2012 is fast drawing to a close. As we prepare to begin 2013, Egan Associates founder John Egan shares his predictions for the next twelve months.
Q: What will be the biggest remuneration issue for 2013?
John Egan: In our judgement, the annual incentive plan will receive the greatest attention over this period. There are a number of reasons shareholders will observe change. One, highly commented on by remuneration advisers, proxy advisers and major institutions, is the quality and comprehensiveness of explanation and transparency in companies’ remuneration reports when describing incentive plans. In addition to the concerns on disclosure, many shareholders also believe that too little emphasis is placed on financial parameters and far too much reward is predicated on vague and poorly articulated performance metrics, in many instances including a number of qualitative criteria requiring the exercise of a considerable level of discretion by the Board.
Q: How do you think annual incentive plans will change, given these concerns?
John Egan: In the period ahead, we anticipate the key annual incentive focus for Boards and KMPs to be whether gateways or modifiers should be introduced which will influence the potential annual incentive under a program. Gateways would normally be an approved budget, a financial hurdle or an improvement on the prior year outcome, be it net profit, EBIT or EBITDA. Another gateway may be the company’s safety or environmental performance.
These gateways could either determine whether any incentive is paid, or lead to a modification of the potential earnings if these performance hurdles are not met. For example, if the financial criterion is not met, the plan design might entail modification of the opportunity, whereby the balance of the incentive available at the target or maximum is reduced by 50%.
Post-GFC, many companies raised the quantum of annual incentive awards because long term incentive awards were unlikely to vest. This fact, combined with a desire to retain executives and enable clawback provisions (already required by law for financial institutions and proposed for other organisations) has seen many companies embrace annual deferral. We believe this trend will continue. The deferral is generally aligned to the company’s share value, though occasionally deferral is in the form of cash.
We also believe that organisations will provide more comprehensive information on the principal criteria being used to assess performance of the KMP team, the weighting of that criteria and the existence of any gateways or modifiers, with comment on how those gateways or modifiers have influenced payments in the year being reported upon.
Q: Do current long term incentive plans have similar flaws?
John Egan: Long-term incentive plans, while receiving less attention than annual incentive plans, remain a key unresolved and poorly qualified and disclosed area of executive reward. In our judgement, however, the key issues will not be addressed quickly.
One such issue relates to the inappropriate use of accounting valuations for the purpose of determining the number of rights or shares to be allocated to an executive under a long term incentive plan. For example, a company might state that it intends an executive’s maximum incentive opportunity to be a proportion of their fixed remuneration and that the long term incentive will vest depending on a shareholder return performance hurdle. To calculate the number of securities to grant the executive under the plan, most employers will use a valuation methodology, which explicitly leads to an allocation at a discount to the prevailing share price, instead of using the current volume weighted average price (VWAP) of the shares. This means that if the hurdle is met, executives receive an award of securities above the proportion of fixed remuneration intended, together with the share price appreciation.
In the five years leading up to the Global Financial Crisis, such grants led to long term incentive awards vesting to executives that were worth up to ten times the intended proportion of their fixed remuneration.
Q: Do you see a way to tackle this problem?
John Egan: Ideally, companies should use the VWAP when calculating the number of share equivalants to grant. If they decide not to do this, however, the Board should put provisions in place to ensure it retains discretion around the vesting of LTI awards so it can maintain the intent of the award.
For example, if a long term incentive award is set to vest and, given share price appreciation, will provide the executive with shares worth well in excess of a predefined proportion of their fixed remuneration, the Board should consider whether only part of the award should vest given:
- the proportion of fixed remuneration the Board had originally intended to award for stretch performance
- the executive’s skin in the game and commitment to the company as reflected by their current shareholding
- whether the share price appreciation represents a genuine return for long term shareholders
- the effort sunk into achieving the shareholder return and strategic actions to ensure such returns continue.
This is an area which we believe will be the focus of further debate over the next three years where shareholders and management endeavour to motivate talent to outperform, but not create precedent or expectations which are misaligned to their worth and/or contribution.
Q: Are there other ways long term incentives have been arousing shareholder ire?
John Egan: In the current volatile market, a number of major investors are questioning the use of a relative total shareholder return metric where executives have been issued with share rights or restricted shares. These shares have vested because executives have out-performed the market in relative terms, but they have also provided poor returns for shareholders in absolute terms.
The reward for these executives has been all the greater because in the wake of the GFC, a number of companies elevated their annual incentive awards to compensate for their belief that grants made in the period 2006 to 2009 would not deliver benefits, because the performance hurdles could not conceivably be met.
We have increasingly seen additional internal measures added to plans using relative total shareholder return as a long term incentive performance metric and believe that the issue will continue to be considered in the year to come.
On another issue, we note that shareholders have strong objections to fully paid shares being issued under long term incentive plans. Unlike providing fully paid shares for annual incentive plans, where the executive has already earned the share, providing fully paid shares for long term incentive plans means holding a number of shares in anticipation that they vest to the executives in three years time subject to outperforming the market. These shares then attract extra remuneration as dividends prior to meeting the shareholder approved performance hurdle. Such arrangements are being phased out. We also note that plans attempting to minimise executive tax such as loan back plans are also now uncommon, but still exist.
Q: Long term incentive plans are thought to be incredibly complex. Will transparency of these plans improve too?
John Egan: Legislation has been proposed to require listed companies to disclose the realised value of executive pay, which will go some way toward dispelling the confusion caused by the current communication around the value of long term incentive plan participation, which involves the incentive’s value being amortised over the life of the security and being represented as an accounting value. While this reflects a true cost to the company, it does not reflect the potential benefit to the executive.
Q: In the government’s Mid Year Economic and Fiscal Outlook (MYEFO), it estimated that the wage index would grow 3.5% through this financial year and the next. Do you think executives will see fixed remuneration increases in line with this?
John Egan: Recent economic data is unlikely to lead to significant increases in in fixed pay in the near term. Analysts’ current outlook indicates continuing pressure on profits and a likely flat bourse through to 2014.
The underlying expectation is that executive fixed remuneration will not be above 3.5% and in many instances below that amount, although given the annual review process is subject to the competitive nature of reward, there will be a high degree of variability in practice.
Q: Many companies have introduced fixed remuneration freezes for the 2013 financial year to address shareholder concerns. Do you believe this will continue?
John Egan: We anticipate the second half of the 2013 financial year will see an increasing number of organisations choosing to freeze fixed remuneration for the coming 12 month period.
The decision to freeze fixed remuneration is influenced by many things. In some cases the Board and their leadership team may accept that in competitive terms they are well positioned and a pay freeze will not disturb that setting; in others there will be a re-alignment of reward with greater opportunity for earnings becoming at risk, aligned to the achievement of performance outcomes. The uplift in reward will be available under either the annual incentive plan or the long term incentive plan.
Q: Are there other trends you think we will see?
John Egan: Radical shifts in remuneration quantum or structure may arise at the time long serving KMPs including CEOs are replaced; incoming CEOs will either be paid fixed remuneration at a reasonable discount to the long serving incumbent or at a premium arising from the needs of the organisation at the time of appointment.
An illustration of a radical adjustment in the structure of remuneration would be that taken to shareholders in respect of the long serving CEO of Seek where the Chief Executive’s fixed remuneration was doubled and the annual incentive program withdrawn. The focus on reward was one of guaranteeing a long serving and successful CEO competitive fixed remuneration and placing upside solely on continuing growth in share value.