A lower long-term economic growth rate – the implication for executive incentives
30/11/2015
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The Australian Treasury’s long-term economic forecaster, Nigel Ray, has lowered the expected long-term economic growth rate from 3% to 2.75%. The revisions stem from lower immigration levels since the end the commodities boom, which in turn means that there is a smaller potential workforce to make existing and proposed capital stock productive (see his speech HERE). At the same event, the Reserve Bank governor, Glenn Stevens, said that shareholders should lower their expectations of ever rising dividends. The alternative is for shareholders to accept the need for companies to take on more risk to generate higher profits (see his speech HERE).

Right.

The world economic system is changing, taking Australia along with it. Despite impressions of economic uncertainty these past six years since the GFC, quantitative easing has smoothed out asset volatility, and inflated their values. Despite continuing QE in Japan and Europe, this crutch is beginning to be dismantled. The US increase in interest rates and less easy money means that there will be more volatility in currencies and stock markets, and equity growth will slow unless there are higher dividends from real business investment and risk-taking.

The second most common long-term incentive (LTI) hurdle, earnings per share growth, has progressively been harder to come by. Buying back stock, as a means to boost EPS growth will become a less viable strategy as the cost of funds rises. Mergers and acquisitions using stock may have a longer life, but it too will be less assured as a means to boost EPS and total shareholder return (TSR) growth. Cranky shareholders will demand more of company boards and executives. The musical chairs of CEOs being turned over in rapid succession, as we have been witnessing, will compel some to take more risk. After all, it is that or no incentive pay or, worse, no job. Over time, risk taking appetite will catch up to the economic reality.

This has implications for how executive pay is delivered. Investor guidelines will also need to catch up. For boards that have the intellect and will to see through the blinders of current governance codes and guidelines, there is a 1st mover advantage as they restructure pay to encourage more risk taking, assuming that they judge their CEO is up to the task.

One pay element that this has implications for is the payment vehicle. Performance rights have become the norm. They may lose or gain in value a little, but on the face of it, they are low risk. If an executive meets consensus forecasts, he/she gets a reward that has realisable value. But as demands for better returns, accompanied by more tolerance for risk taking, increase, boards may want to consider pay vehicles with more binary outcomes. That is, they are worth nothing or a lot.

This is a starting point for thinking afresh. It accords with calls by the federal government, entrepreneurs and venture fund managers for more risk tolerance, and acceptance of occasional failures on the path to wealth creation.

However, in reality, the solution will most likely be tempered, perhaps with a mix of payment vehicles, or a moderation of binary outcome requirements.

These payment vehicles require increases in share price to provide wealth. If share prices stay the same or decline, executives receive nothing (or at least a lot less). Payment vehicles include traditional share rights, share options, share appreciation rights (SARs) and market share units (MSUs). Guerdon Associates has pointed out that the new tax legislation makes share options and SARs very viable as a means to generate shareholder and executive wealth for a bit of additional risk (see HERE). MSUs are vehicles whereby the number of shares delivered is equal to the number of MSUs multiplied by the ratio of the end share price to the start share price. While Treasury did not take us up on our suggestion that start-ups would benefit from concessional tax treatment for MSUs (see HERE), they are still highly viable for regular listed companies. And while they have a bias to more risk taking, there is also the potential for reward if the right opportunity does not arise during the performance period.

While interest rates remain low, early adopters in resuscitating or adopting these pay vehicles can also deliver more potential leverage value in reward for a relatively modest accounting expense (see HERE).

There are also implications for performance measures, performance periods, and deferral periods that changing risk expectations may have on executive reward. These will be addressed in articles during 2016.

© Guerdon Associates 2021
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