The Dilemma with Incentive Structures

An important role for the Board Remuneration Committee is to establish clarity with executives and shareholders around the primary levers that would support additional remuneration for key achievements during a Financial Year.

What has emerged in recent years are concerns expressed by shareholders around the level of annual incentive payments, the performance criteria supporting incentives, whether incentives should be paid for meeting the basic job requirements including achieving the annual budget or plan, and whether incentives should only arise from year-on-year relative improvement in alignment with the relevant market sectors.

Further core issues which have contributed to less than positive feedback from shareholders include paying incentives for what they believe represent the core accountabilities of an organisation’s leadership team.  Reflective of these issues would be the payment of incentives for meeting an organisation’s safety policy, the payment of incentives for achieving improvement in employee engagement, the payment of incentives for maintaining a positive engagement with customers and/or improving unsatisfactory engagement or an unsatisfactory safety policy and, consequently, high insurance premiums.

Shareholders have also increasingly commented on incentives being paid for year-on-year improvement which has been driven by the market and while a company has improved its revenue and its profitability, it has not increased its market share and has performed below the median in relation to profit improvement or revenue growth in a sector.

In this latter context, shareholders have also commented on the Board’s use of discretion in paying incentives to a leadership team for an annual performance which was below the prior year, the plan and the budget, though when compared to peers reflected effective stewardship of the organisation, that is, relative performance in relation to revenue, profit or other measures which protect dividends and share price, management have outperformed peers.

This issue has arisen increasingly in relation to equity-based long-term incentives where performance or share rights have replaced options and while management has outperformed the market, the company’s share price is below the market price at the time share rights or performance rights were issued to management.  That is, the company’s relative as distinct from absolute performance has been sound though shareholders’ welfare has not improved.

Many organisations have also over the past decade introduced a balanced scorecard as distinct from a series of, say, three to six key performance objectives.  In a number of balanced scorecards, equal weighting has been applied to financial metrics, leadership metrics, the implementation of strategy, employee engagement and a measure of customer satisfaction, with other factors being strongly aligned to industry/sector influences.  In this context, workplace safety and the environment have featured prominently in a number of resources and industrial companies.

Notwithstanding these observations which challenge the forensic engagement of Remuneration Committees as distinct from management delivering a program for endorsement, Boards will often use the annual incentive, and occasionally the long-term incentive, to ensure that management focus on areas where performance is sub-optimal.  This will often include managing the relationship with the customer more effectively, placing near-term emphasis on the management of workplace safety and the environment or focusing on critical transformation initiatives.

Egan Associates believe this core area of reward variability necessitates, in many instances, more engagement and discussion at Board level than many companies have applied.  Our feedback from Boards and observing comments by proxy advisers and shareholders reveal that many organisations are paying significant incentives to well-paid executives for doing their job, rather than enhancing the company’s value and increasing returns to shareholders.

The increasing emphasis of our client work in an era of modest adjustments to fixed remuneration has been on both annual and long term incentive programs.  This is reflective of the increasing involvement of Non-Executive Directors in more closely managing at risk variable reward and ensuring it is aligned to year-on-year improvement in the company’s performance and shareholder returns, while having a parallel focus on sustainability.

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