Executive remuneration has become a highly political subject and anything political has to be complicated. But Egan Associates can’t help thinking that the purpose of executive remuneration has been muddied by the increasing complexity of its elements. Given these concerns, we thought we’d take remuneration back to basics. What is the purpose of remuneration?
For most workers remuneration is compensation for their efforts, providing them with some or all of the money required to fund their life and retirement needs. For executives, it’s not that simple.
After examining a cross section of annual reports in the ASX 300, we found that many reports state executive remuneration’s purpose is to attract and retain “appropriately qualified” and experienced talent in a competitive market. They also state that executive remuneration is intended to encourage and reward excellent or superior performance including the management of risk aligned to the business strategy that will create long-term sustained value/wealth for shareholders. Some also mentioned the need to align shareholder and executive interests, focus effort and foster corporate governance and ethics.
We can split these pieces into the current three primary remuneration elements in their traditional sense:
- Fixed Remuneration – Attract and retain appropriately qualified and experienced talent. Recognise variable accountability. Provide a stable threshold payment for services.
- Short Term Incentive (STI) – Focus effort and encourage and reward superior performance aligned to the business strategy and shareholder interests. Foster corporate governance and ethics.
- Long Term Incentive (LTI) – Encourage and reward superior performance aligned to the creation of long-term sustained value for shareholders while managing risk. Align shareholder and executive interests. Foster corporate governance, ethics.
Insurance Australia Group has a similar split in its annual report:
Are the current remuneration elements fulfilling their purpose?
Fixed Remuneration – Given the level of executive pay, it certainly seems it is achieving its goal of recognising varying levels of accountability and providing a threshold payment for services rendered – where this breaks down is when there is a change in the scale, complexity and market value of a company that has arisen from market conditions as well as divestment initiatives creating a new market status. A further challenge for Boards is the pay differential between the CEO, key management personnel and the next level of management. The fixed remuneration level also plays a role in the attraction of employees, although for many roles, CEOs and Boards should recognise that premium reward should only come from improving performance, not through fixed remuneration.
Short Term Incentives – Although this pay element attempts to require effective performance before an award is granted, it is far from perfect. The biggest area where incentives often fail is in encouraging and differentiating reward for superior performance. Thresholds for STI payments are often set so low that the STI, or at least a part of it, becomes a deferred fixed remuneration payment. The executive will receive the payment if they simply do their job to an acceptable level which falls short of the budget or business plan. If we considered how much of executives’ remuneration was received for competent performance and compared it to remuneration overseas, Australia’s fixed remuneration payments would seem high.
A key task for Board Remuneration Committees is ensuring that incentives are paid for improving performance and shareholder returns in the context of risk appetite and competitive influences. Thresholds should represent an uplift on prior year outcomes or an expected improved performance trend line.
Long Term Incentives – This element is intended to focus executives on longer term and sustainable performance outcomes, but not always effectively from a shareholder’s perspective: the complex nature of LTI schemes has led to many executives believing that a pay off from their LTI is more like a lottery than the result of any effort on their part. A global study by PwC in 2012 found that the more complex and long term a pay plan, the less it was valued. This is despite the cost to the company of running such plans. A carrot made of gold, however costly, will not entice a horse to follow – the horse does not eat gold. In a similar way, an executive can hardly be motivated by a plan they do not value, no matter how lucrative it may be.
The connection between performance and value of share plans is also often decoupled by volatile markets – Boards often award large grants of rights when the share price is depressed in order to provide a certain future monetary value to the executive. A market-led return of the share price back to higher levels will often provide little or no additional value to long term shareholders, but will in many cases deliver executives significant income without their having ’skin in the game’.
Thus we observe two major failures where remuneration elements are not achieving their goals:
- Many STI plan performance conditions are rewarding mediocre performance, not superior performance, leading to a situation where these plans become another form of ‘fixed pay’.
- LTI plans are often too complex, typically relying on forecast performance expectations across several industry sectors where risk appetites can be highly varied and also often reward executives in volatile markets for meeting hurdles which fail to deliver increased value to shareholders.
How can companies tailor plans to better fit remuneration’s purpose?
Fixing the first failure is simple: set executives goals they will not always achieve. This may require a changing of perceptions where executives understand they will not always earn a bonus, rather only in years where they have significantly improved performance.
As for the second issue, we note that the recorded purpose of LTIs and STIs often overlap, with the term of the LTI the only significant difference between the two. With more and more companies mandating a deferral of a proportion of the STI, the difference in outcome and alignment is reducing. We believe one solution is to embrace a single and more controlled plan while still achieving the motivation and retention goals – cancel the LTI and replace it with a STI where a significant proportion of the incentive is deferred into equity for a long period (say three to five years).
Under this scenario, the STI reward opportunity will need to be elevated, performance criteria will need to be rigorous and have a focus on both the annual business plan and milestones aligned to 3 and 5 year strategic planning horizons.
The scenario could have a number of advantages, including:
- The deferral would act in the same way as the LTI to focus the executive’s actions on sustainable, long term performance, but not represent a lottery to the executive, who will value it more than an uncertain future reward. The STI need not replace the total allocated value of the LTI as the plan is less complicated and the outcome will be known annually.
- The plan would align executive and shareholder interests as share rights are granted at their face value on each occasion an annual incentive is awarded to make up the percentage of the executive’s bonus that has been deferred. The executive would know the number of shares they have received at an early date, and know they must hold those shares for a period of time. If the share price falls, the executive would see the fall from the perspective of an owner of shares, rather than as the possible future beneficiary of an unknown number of shares.
- The Board can adjust the annual performance goals to factor in volatility, a much easier task than attempting to set goals three to five years in advance.
- Under the deferral model Boards will also be in a position to claw back lumpy performance outcomes which may be seen as having arisen through bringing revenue forward and deferring costs or similar initiatives which are to the detriment of shareholder interests.
- The use of discounting mechanisms to determine grant size, which we have always considered ill advised, would fall from use.
Where companies adopt variable and focused performance hurdles to ensure adjusted shareholder alignment each year and use equity instruments relevant to changing market conditions, they may rightly believe that the more traditional LTI can apply the best leverage to produce positive outcomes for shareholders while offering executives future reward opportunity to create sustainable accrued value. Plan design will need to be responsive to both the company’s circumstance and market dynamics, reflect long term shareholder value creation, offer an appropriate reward opportunity to participating management given the challenges and opportunities on the horizon, be readily explainable to shareholders and staff and minimally dilutive while acknowledging the market’s expectation of the company’s future prospects. Cash poor, high growth and start-up organisations will generally follow the traditional LTI plan.
Either way, shareholders will need to have confidence that the Board are devoting sufficient attention to the performance scheme and in particular are engaging effectively with independent external remuneration advisers in order to ensure rewards will only arise when relevant performance conditions have been met and significant awards will only eventuate when exceptional results are achieved. Under the annual plan, as the opportunity for payment will be substantially increased, the level of forensic attention will need to be proportionally adjusted. Equally, retention of the traditional LTI plan will require regular review of the appropriateness of the plan design including the nature of the equity offering, be it an option or a right, the allocation strategy having regard to accounting values and recent share price performance, the period of performance and the performance hurdles.