollar level, and the majority of this pay is performance-based and qualifies for deduction under 162(m), although Mr. Reynolds received equity awards in prior years that were not qualified under 162(m).

Retirement Plans — Supplemental Executive Retirement Plan (SERP)

 

The Named Executive Officers, except Mr. Reynolds, participate in the SERP. The Committee determines which executive officers are eligible to participate in the SERP. Mr. Reynolds was offered the opportunity to participate in SERP when he was hired. However, he elected not to do so. He participates in the PSE tax-qualified Retirement Plan and receives an annual contribution to his account in the Deferred Compensation Plan for Key Employees in lieu of participating in the SERP (see below for description of the Deferred Compensation Plan). The Company maintains the SERP for executives to provide a benefit that is coordinated with the Retirement Plan. Without the addition of the SERP, these executives would receive lower percentages of replacement income during retirement than other employees. Additional information regarding the Retirement Plan and the SERP, as well as current balances, is shown in the “2006 Pension Benefits” table.

 

Retirement Plans — Deferred Compensation Plan

 

The Company’s Named Executive Officers are eligible to participate in the Deferred Compensation Plan. The Deferred Compensation Plan provides executives an opportunity to defer up to 100% of base salary, annual incentive bonus and vested performance shares, plus receive additional Company contributions made by PSE, into an account with four investment tracking fund choices. The funds mirror performance in major asset classes of bonds, stocks, Puget Energy stock, and an interest crediting fund that changes rate quarterly based on corporate bond rates. Similar to the SERP, the Deferred Compensation Plan is intended to allow the executives to defer current income, without being limited by the Internal Revenue Code contribution limitations for 401(k) plans. The Company contributions are also intended to restore benefits not available to executives under PSE’s tax-qualified plans due to Internal Revenue Code limitations on compensation and benefits applicable to those plans. Mr. Reynolds receives an annual Company contribution to his Deferred Compensation account equal to 15% of the base salary and annual incentive payment he received during the prior year. This account is a feature of Mr. Reynolds’ employment agreement. Additional information regarding the Deferred Compensation Plan and Mr. Reynolds’ employment agreement arrangement, as well as current balances, is shown in the “2006 Nonqualified Deferred Compensation” table.

 

Post Termination Benefits

 

The Company provides change in control agreements to its Named Executive Officers to establish in advance the terms of payments if the Company should have a change in control. When the Company has a change in control, it is likely that some or all of the executives will not be offered jobs in the new company. Change of control agreements are important for two reasons. First, many executives when joining a new company require a level of assurance that they will receive pay in the event of a change in control after they join the Company. Secondly, the Company provides change in control agreements so that the executive officers are focused on the Company’s ongoing operations and not distracted by the employment uncertainty that can arise in the event of a change in control. In 2006, the Committee reviewed and amended existing change in control arrangements in light of benchmarking information provided by Towers Perrin, and believes that the amended arrangements provide competitive benefits. The change in control agreements call for accelerated vesting of equity awards in the event of a change in control, meaning that participants will receive accelerated vesting even if their employment continues with the new company. Payment of severance benefits to Mr. Reynolds would occur in the event of a change in control. Payment of severance benefits, however, requires a “double trigger” of change in control and the executive not continuing employment with the new company, except Mr. Reynolds’ employment agreement provides that payment of severance benefits will be made at the time of a change in control. The “Potential Payments Upon Termination or Change in Control” section describes the change in control agreements with the Named Executive Officers as well as other plans and arrangements that would provide benefits on termination of employment.

 

Other Compensation

 

In addition to base salary and annual and long-term incentive award opportunities, the Company also provides the Named Executive Officers with benefits and perquisites targeted to competitive practices. The executives participate in the same group health and welfare plans as other employees. Company vice presidents and above, including the executives, are eligible for additional disability and life insurance benefits. The executives are also eligible to receive reimbursement for financial planning, tax preparation, and legal services, business club

memberships and executive physicals. The reimbursement for financial planning, tax preparation, and legal services is provided to allow executives to concentrate on their business responsibilities. Business club memberships are provided to allow access for business meetings and business events at club facilities and executives are required to reimburse the Company for individual use of club facilities. Perquisites do not make up a significant portion of executive compensation, amounting to less than $10,000 in total for each executive in 2006.

 

Relationship Among Compensation Elements

 

A number of compensation elements increase in absolute dollar value as a result of increases to other elements. Base salary increases translate into higher dollar value incentive opportunity for annual and long-term incentives, because each plan operates with a target level award set as a percentage of base salary. Base salary increases also increase the level of retirement benefits, as do actual annual incentive plan payments. Some key compensation elements are excluded from consideration when determining other elements of pay. Retirement benefits exclude LTIP payments in the calculation of qualified retirement (pension and 401(k)) and SERP benefits.

 

The Board of Directors of Puget Energy delegates responsibility to the Compensation and Leadership Development Committee to establish and oversee the Company’s executive compensation program. For a discussion of the Committee’s policies and procedures, see the “Compensation and Leadership Development Committee”. Each member of the committee meets the independence requirements of the SEC and the NYSE.

 

The Compensation and Leadership Development Committee has reviewed and discussed the “Compensation Discussion and Analysis” with the Company’s management. Based on this review and discussion, the committee recommended to the Board of Directors, and the Board has approved, that the Compensation Discussion and Analysis be included in this proxy statement and the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 for filing with the SEC.

 

Compensation and Leadership
Development Committee of
Puget Energy, Inc.

 

Stephen E. Frank, Chair
William S. Ayer
Herbert B. Simon

 

The following information is furnished for the year ended December 31, 2006 with respect to the “Named Executive Officers” during 2006. The positions and offices below are at Puget Energy and PSE, except that Mr. Markell and Ms. McLain are officers of PSE only. Salary compensation includes amounts deferred at the officer’s election.

 

 

 

 

 

Detail of All Other Compensation

 

 

 

 

 

The following table presents information regarding 2006 grants of annual incentive awards and LTIP awards, including the range of potential payouts for the annual incentive awards and performance share awards.

 

 

 

 

The following table provides information regarding outstanding stock options and unvested stock awards held as of December 31, 2006.

 

 

 

 

 

The following table provides information regarding vesting of stock awards during 2006. No stock options were exercised during 2006.

 

 

 

 

The following table provides information for each of the Named Executive Officers regarding the actuarial present value of the officer’s accumulated benefit and years of credited service under each of the Retirement Plan for Employees of Puget Sound Energy, Inc. (the “Retirement Plan”) and the Puget Sound Energy, Inc. Supplemental Executive Retirement Plan (the “SERP”). The present value of accumulated benefits was determined using interest rate and mortality rate assumptions consistent with those used in the Company’s financial statements. Except as described below in footnote (1), relating to Mr. Reynolds, each of the Named Executive Officers participates in both plans.

 

 

 

 

 

Retirement Plan

 

The Retirement Plan is a broad-based, tax-qualified defined benefit plan that provides benefits upon retirement or other termination of employment to eligible employees of the Company, PSE and their affiliates. Benefits under this plan are funded by the Company, PSE and their participating affiliates and are paid out of a trust. PSE’s and the Company’s salaried employees, including the Named Executive Officers, are eligible to participate in the Retirement Plan and accrue benefits under the plan in accordance with the plan’s cash balance formula, beginning on their date of hire. Under this formula, a bookkeeping account (a “Cash Balance Account”) is established in the name of each participant. For participants who were participating in the Retirement Plan on March 1, 1997, the opening balance in this account is based on the actuarial present value of their accrued benefit, as of February 28, 1997, under the previous Retirement Plan formula. For all other participants, the opening balance is zero. As of the last day of each calendar year beginning with 1997, each participant’s Cash Balance Account is credited with an amount equal to a percentage of the participant’s eligible compensation for such year. The applicable percentage for a participant depends on the participant’s age as of the last day of that year, and is determined as follows:

 

 

If a participant’s employment terminates during a calendar year, the participant’s compensation credit for such year will be based on the participant’s age and eligible compensation as of the date his or her employment

terminates and will be credited to his or her Cash Balance Account as of the earlier of the last day of such calendar year or the date on which the participant’s Retirement Plan benefit is paid or commences to be paid. Eligible compensation generally includes base salary and bonuses (other than bonuses paid under the Puget Sound Energy Long Term Incentive Program for Senior Management, signing, retention and similar bonuses and bonuses paid after the end of the year in which the participant’s employment terminates), up to the limit imposed by the Internal Revenue Code. For 2006, the Internal Revenue Code compensation limit was $220,000. For 2007, it is $225,000.

 

Each participant’s Cash Balance Account also receives interest credits as of the last day of each calendar quarter, based on the balance in such account as of the first day of such quarter. The interest crediting rate is 4% per year (1% per quarter) or such higher amount as PSE may determine. For 2006 and 2007 the annual interest crediting rate is 6.5% (1.625% per quarter). If a participant’s Retirement Plan benefit is paid, or commences to be paid, during the calendar quarter, then interest credits will be prorated through the last day of the month preceding the month in which such benefit is paid or commences to be paid.

 

A participant’s Retirement Plan benefit generally vests upon the earlier of the participant’s completion of five years of active service with the Company, PSE or their affiliates or attainment of age 65 (the Retirement Plan’s normal retirement age). Normal retirement benefit payments begin to a vested participant as of the first day of the month following the later of the participant’s termination of employment or attainment of age 65. However, subject to the reduction for early commencement described below, a vested participant may elect to have his or her benefit under the Retirement Plan paid, or commence to be paid, as of the first day of any month commencing after the date on which his or her employment with the Company, PSE and their affiliates terminates. As of December 31, 2006, Mr. Reynolds and Ms. McLain were vested.

 

The normal form of benefit payment for unmarried participants is a straight life annuity providing monthly payments for the remainder of the participant’s life, with no death benefits. The straight life annuity is actuarially equivalent to the balance in the participant’s Cash Balance Account as of the date of distribution, projected to the last day of the month containing the participant’s 65th birthday (if benefits are paid or commence to be paid prior that date) using the interest crediting rate(s) in effect at that time. For married participants, the normal form of benefit payment is an actuarially equivalent joint and 50% survivor annuity with a “pop-up” feature providing reduced monthly payments (as compared to the straight life annuity) for the remainder of the participant’s life and, upon the participant’s death, monthly payments to the participant’s surviving spouse for the remainder of the spouse’s life in an amount equal to 50% of the amount being paid to the participant at the time of his or her death. Under the pop-up feature, if the participant’s spouse predeceases the participant, the participant’s monthly payments increase to the level that would have been provided under the straight life annuity. In addition, the Retirement Plan provides several other annuity payment options and a lump sum payment option that can be elected by participants. All payment options are actuarially equivalent to the straight life annuity. However, in no event will the amount of the lump sum payment be less than the balance in the participant’s Cash Balance Account as of the date of distribution (in some instances the amount of the lump sum distribution may be greater than the balance in the Cash Balance Account due to differences in the morality table and interest rates used to calculate actuarial equivalency). In determining actuarial equivalency, all forms of payment use the 1984 Unisex Pensioners Mortality Table and an 8% interest rate, except for the lump sum and social security adjustment options, which use the applicable mortality table and applicable interest rate, as required by the Internal Revenue Code. Currently, the applicable mortality table is the 1994 Group Annuity Reserving Table (unisex) and the applicable interest rate is the average annual interest rate on 30-year Treasury securities in effect for September of the year preceding the year of distribution. For 2006, the applicable interest rate was 4.47%. For 2007, it is 4.85%.

 

If benefit payments commence prior to the participant’s attainment of age 65, then the amount of the monthly payments (which, as noted above, is calculated by taking into account interest credits that would have been earned through the last day of the month containing the participant’s 65th birthday) will be reduced for early commencement to reflect the fact that payments will be made over a longer period of time. This reduction is subsidized — that is, it is less than a pure actuarial reduction. The amount of this reduction is, on average, 0.30% for each of the first 60 months, 0.33% for each of the second 60 months, 0.23% for each of the third 60 months and 0.17% for each of the fourth 60 months that the payment commencement date precedes the participant’s 65th birthday. Further reductions apply for each additional month that the payment commencement date precedes the participant’s 65th birthday.

 

If a participant in the cash balance portion of the Retirement Plan dies while employed by the Company, PSE or any of their affiliates, then his or her Retirement Plan benefit will be immediately vested. If a vested participant dies before his or her Retirement Plan benefit is paid, or commences to be paid, then the participant’s Retirement Plan benefit will be paid to his or her beneficiary(ies). If a participant dies after his or her Retirement Plan benefit has commenced to be paid, then any death benefit will be governed by the form of payment elected by the participant.

 

Supplemental Executive Retirement Plan

 

The SERP, which is a non-qualified defined benefit plan, provides a benefit to participating executives that supplements the retirement income provided to such executives by the Retirement Plan to the extent the Retirement Plan benefit formula provides a benefit that is less than a target benefit. PSE designates which executives are eligible to participate in the SERP. Mr. Valdman, Ms. O’Connor, Ms. McLain and Mr. Markell participate in the SERP. SERP benefits are paid by PSE out of its general assets. As a non-qualified deferred compensation plan, the SERP is subject to Section 409A of the Internal Revenue Code (“Section 409A”). The SERP document has not been formally amended to reflect Section 409A. However, PSE is administering the SERP in good faith compliance with the requirements of Section 409A and the following discussion reflects such administration. PSE intends to amend the SERP document to reflect Section 409A on or before the deadline imposed by Section 409A (currently, December 31, 2007). Benefits accrued and vested under the SERP prior to 2005 (“Frozen SERP Benefits”) are not subject to Section 409A’s requirements and continue to be governed under the terms of the SERP as in effect on December 31, 2004.

 

A participant’s SERP benefit generally vests upon the participant’s completion of five years of participation in the SERP while employed by the Company, PSE or any of their affiliates. Ms. McLain is vested in her SERP benefit based on her years of service. By agreement with PSE, Mr. Valdman became vested in his SERP benefit on the date he was hired. The monthly benefit payable under the SERP to a vested participant (calculated in the form of a straight life annuity payable for the participant’s lifetime commencing at the later of the participant’s date of termination or attainment of age 62) is equal to (1) below minus the sum of (2) and (3) below:

 

 

Normal retirement benefits under the SERP generally are paid or commence to be paid as of the first day of the month following the later of the participant’s termination of employment or attainment of age 62. Except as provided below, SERP benefits are normally paid in a lump sum that is equal to the actuarial present value of the monthly straight life annuity benefit. A participant may elect to have this lump sum transferred to the Deferred Compensation Plan, rather than paid directly to the participant, after which it will be paid in accordance with the provisions of the Deferred Compensation Plan. In lieu of the normal form of payment, a participant may elect to receive his or her SERP benefit in the form of monthly installment payments over a period of two to 20 years, in a

straight life annuity or in a joint and survivor annuity with a 100%, 50% or 25% survivor benefit. All payment options are actuarially equivalent to the straight life annuity. In determining actuarial equivalency, the SERP uses the same mortality tables and interest rates as are used by the Retirement Plan. Frozen SERP Benefits are normally paid in the form of a straight life annuity for single participants and in the form of an actuarially equivalent joint and 50% surviving spouse annuity for married participants. However, participants can elect any of the payment options described above for their Frozen SERP Benefits. Of the Named Executive Officers, only Ms. McLain has Frozen SERP Benefits. None of the Named Executive Officers is eligible for early retirement benefit payments under the SERP.

 

If a participant dies while employed by the Company, PSE or any of their affiliates or after becoming vested in his or her SERP benefit, but before his or her SERP benefit has commenced to be paid, then the participant’s surviving spouse, if any, will receive a lump sum benefit equal to the actuarial equivalent of the survivor benefit such spouse would have received under the joint and 50% surviving spouse annuity option. This amount will be calculated assuming the participant would have commenced benefit payments in that form on the first day of the month following the later of his death or attainment of age 62. The lump sum benefit will then be reduced by one-third of one percent (1/3%) for each month by which the participant’s date of death preceded what would have been his 62nd birthday. Distribution will be made to the participant’s surviving spouse as soon as administratively practicable after the participant’s death. If the participant is not married, then no death benefit will be paid. If a participant dies after his or her SERP benefit has commenced to be paid, then any death benefit will be governed by the form of payment elected by the participant.

 

The following table provides information for each of the Named Executive Officers regarding aggregate executive and Company contributions and aggregate earnings for 2006 and year-end account balances under the Deferred Compensation Plan.

 

 

 

 

Deferred Compensation Plan

 

The Named Executive Officers are eligible to participate in the PSE Deferred Compensation Plan. The Deferred Compensation Plan is a nonqualified plan and its benefits are paid by PSE out of PSE’s general assets. The Deferred Compensation Plan is subject to the requirements of Section 409A of the Internal Revenue Code. PSE is currently administering the Deferred Compensation Plan in good faith compliance with Section 409A’s requirements and the discussion below reflects such administration. PSE intends to amend the Deferred Compensation Plan document to conform it with Section 409A’s requirements on or before Section 409A’s current amendment deadline of December 31, 2007. Deferred amounts earned and vested prior to 2005 are not subject to Section 409A’s requirements and continue to be governed under the terms of the Deferred Compensation Plan in effect on December 31, 2004.

 

Executives may defer up to 100% of base salary, annual incentive compensation and vested performance shares. In addition, each year, executives are eligible to receive Company contributions to restore benefits not available to them under PSE’s tax-qualified plans due to limitations imposed by the Internal Revenue Code. The Annual Investment Plan Restoration Amount equals the additional matching contribution under the 401(k) plan that would have been credited to an executive’s 401(k) plan account if the Internal Revenue Code limitations were not in place and if deferrals under the Deferred Compensation Plan were instead made to the 401(k) plan. The Annual Cash Balance Restoration Amount equals the actuarial equivalent of any reductions in an executive’s accrued benefit under the retirement plan due to Internal Revenue Code limitations or as a result of deferrals under the Deferred Compensation Plan. An executive must generally be employed on the last day of the year to receive these Company contributions, unless he or she retires or dies during the year in which case PSE will contribute a prorated amount.

 

In lieu of participation in the SERP, Mr. Reynolds receives an annual credit of performance-based stock equivalents to his Deferred Compensation Plan’s Performance-Based Retirement Equivalent Stock Account each January commencing on January 1, 2003. The number of stock equivalents is determined by calculating the number of shares obtained by taking 15% of Mr. Reynolds’ base salary and annual bonus for the preceding year and dividing that amount by the average per-share closing price of Puget Energy stock on the last day of October, November and December of the preceding year. The stock equivalents are entitled to dividend equivalents equal to all dividends declared on Puget Energy stock, which are then credited to the Performance-Based Retirement Equivalent Stock Account as additional stock equivalents. The stock equivalents vest over seven years from January 1, 2002 at 15% per year for the first six years, with the balance vesting on the date of the 2008 Annual Shareholders Meeting.

 

Executives choose how to credit deferred amounts among four investment tracking funds. The tracking funds mirror performance in major asset classes of bonds, stocks, Puget Energy stock, and interest crediting. The tracking funds differ from the investment funds offered in PSE’s 401(k) plan. The 2006 calendar year returns of these tracking funds were:

 

 

Executives may change how deferrals are allocated to the tracking funds at any time, subject to insider trading rules and other Deferred Compensation Plan restrictions that limit the transfer of funds into or out of Puget Energy stock. Changes generally become effective as of the first trading day of the following calendar quarter.

 

Executives generally may choose how and when to receive payments under the Deferred Compensation Plan. There are three types of in-service withdrawals. First, an executive may choose an interim payment of deferred based salary, annual bonus or vested performance shares by electing a payment date at the time of his or her deferral election. The interim payment cannot occur earlier than the third year following the year of the deferral election. Second, an in-service withdrawal may also be made to an executive upon a qualifying hardship event and demonstrated need. Third, only with respect to amounts earned and vested prior to 2005, the executive may elect an in-service withdrawal for any reason by paying a 10% penalty. Payments upon termination of employment depend on whether an executive is then eligible for retirement. If the executive’s termination occurs prior to his or her

retirement date (generally the earlier of attaining age 62 or age 55 with five years of credited service), the executive will receive a lump sum payment of his or her vested account balance. If the executive’s termination occurs after his or her retirement date, the executive may choose to receive payments in a lump sum or via one of several installment options based on the executive’s vested account balances. Mr. Reynolds is the only Named Executive Officer currently retirement eligible. Payments to the executive following a termination or retirement date are generally delayed for six months in accordance with the requirements of Section 409A of the Internal Revenue Code, except distributions of Puget Energy stock take place in the following January and each January thereafter if applicable.

 

The “Estimated Potential Incremental Payments Upon Termination or Change in Control” table reflects the estimated amount of incremental compensation payable to each of the Named Executive Officers following an executive’s termination of employment in the event of (i) an involuntary termination without cause or for good reason that is not in connection with a change in control; (ii) a change in control; (iii) an involuntary termination without cause or for good reason in connection with a change in control; (iv) retirement; (v) disability; or (vi) death. The amounts shown assume that the termination was effective as of December 31, 2006 and that the price of Puget Energy stock upon which certain of the calculations are made was the closing price of $25.36 on December 29, 2006. These amounts are estimates of the incremental amounts that would be paid out to the executive upon such terminations. The actual amounts to be paid out can only be determined at the time of the executive’s termination.

 

Payments Made Upon Termination

 

Regardless of the manner in which an executive’s employment terminates, the executive is entitled to receive amounts earned during the term of employment. These amounts, which are not included in the “Estimated Potential Incremental Payments Upon Termination or Change in Control” table, include:

 

 

Payments Made Upon Retirement

 

In the event of the retirement of a Named Executive Officer, in addition to the items identified above, the executive will receive the estimated incremental benefits reflected in the table below as a result of the following:

 

 

Named Executive Officers also receive a pro-rata payment of annual incentive awards, which is paid pro-rata to the extent earned in the year following retirement, provided the executive worked a minimum of 520 hours during the year. No estimated amounts are shown in the table below for annual incentive compensation earned in 2006.

 

Payments Made Upon Disability or Death

 

In the event of the disability or death of a Named Executive Officer, in addition to the benefits listed above, the executive will receive benefits under the PSE disability plan or life insurance plan available generally to all salaried employees. These disability and life insurance amounts are not reflected in the table below. The executive will also receive supplemental disability and life insurance. The disability coverage is extended to include base salary and target incentive pay. Life insurance benefit is provided at two times base salary and target annual incentive bonus if the executive dies while employed by PSE with a reduction for amounts payable under the applicable group policy, or a single sum amount equal to the actuarial equivalent of the combined annual annuity benefit if the executive dies after retiring.

 

Payments Made Pursuant to Employment and Change in Control Agreements

 

Puget Energy and Puget Sound Energy (the “Companies”) entered into an employment agreement with Mr. Reynolds as of January 1, 2002 to secure his services as Chief Executive Officer and President. The agreement has an initial term of three years after which time it will be automatically renewed for one-year terms unless notice of termination is given by either party at least 180 days prior to the expiration of the then current term. Pursuant to the agreement, Mr. Reynolds was appointed to the Board of Directors and the Board will recommend him for reelection during the term of the agreement. The agreement was amended on May 10, 2005 and February 9, 2006. The agreement provides for the following benefits, the estimated value of which is included in the “Estimated Potential Incremental Payments Upon Termination or Change in Control” table.

 

If at any time the Companies terminate Mr. Reynolds’ employment without cause, or Mr. Reynolds terminates his employment with good reason, Mr. Reynolds will then receive the following severance benefits:

 

 

If a change in control occurs during the term of the employment agreement, Mr. Reynolds will receive the following compensation and benefits at the time of the change in control:

 

 

The employment agreement contains a noncompetition covenant. Mr. Reynolds commits that for a period of two years following his voluntary termination, without good reason, he will not perform services for any person or entity selling or distributing electric power or natural gas in Washington, Oregon or Idaho, unless the Company consents in writing. The Company may enforce this covenant through injunctive relief or other appropriate remedies.

 

The employment agreement also contains an indemnification clause in favor of Mr. Reynolds. The Company commits to defend, indemnify and hold harmless Mr. Reynolds from all liabilities in connection with his service. As part of that commitment, the Company will continue to cover him under the Company’s directors’ and officers’ liability insurance for six years following his termination of employment.

 

Under the employment agreement, “change in control,” “good reason,” and “cause” have the following meanings:

 

Change in Control means any one of the following events: (i) any person becomes the beneficial owner of more than 30% of Puget Energy’s common stock or voting securities, with certain exceptions; (ii) the incumbent directors (including those nominees subsequently nominated or appointed by incumbent directors) cease for any reason to constitute at least a majority of the Board of Directors; and (iii) consummation of a reorganization, merger, consolidation or other business combination involving Puget Energy, or a sale of substantially all of the assets of either of the Puget Energy or PSE, unless (x) after such transaction the beneficial shareholders of the outstanding Puget Energy common stock and voting securities entitled to vote on director elections immediately prior to the transaction retain more than 60% of such common stock and voting securities; (y) no beneficial shareholder owns 30% or more of the then outstanding common stock or voting securities entitled to vote on director elections, and (z) at least a majority of the directors resulting from such transaction were incumbent directors at the time of executing the initial agreement providing for such transaction.

 

Good Reason includes the following actions by the Company: (i) assigning duties inconsistent with, or taking actions in diminution of, his position (including status, offices, titles and reporting requirements), authority, duties or responsibility under the employment agreement; (ii) failing to comply with the provisions of the employment agreement; (iii) requiring that he be based at any location other than its corporate headquarters or relocating the corporate headquarters more than 25 miles from Bellevue, Washington; and (iv) failing to assign the employment agreement to a successor or the successor failing to assume and be bound by it explicitly. Good Reason is triggered on a reasonable determination by Mr. Reynolds that any of the above events has occurred.

 

Cause means (i) the willful and continued failure to substantially perform Mr. Reynolds’ duties or (ii) the willful engaging in gross misconduct materially and demonstrably injurious to the Company. Cause does not include any act or omission believed to be in good faith and in the best interests of the Company.

 

In February 2006 PSE entered into amended change in control agreements with each of Mr. Valdman, Ms. O’Connor, Ms. McLain and Mr. Markell (the “Executives”), the terms of which are the same for all four Executives. If a change in control occurs, for a period of two years following the change in control of PSE (the “employment period”), the Executives will receive continued base salary, annual incentive bonus and other incentive, savings and retirement plans and programs applicable to PSE peer executives at comparable levels to those prior to the change in control. These benefits are not reflected in the “Estimated Potential Incremental Payments Upon Termination or Change in Control” table.

 

At the time of the change in control, the Executives will receive the following benefits, the estimated value of which is included in the “Estimated Potential Incremental Payments Upon Termination or Change in Control” table.

 

 

After a change in control, if at any time during the employment period PSE terminates an Executive’s employment without cause or due to disability or death, or the Executive terminates his or her employment with good reason, PSE will pay the Executive:

 

 

If any payments paid or payable under the amended change in control agreement or otherwise are characterized as “excess parachute payments” within the meaning of Section 280G the Internal Revenue Code, then PSE will make cash payment to or on behalf of the Executive equal to any excise taxes imposed by Section 4999 of the Internal Revenue Code due to payments received under the amended agreement or any other payment or benefit from the Company, plus the income taxes payable by him or her resulting from this cash payment.

 

The amended change in control agreements contain a confidentiality clause. The Executives must keep confidential all secret or confidential information, knowledge or data relating to the Company and its affiliates obtained during their employment. The Executives may not disclose any such information, knowledge or data after their respective terminations of employment unless PSE consents in writing or as required by law. PSE cannot withhold or defer the payment of any amounts otherwise due under the agreement based on an Executive’s asserted violation of the confidentiality clause.

 

Under the amended change in control agreements, “change in control” has the same meaning as under Mr. Reynolds’ employment agreement. “Good reason” and “cause” have the following meanings:

 

Good reason means (i) the assignment of any duties inconsistent with, or taking action in diminution of, the Executive’s position (including status, offices, titles and reporting requirements), authority, duties or responsibilities; (ii) any failure by PSE to comply with the provisions of the agreement regarding compensation during the employment period; (iii) requiring the Executive to be based at any location other than the Seattle/Bellevue metropolitan area; (iv) any purported termination of the Executive’s employment other than as expressly permitted by the amended agreement; and (v) PSE’s failure to assign the amended agreement to a successor to PSE or failure of a successor to PSE to explicitly assume and agree to be bound by the amended agreement.

 

Cause means (i) the willful and continued failure to substantially perform the Executive’s duties or (ii) the willful engaging in gross misconduct materially and demonstrably injurious to PSE. Cause does not include any act or omission believed to be in good faith and in the best interests of PSE.

 

In addition to the benefits provided under his change in control agreement, Mr. Valdman’s employment offer letter provides that if there is a change in the PSE CEO and President and due to that change Mr. Valdman’s employment is terminated or there is a significant decrease in the role, scope and compensation structure for his employment that is not otherwise covered by a change in control agreement, Mr. Valdman will be paid a severance payment equal to one year’s base salary; a pro-rata share of the annual incentive at 100% of target; a relocation allowance not to exceed $50,000; and the vested portion of the restricted stock granted at the time of his employment, provided that he executes a waiver and release in a form provided by PSE.

 

The table below presents estimated incremental compensation payable to each of the Named Executive Officers as described above. The incremental compensation is presented in the following benefit categories: