The credit tsunami engulfing the world has precipitated, and will continue to precipitate, long-lasting changes across our global economy. While executive remuneration regulation, governance and practice has been subject to change since the beginning of the new millennium, the massive impacts of the financial meltdown will not only accelerate this change, but also introduce new elements not previously contemplated.

This article dusts off our crystal ball and predicts what these will be, how they will happen and the market’s likely response.

Regulation

There will be regulatory change. This was flagged in most OECD countries before the credit crisis, and usually featured as part of each prospective government’s new election platform. Australia took part in this global trend, despite already having an arguably superior regulatory system in place. That is, more rigorously than most other OECD countries, Australia required:

• Full disclosure and consistent valuation of the top 5 /key management personnel remuneration, including superannuation and pension benefits, fringe benefits, equity plan value and termination payments over the prior 2 years;
• A description of the remuneration policy and a discussion of the relationship between that policy and company performance;
• Disclosure of performance measures (including any peer companies used for comparative performance assessments), performance requirements, and the extent that these were achieved;
• If any discretion in performance payments was practiced or allowable;
• Contractual terms;
• A non-binding shareholder vote on the reporting of these items; and
• Shareholder approval of large termination payments to directors.

In addition, as with many OECD countries, Australia required that any dilutionary equity grant to directors be subject to shareholder approval. Contrasting Australian practice with the more advanced OECD countries, UK reporting, while in place longer, is not as comprehensive, and US and Canadian reporting, which came later, do not have the shareholder vote requirement.

The regulatory change that was flagged before the crisis typically involved additional or amended disclosures to probably include:

• Indicating that performance-based executive remuneration arrangements are “genuinely” linked to performance;
• Naming remuneration consultants and clarifying the extent of their independence from management;
• Directors being made accountable to shareholders for the level of remuneration received by directors and senior management, at least via the non-binding vote concept;
• Ensuring remuneration disclosures of directors and senior management are comprehensive and comprehensible (hopefully by simplifying requirements to what is useful);
• Enhancement of the disclosure of options, termination payments and equity value protection schemes.

In addition, we expect there is a reasonable likelihood that there will be further regulation in regard to:

• Requiring shareholder approval of all executive director equity grants and possibly termination payments
• Banning non-recourse loans to directors and senior management.

Senator Nick Sherry will provide more detail on likely Australian developments at our Remuneration Forum to be held in Sydney on 16 March (see later in this newsletter for further details).

The economic meltdown since these changes were mooted has prompted additional calls from the government and regulatory agencies to link banks’ executive pay to capital requirements and explicitly better risk management. That is, higher Tier 1 capital may be required if banks cannot demonstrate that:

• Incentives are oriented to long-term and sustainable profit growth
• Performance measures take account of profit and the cost of capital (i.e. using economic profit or similar measures)
• A significant amount of incentive payments is deferred, and subject to clawback if results are not sustainable
• The vehicle of payment is in a form of equity that is aligned with shareholders’ long term interests
• Multiple, and perhaps non-financial, measures related to sustainability, culture, ethics etc are taken into account
• Fixed pay is sufficient to ensure that there will not be total or over reliance on incentive pay

It is possible that there could be additional and even more prescriptive mechanisms requiring banks to assess performance that is risk adjusted, or indexed based on the banks’ extent of Tier 1 capital.

APRA’s John Trowbridge will be available to respond to questions on the process for this in relation to financial institutions to directors and institutional investors at our Remuneration Forum on 16 March.

The regulation of banker pay will have a cascading effect on the practices of all listed companies, as governance groups and proxy firms seek to incorporate similar concepts of risk, sustainability and clawback in their general guidelines.

Pay freezes

Many boards we are working with are considering pay freezes, with several already having made decisions on this. While there will always be exceptions, executives and directors should not count on pay or board NED fee increases this year. While this has not yet been observed, as with the last recession, we expect that some companies will request executives take a pay cut.

Bonuses

Bonuses will still be paid, but only to those that can respond to the new emphasis implied by the new measures noted above. The amounts paid should generally be down, on average, across the market.

Bonus deferral

Almost certainly, bonus deferral will be explicit or inferred in the new APRA regulations for Australian banks, and is already a feature in UK Financial Services Authority (FSA) thinking.

A good example of how bonus deferral could be applied is in the UBS description of their new plan (see HERE) and reported on in our last issue (see HERE).

Basically this requires the bonus earned on this year’s performance to be deferred (in whole or part), to see if performance is maintained next year. If not, the bonus is adjusted downwards.

Of all the many prescriptions coming forth from banker pay regulation, this has the most potential to spread to other sectors. And it probably will.

In some ways bonus deferral plans that function like this confuse the divide between STI and LTI. Some companies will take this “hybrid” solution to do away with ineffective and difficult LTIs. But the issues are complex, so deferred bonus as a “solution” may create more problems later. To use deferred bonus as a replacement for a defective LTI may not be as effective as replacing a defective LTI with an effective LTI. Not that these will stop adoption of this method outside the banking sector.

Performance measures – a lot of change quickly

In the past two years we have observed that many companies have added a second, separate LTI performance measure to the traditional relative TSR measure. More companies are also amending their relative TSR peer group to only include companies that are competitors, rather than those that comprise an index.

Change in performance measures will be accelerated during the next two years.

If the government is true to its election platform word, then expect to see more vigorous efforts to have companies comply and disclose performance requirements more adequately, especially for STI plans. Now, many just fail to disclose, or claim commercial confidentiality as a rationale for non-disclosure.

Performance measures and risk management

But of a more material nature will be the increased acknowledgment of risk.

The Chairman of the Institute of International Finance, for example, quite elegantly suggested that:

“compensation incentives should be based on performance and be aligned with shareholder interests and long-term, firm-wide profitability, taking into account overall risk and the cost of capital” (see HERE).

That sentence is worth repeating to every member of every board of every listed company is Australia. In a nutshell it summarises what we have suggested to our readers and clients since the establishment of Guerdon Associates.

The first to launch into balancing risk and reward in a significant way will be the banking industry, partly in response to forthcoming APRA regulation, and partly to reassure investors that their money is “as safe as a bank”, but more so!

But this trend will not be limited to banks. Other first movers will include companies needing to recapitalise (and there are quite a few of these). The second and third waves will be those stung with the additional costs of capital, as they seek to re-base reward on a risk-adjusted basis. The measures used will start to look very different from our recent past. More will be interested in variations of economic profit and EVA™.

For companies where these methods will be too complex (and this will be most companies), there will be greater use of simpler cash flow measures discounted by risk.

Performance measures – some short term coping for survival

And while larger companies will be looking to incorporate risk into their incentive reward measures, many more companies will be seeking practical measures to just survive. With the cost of money increasing with its scarcity and reassessments of risk, boards will require management to improve on management of working capital. Capital efficiency will, to some degree, supplant earnings growth as a key driver during these lean times. So look out for more use of ROIC, ROWC, and ROFE in incentive plans.

The same focus will also be applied to maintaining margins. Revenues may be declining due to exogenous factors. But investors will look more kindly on companies that can suffer this with the good grace of intact margins!

Performance measures – the “luxury” of non-financials

All too rarely does one find a true alignment between a company’s present and prospective performance and the compensation received by its top executives. Witness the high proportion of ‘NO’ votes last AGM season as everyone became confused and forgot that remuneration reports detail last year’s pay for last year’s performance when this year’s performance would not earn a zac.

Just as hard to find are remuneration practices that provide incentives to management to act in a company’s long-term interests.

Most current remuneration practices are partly based on a false premise: they are focused principally on rewarding past performance rather than shaping future performance. And, as any investor will tell you, past performance is not necessarily a guide for the future. By focusing reward on the past, a crucial element of performance is being ignored — just how well placed is the organisation to deliver sustainable returns?

To make sure that greater emphasis is placed on investment for the future and to act as a counterweight to short-termism and to pressures from the reporting treadmill, a proportion of senior executives’ annual bonus should be based on criteria linked to the ability of the organisation to deliver sustainable performance in the future.

Fantasy? No. Many authorities (such as the UK’s FSA – see HERE) want companies to reward non-financials that are indicative of future health.

Many companies are already doing this for their short term incentives (STIs). The criteria used would tie individual executive bonuses to the company’s strategy execution through a combination of non-financial measures (e.g., progress on innovation or market share, both compared to plan) and judgments (e.g., diversification strategy or progress on talent management).

This approach has the merit of combining rewards for past performance with forward-looking measures. It would deliver fewer perverse incentives than present short-term, numerical assessments linking remuneration to stock market performance. It would be flexible, in allowing remuneration committees to set annual milestones and gather evidence to frame their judgments. It would also deliver the huge benefit of encouraging boards of directors and their remuneration committees to be more explicit and informative about their strategies and how they expect management to execute the strategy.

Shareholders may be nervous about replacing hard, numerical criteria with subjective, unquantifiable principles. But the opposite of financial is non-financial, not woolly.

Companies considering this approach are thinking beyond the economic downturn.

More pay in equity

The call for more executive bonus pay to be delivered in equity, as well as deferred, will accelerate a trend that has been evident for at least four years. Earlier Guerdon Associates research indicated that CEOs who owned more equity have better performing companies (see HERE).

Governance

To focus entirely on bonuses would be to miss the much bigger lesson many boards and investors are currently learning — that shareholders and boards need to be better at scrutinising the risks their staff take. So part of the answer lies in better corporate governance, not regulation. No amount of box-ticking can replace prudence, common sense and intelligence.

Unfortunately, it is likely we will get the box ticking too. Hopefully this does not compound problems by diverting boards from governance.

Non executive director pay

Among the larger companies, the almost universal belief is that now is not the time to receive a fee increase, despite the increased workload that these economic times bring.

However, there are many boards where planned director transition needs to take place, with new directors joining boards where their service is overlapping with retiring directors. In many of these cases companies will still need to ask shareholders for an increase in the fee pool, irrespective of the state of the economy or health of the company.

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