Are Boards ensuring that incentives, be they annual Incentives or long-term Incentives, only deliver benefits when performance reflects demanding, albeit realistic, expectations and above market norms?
Recent press commentary and observations by Proxy Advisors and major institutions are increasingly focused on payments under annual incentive plans where performance is below analysts’ expectations or below the prior year, and where the market’s understanding of potential awards under a long-term Incentive reflects an outcome proportional to relative performance.
These dilemmas and comments are also influenced by volatile markets. In recent months, and in many cases in the period between the conclusion of the financial year and the AGM, there has been a decline in share prices and prospects remain uncertain.
In recent weeks, observations which will potentially impact executive reward have been made in relation to the prospect of minimal earnings per share growth and in relation to volatile and declining share market performance. the latter created almost entirely as a result of significant declines in two S&P/ASX sub-indices, notably materials incorporating resources and energy incorporating the oil and gas sector.
These circumstances create a considerable dilemma for Boards in both awarding participation in equity based long-term incentive plans at share prices up to 30% below 2014 levels which lead to a larger proportion of equity being allocated to management and in approving the vesting of securities in the current setting where the company may have out-performed others but the price of securities is significantly below that at the time of the grant. That is, shareholders’ wealth has declined though management can be rewarded for their relative outperformance as opposed to absolute performance improvement.
These are issues in the current volatile global economy with which Boards need to wrestle and management need to accept that their rewards should be aligned to the absolute return to shareholders as well as relative return.
An interesting dilemma in this context and one which has arisen in the past is whether Boards determine that management should be rewarded despite shareholders not realising share price growth during a three or four year LTI performance period despite relative performance of the company having been sound. In parallel with such a judgement might well be the containment of “upside” which is beyond management’s control where commodity prices or global demand in a particular sector far outstrip any general index in an economy and share prices double or treble arising from such global events, not management’s efficiency or effectiveness.
In this latter context, if the intent of an award is to deliver to the executive half his/her fixed remuneration or one times their fixed remuneration, should their rights to outperformance be capped at twice the expectation rather than five or six times, the latter scenario occurring during the pre-GFC boom period.
Boards need to consider their executive reward policy strategy in managing these challenging outcomes, which are beyond the influence of the executives, and where the executives may potentially be penalised in one context and substantially over-rewarded in another. Equally, recent comments emanating from major investors indicate that management currently seem to be rewarded as if they are entrepreneurs with their personal capital totally exposed rather than with leverage provided by investors where exposure of their personal assets is minimal or non-existent.
Reward opportunity for the most senior Executives in a leading ASX company, while subject to input from the Executives, should be independently determined by the Board.
The participants in this challenging environment are increasingly diverse. The Board and/or management will generally call upon external advisors, the experience of whom reflects the changing landscape, the complexity of reporting and the formulation of appropriate performance conditions.
While our observations reveal that more than one in five KMPs are not recipients of an annual incentive, an even greater proportion of equity based long-term Incentives are not vesting as performance hurdles are not met. Interpretation of the competitive landscape and reward opportunities available, which will often be the subject of enterprise scale and industry sector, are leading to internal debate around performance expectations and competitive influences. In many respects, this is also increasing dialogue between the CEO and the Board.
Boards have a prime accountability to ensure that management are rewarded for their accomplishments and must temper those observations in the context of the company’s performance, its challenges and the degree to which management can influence or mitigate those challenges while increasing shareholder returns.
In the last two or three years, many companies have also adopted, by traditional standards, a highly conservative approach in adjusting fixed remuneration. These adjustments indicatively vary from no adjustment to up to 3%. Where the 3% adjustment is critical for the majority of staff on annual remuneration below the maximum tax bracket threshold of $180,000, those on $300,000 or in excess of $1,000,000 generally experience a significant differential between themselves and employees they manage. With the benefit of incentives, these Executives are likely to be able to meet cost of living increases which are progressively contained below 3% per annum.
In the current economic setting Boards are increasingly forming the view, particularly where remuneration levels have increased significantly over the last five or more years, that fixed pay is not the area in which Senior Executives’ total reward will differentiate the “A Team” from those who do not “make the grade”. In this context, we believe that advisers also play a role and have a responsibility as independent professionals to recognise a changing landscape in the Executive marketplace where fixed remuneration is generally well catered for.
Notwithstanding these challenges, a new dilemma for the Board and fundamental in discussion with the leadership team is the manner in which a minority of organisations is now communicating and managing the award of securities under Long Term Incentive Plans.
Many organisations, on advice and often without full disclosure to shareholders, are valuing share rights at a substantial discount in the context of a highly volatile market. This means that far larger numbers of securities can be awarded, offsetting the risk of a declining rate of growth in share values and increasing the probability of meeting performance conditions.
Commonly, rights are subject to ordinary performance: i.e. achieving a market median which is generally below average performance and certainly below the average shareholder’s view of the level of performance which justifies additional reward.
These strategies are often recommended by those who are motivated to “please” management. What is endorsed may be possible from a legal perspective although not necessarily appropriate. In some industry sectors, Boards which have taken the high moral ground are finding themselves under pressure where counterpart Boards have accepted and implemented advice of this nature.
While the structure of performance hurdles has not varied significantly over the last decade, there has clearly been a shift among the ASX 300 toward a share right, which involves the delivery of a fully paid share rather than the option, the value of which is entirely dependent on share price growth.
An aspect of valuation methodologies which will provide the right to future shares at a discount to the prevailing share price incorporates consideration of dividends and the risk of failure. Individuals who are not shareholders do not have a right to dividends. In our judgement, Management who have a future right to shares, subject to their performance, should not be recipients of the dividend offset as their right to the share is subject to service of three, four or more years and the achievement of performance hurdles over a three or four year period, desirably beyond the average accomplishments of peer companies.
A key question for Boards, Executives and their advisers relates to the appropriateness of established universal reward paradigms in the current environment. On the one hand, new leadership at the national level is aspiring to create an economic climate which will support higher wages for all participants in the workforce. Can such a philosophical position co-exist where the pay relativities across strata of the organisation are reduced and at-risk reward as a construct is retained, while transparently disclosed, in proportions which are reflective of shareholder returns commensurate with the level of risk accepted? In the case of the shareholder, the financial risk associated with their investment is an appropriate return on their personal capital.
Australian Boards with a growing international footprint have, in recent years, also addressed a traditional dilemma of matching global reward strategies in the context of exchange rate volatility. In particular, the Australian dollar has varied from 110% in value to the US dollar to its current level of 70%.
In this context, what are shareholders’ and Executives’ appetites to embrace a US reward strategy for the top 5% of their workforce? Fixed remuneration levels could be halved, annual incentives uplifted by 50% on current levels and equity based incentives could be doubled. In comparison, the European model has traditionally adopted fixed remuneration levels not broadly dissimilar to those embraced in Australia, as well as defined retirement benefits, comparable annual incentives and broadly comparable participation in equity based incentives.
Questions worthy of discussion might include:
- Is the top 5% of Australia’s talent a global pool willing to live abroad to optimise return for their personal capital? Or are they satisfied with building a career with Australian practices as their base while accepting accountability to manage workforces across jurisdictions and geographies?
- Is the challenge faced by Boards and their advisers one of embracing a global, local, or moral viewpoint and to what extent should a Board’s independent adviser participate in assisting a Board develop its viewing point?
- To what extent should an adviser be independent of other advisory opportunities beyond the legal, accounting, taxation and strategic issues which impact the remuneration decision?