Increase the Weight of Non-Financial Measures to Regain Trust

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The recommendations of the recently released Retail Banking Remuneration Review directly oppose the stance of many investors, who have become focused on basing executive bonuses predominantly on financial measures.

Non-financial measures needed to built trust

In the last AGM season there was criticism of companies whose bonuses were considered too heavily based on “soft” or “flaky” non-financial performance criteria. The investors behind this criticism might need to reconsider their stance after reading the review by former Australian Public Service Commissioner Steven Sedgwick. Sedgwick was appointed by the Australian Bankers’ Association.

While he found that there was “not sufficient evidence of significant systemic risks of poor outcomes for customers to support an outright ban on all product based payments in retail banking”, Sedgwick did recommend that the impact of financial incentives on the remuneration of staff be reduced, because “incentives have at least appeared to drive behaviour that was not in the best interests of customers and, on occasion, scandalously so”.

The main focus and scope of the review are frontline staff in banks (Sales staff, tellers and their supervisors and near managers) as well as third parties (including Brokers, Aggregators, Franchisees, Introducers and Referrers). Two key recommendations were that:

  • Incentives no be longer paid to any retail staff based directly or solely on sales performance
  • Instead, eligibility to receive any personal incentive payments should be based on an assessment of that individual’s contribution across a range of measures, of which sales (if included at all) will not be the dominant component.

Sedgwick specifies further that any financial measures included in an overall assessment should:

  • Be product neutral
  • In the case of a scorecard, together attract a maximum effective weight of 50% as quickly as systems and other changes can be introduced, falling to 33% or less by 2020.

(Emphasis has been added by Egan Associates.)

While Boards might think the scope of the report means it has little relevance to executive pay, Sedgwick is adamant that for his reforms to be successful, they would need to apply to senior staff as well.

“In a hierarchical organisation like a large bank the extent of consistency and alignment of the performance assessment criteria in play at each layer of the organisation is important to achieving a consistent cultural orientation,” he states. “Some principles should be common across all layers of the organisation, namely: assessments of individuals [should] be based on overall performance against a number of measures; and sales or financial measures more generally should not dominate customer-focused criteria in that assessment.

Sedgwick expressed the view that the level of customer trust in banks has become so bad that banks don’t have time to wait for regulations on this matter. They have to act now.

Yet if banks try to reduce the impact of financial criteria to 33% of executive bonuses, many investors voting on remuneration reports will be disgruntled as they hold the view that non-financial criteria should determine less than 50% of management incentives.

Sedgwick also spoke out against financial gateways, noting that they increased risk because they sent a signal that financials were more important than anything else. This is, of course, why investors like them. No incentives are paid unless the company performs — hence the name pay for performance.

So who is right? And what does Sedgwick’s report mean for companies in industries other than banking?

Both sides are right, to a certain extent.

Sedgwick’s report is not the only one raising questions about current incentives. Investors bemoan executive short-termism where substantial cash payments are made for a single year’s results, only to have a company’s market value plunge as prior decisions come home to roost. This indicates that investors’ focus on financial outcomes might need refinement.

Yet, due to the way non-financial incentives are often designed and disclosed, in many situations it appears to investors that executives receive a free kick — the non-financial incentives always vest, no matter what. Sedgwick touches on this in his report, noting that unless non-financial measures can reliably differentiate between the performance of teams or individuals, they cease to matter, with financial measures becoming the only factor of differentiation. Sedgwick stated that the use of discretion could be a powerful tool in this regard as long as it is applied consistently and with integrity.

Egan Associates is of the view that KPIs which have a clear focus on the sustainability of an organisation are of increasing importance. The key is explaining how non-financial incentives and discretion work and ensuring that they truly do lead to differentiated remuneration outcomes.

The banking industry has shown how an industry can lose the trust of their customers. They may be able to regain it, with Sedgwick’s help. Other industries would be better to avoid the situation to start with.

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