CEO Power and Pay

CEO pay following the Royal Commission

The lack of profit improvement or indeed a significant decline in profitability between the 2018 and 2019 financial years substantially arising from the Hayne Royal Commission has had a dramatic impact on KMP incentives among the nation’s leading financial services companies.  One leading bank, in addition to paying no KMP bonuses in the current year, has also clawed back deferred bonuses which will now not crystallise and be paid.

These initiatives may have in part been perceived as a strategy to avoid a second strike against the company’s annual remuneration report.  Equally, they may reflect a board decision to hold senior executives to account for sub-optimal performance and inappropriately structured incentive plans for less senior staff where rewards reflected initiatives in a number of instances detrimental to the organisation’s customers.

In 2019, the Commonwealth Bank CEO received a cash bonus at 45% of his maximum opportunity following zero payments in the 2018 financial year.  Group executives’ annual incentives in the 2019 financial year varied from 31% to 52% of their maximum entitlement.

At ANZ, the CEO received an annual incentive at 48% of the maximum opportunity and no increase in fixed remuneration.  For KMPs, the average annual incentive was 45% of the maximum opportunity.

At Westpac, the CEO received no annual bonus for the 2019 financial year, though did receive the benefit of deferred incentives from prior years.  His 2020 total target remuneration was also reduced by 23%, with the board acknowledging that the Managing Director’s total target remuneration has not increased since his appointment in 2015.  For the 2020 year, total target remuneration for group executives was reduced by 12.5%.  Within that group, there were degrees of variance in respect of the treatment of individuals, with their positions being matched to market.

Research on CEO power and pay

A recent research study published in the Journal of Business, Finance & Accounting by Rebecca Bachmann and others from the University of Technology have highlighted several issues, not the least of which may provide a foundation for a refinement of APRA’s split of KPIs 50/50 between financial and non-financial criteria.  The study highlights issues linking bonus payments to CEO power and non-quantitative measures having reviewed a number of ASX 500 annual report remuneration disclosures over the period 2004 to 2016.

It tests a number of hypotheses, including:

  • a positive association between the ratio of annual cash bonuses to CEO power;
  • a positive association between CEO power and the proportion of non-financial targets used in cash bonus contracts;
  • a negative association between the proportion of non-financial targets used in cash bonus contracts and subsequent firm performance;
  • a negative association between non-financial targets that are qualitative or undefined and subsequent firm performance; and
  • a positive association between non-financial targets that are quantitative and subsequent firm performance and between non-financial targets which focus on corporate social responsibility (CSR) and subsequent firm performance.

The article examines performance having regard to a number of universally accepted financial metrics.  The CEO Power Index in the context of their research is represented by the sum of the individual components divided by the number of components available for assessment.  Measures of CEO power have regard to CEO tenure, the level of their shareholding, the board size and independence, the relative competitiveness of the CEO remuneration arrangements, the CEO’s engagement as a member of board committees and, in particular, their engagement on nomination and remuneration committees, and the proportion of co-opted members on the board’s remuneration committee.

Their research supported the hypothesis that there was a positive association between CEO power and the bonus ratio.  They found that the engagement of consultants is inversely associated with the bonus ratio for cash but positively associated with the bonus ratio for equity awards.  Their research also suggested that powerful CEOs are able to negotiate a greater proportion of their cash bonus toward non-financial performance target and would prefer to manipulate equity incentives that have greater payouts than cash bonus incentives.

In relation to non-financial targets, these were divided into qualitative, undefined, quantitative and CSR.  The research found no association between the ratio of non-financial performance targets and company performance in general and therefore rejected the third and fourth hypotheses.  However they identified that when organisations disclosed that they used non-financial targets, though did not define or describe what those targets were there was a negative and significant relationship with subsequent firm performance across all the samples explored.

There was partial support for the fifth hypothesis, particularly when non-financial targets were quantitative in nature.  There was a positive and significant relationship across all samples supporting the fifth hypothesis.  Finally, when non-financial targets related to Corporate Social Responsibility, they also observed a positive and significant relationship to subsequent corporate performance.

They found no significant difference in the economic characteristics of organisations where CEOs had high power or low power.

Implications of this research

The research revealed that external auditors play an important role on behalf of shareholders in relation to disclosures and corporate governance believing that their engagement mitigates the ability of CEOs to establish power within the organisation.  In that context, they found the Big 4 negatively associated with CEO power and contributed to 30% of the explanatory power though were not associated with the bonus ratio or non-financial ratios.  In this context more generally, their observation was that auditors demonstrating independence and integrity had a positive influence.

Their research suggested that powerful CEO’s achieved higher bonus payouts through the use of discretionary non-financial targets.  Specifically they observe that CEOs who are rewarded through a majority of non-financial targets achieve a greater proportion of their bonus opportunity compared to CEOs with a majority of financial targets.  Indicatively, they observe that CEOs on average achieve 10% more of their bonus if non-financial targets are undefined.  Notwithstanding, their research also revealed that non-financial performance targets do not necessarily impact on an organisation’s performance negatively.  However, qualitative and undefined non-financial performance targets appear to be less effective in incentivising CEOs and rewarding shareholders.

This research would clearly support the requirement for organisations to clearly define non-financial performance criteria used to determine annual incentive payments to CEOs and KMPs and desirably to reveal the link between the achievement of those performance targets to the quality and sustainability of an organisation’s returns, as well as its broader contribution to the communities with which it is engaged.

This research in our judgment, will sponsor further work and comment extending literature and examining the relationship between the research outcomes and initiatives being taken by regulators, evidence presented at the Hayne Royal Commission and other Government sponsored enquiries into the integrity of corporate governance in its widest context.