This article dusts off our crystal ball and presents our outlook for director and executive pay, and also for board effectiveness, for calendar 2016.

Economically, it appears that Australia is well on the way in the transition from emphasising commodities investment and exports to its other strengths in services. A lower exchange rate and favourable trade deals, maintain its relative attractiveness as a destination for foreign capital investment, which will only be boosted if company tax rates are reduced as expected.

The government has already acted on equity plan taxation so that companies have more scope to apply non-cash compensation to attract and retain valuable employees. And despite more market volatility, equity compensation is still cheap provided interest rates remain at historic lows. There is broader discussion of “risk tolerance and incentives”, which is a welcome development given 7 years of focussing on “risk minimisation and incentives”. We may eventually see a progression of the discussion to “returns, risk and incentives” in coming years.

These new sentiments in regard to risk have been accompanied by greater equity volatility as the smoothing effects of global quantitative easing are reduced in line with US interest rate adjustments. But, as Australia’s latest Prime Minister puts it, volatility is “our friend”. If not exactly, “our” friend, it will be a friend to some, as more investment and acquisition opportunities arise for both local and offshore investors agile enough to seize them.

As the trough of economic transition is passing, board remuneration committees need to be aware of the new issues and opportunities likely to arise. In this regard, 2016 may see changes arising from economic fundamentals and their implications for competition, legislative change, and government focus.

Permit agility within LTI performance measures

The maturing of the market to the application of relative TSR measures is welcome, and should continue in 2016. That is, there is an acceptance among investors that relative TSR is good for some companies’ long-term incentive plans, and not for others. 2016 should see more boards considering whether, or if, the form of relative TSR incentive remains an appropriate incentive, and compare it to alternatives.

For some companies, the LTI standby performance measures of EPS growth and capital efficiency (such as ROCE) may be unsuited to an era of growth, volatility and opportunity. Agile and acquisitive companies do not time their acquisitions or mergers to neatly coincide with 3 or 4 year performance periods. The great majority will be capital dilutive at day 1 of the acquisition, and are likely to be in that state for 12 to 18 months on average.

Therefore, when setting performance benchmarks, or better still, the measures themselves, consider alternative methods that permit value-enhancing longer term mergers and that ensure acquisitions do not punish executives for doing the right thing. The option to permit a re-test is not well received by investors and proxy advisers. While their guidelines may themselves be due for a re-test regarding re-testing, this is not going to happen in 2016. Rather, the most viable approach in 2016 will be an amendment of the measure itself. For example, one activist investor who takes minority interests, a board seat, and membership of the remuneration committee, accepts EPS growth and capital efficiency measures, since the capital component is a board decision, not an executive one. So he favours matrices of revenue growth and sales margin as primary measures to indicate added value. But this alternative view is not representative, so remuneration committees need to carefully consider more sensible alternatives to EPS growth and capital efficiency if they see their company positioned as higher growth and agile.

For companies sticking with EPS growth and capital efficiency, 2016 will see many remuneration committees being more rigorous in defining the earnings component. In 2015 proxy advisers took a dim view of boards “changing the goal posts”, as they see it, by “arbitrarily” carving out certain expenses to boost earnings, and so deliver incentive payments to executives. In their defence, proxy advisers have been consistently signalling their disdain for this practice for some years. So, a lesson taken to heart by several ASX 300 boards in 2016 will be rigorous application of a robust earnings definition. After application, there is no sign yet that proxy advisers and investors are generally against boards amending vesting ex-post facto if a good rationale is provided. So the lesson is, do not fiddle the measures after they have been set, use good sense to assess the result, and apply discretion, if required to reduce or increase the vesting.

Change in control provisions

The cheaper A$, and hopefully lower company tax rate, will entice more foreign companies, sovereign wealth funds and other investors to these shores. But the lower exchange rate in itself will enhance the profits of local exporters. Sifting through the auctions that will take place needs management integrity, diligence and motivation. Many company directors have experience here already, and are likely to ensure management motivation with explicit, robust and fair change in control provisions as 2016 gathers pace.

Conserve cash with an equity splash

There are those companies on the other side of the agility spectrum, such in mining and energy, that are starved of cash, and still need employees to keep wheels turning until the next up-cycle. 2016 should see more use of broad based equity solutions for continued attraction and retention of employees while conserving cash. Equity in lieu of cash salary may not be so unattractive to employees wanting to retain jobs, or executives who have been through enough cycles to know that they will reap a return for several years. The government’s 2015 tax changes to equity will enhance these companies’ survival strategies.

Equity payments as a component of non-executive director feesarenow a more viable option than post-tax purchases, and can facilitate compliance with mandatory holding requirements.

2016 is also likely to see the broader and more frequent use of employee equity plans for the start-up companies that the tax changes were designed for.

Variation in performance targets among peers

It is evident that within industry groups there is greater disparity in opportunity. Investors are becoming more discerning, and are identifying winners. This should change the balance in remuneration committee considerations for setting performance targets. Over-reliance on the disclosed targets of peers may get some boards into trouble, as investors and proxy advisers tend to have a bias in assessing performance targets against consensus forecasts for each company. 2016 should see greater recognition of consensus forecasts in setting targets, rather than how easy the competitor CEO has it down the road.

Thoughtful engagement

The theme for several years since the “2 strikes” law has been one of engagement between boards and their investors. Directors have been quick learners, and almost half of the ASX 300 now routinely engages with investors and proxy advisers, especially on remuneration matters. However, as several found last year, “routine” was not entirely welcome. In 2015 many boards did not yet fully appreciate the pressure investors and proxy advisers experience during proxy season, especially if the proxy adviser or investor has suffered from significant staff turnover. As a result, some directors will take into account the extent that the individuals lodging the proxy has had their feet under the desk, and time and adjust the content of their engagement accordingly. If nothing has changed (executive pay levels, performance measures, pay vehicle, the proxy lodger, and the investors’ proxy guidelines), send a polite email. Otherwise, tailor the timing and engagement materials to help the proxy lodger through it all. 2016 will see more directors being more thoughtful in their engagement process.

IPO companies with a tech bias and greater use of equity

According to investment bankers, 2016 should continue to see more technology company IPOs, among others. While the number will likely be lower than in 2014 and 2015, the nature of the companies undertaking IPOs will probably see greater and broader application of equity grants to employees. This may impact the wider market, as established companies also compete for technology talent.

Also evident will be greater use of equity grants to technology NEDs, relative to other industries. However, it is not evident at this stage that NED equity remuneration will expand beyond the technology, biotechnology and exploration companies where it will be applied in 2016.

Board renewal and board fees

The debate regarding diversity is maturing at a rapid rate. For many it has moved beyond the need to attract qualified women directors. The emphasis now is on attracting people with, for example, knowledge of disruptive technology or international markets – the former are one, or even two generations younger than most current directors, while the latter may not be white, or protestant or permanently reside in Melbourne’s inner east or Sydney’s lower north shore.

It may be an indictment of prior management that there remains a supply problem with qualified women directors, but it remains to be seen whether there is a supply problem for potential directors with technology or international experience. And while the lower A$ reduces the attractiveness of director fees for potential recruits residing in Hong Kong or Singapore, Australian director fee levels still comfortably exceed those being paid in the rest of Asia. The fees are, however, woefully low for attracting directors in North America.

There is evidence that established company boards are more “adventurous” with board renewal. In these cases, boards will utilise external facilitation of their next board review.

Pressures on the supply of the new directors needed for IPO companies, private technology companies and superannuation funds are likely to be offset to some extent by mergers and acquisitions among both companies and superannuation funds.

Overall total board fees remain historically low relative to CEO remuneration. Base board fees will overall remain relatively flat, at about 3%. However, it is likely there will be more variability among boards in the rate of fee increases than in the past. The boards with higher fees will be better positioned for board renewal from a pipeline of younger and otherwise more diverse generation not ready to consider retirement, and more willing to take on multiple NED roles if the fees are enough to cover their high earning capacity.

So while NED fee increases may average 3%, there will be a range of increases from zero to 10%, with the occasional equity grant as well.

Diversity and pay

The 2015 trend to make up the deficit in pay based on gender will continue. Longer term this will increase the pipeline of qualified women who participate in the workforce. In the short term it will be a cost that companies will bear as the momentum for correcting diversity imbalances strengthens.

2016 will see many more companies disclosing these policies, and some the costs. Investors will take notice, as they did in 2015, as one of the inputs used to assess boards and their directors coming up for re-election.

Executive remuneration increases

The rate of increase for 2016 is likely to be similar to prior years, with an expected median fixed pay increase of 3% to 3.5%. However, this masks what we expect to be significant variation by industry and company. Significant movement is expected at the lower end of the ASX 300 as it changes membership, with stock re-ratings having an oblique effect also on executive remuneration.

Concluding remarks

2016 will be an interesting year for the board nomination and remuneration committee, and for institutional investors. Boards will need to be rigorous in setting incentive measures to ensure they reflect expectations for M&A activity and other capital management strategies so that management is not punished for “agility”. They will also have to be more rigorous in the definition of earnings. Board renewal will continue to be a focus at many more companies, driven in part by the need to diversify due to technology and market imperatives. Sourcing qualified women directors remains an interesting challenge for many boards, while the increased cost of qualified women will not be challenged.

 

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