Regulators around the world are itching to prescribe rules to ensure executive pay promotes sustainable long term results, despite the fact that many investors are not particularly long term in their perspective.  In Australia 70% of stock value is turned over annually.

The European Union (see HERE), UK (see HERE), and US (see HERE) have legislated on executive pay.

Australia has also experienced expanded executive pay regulation, with APRA’s regulations and guidelines the most focussed on sustainability (see HERE).

Unfortunately, the unintended consequence of some regulation is at odds with long-term performance and sustainability. For example, Australian share plan taxation changes mean that there is less incentive to focus on long-term results. Ärguably, the terms of reference to, first, the Productivity Commission, and now CAMAC, have steered executive pay enquiries to consider prescribing executive pay methods, including the form and nature of incentives.

However, non executive directors (NEDs) have a more acute sense of performance sustainability than the executives they employ. Earnings and share price volatility does not please long-term investors, who will vent their displeasure at AGMs. NEDs out-serve the CEOs they hire and fire, with an average ASX 300 NEDs tenure of 8+ years versus their CEOs of 5 years. And, while motivation for being a NED varies, all have a vested interest in preserving reputations founded on sound business judgment. Lastly, of course, NEDs have a fiduciary duty to the long term interests of the company.

Guerdon Associates has developed the following remuneration committee checklist to ensure executive remuneration better supports long-term performance sustainability and growth.

1. Hold through retirement

Ensure executives maintain a stake in the company’s long-term performance and earnings sustainability after they leave. In some countries, such as the US, there are advocates of executives being required to hold stock until retirement. We think this is suboptimal. It only encourages executives to depart on an upswing, and fails to retain executives through the ups and downs of various cycles. We have addressed this before (see HERE). Instead, we suggest the vesting and holding periods be aligned with the legacy associated with the decisions executives made while in employment. The approach is also supported by the Australian Institute of Company Directors (see HERE). As this legacy winds down over time, so does the amount of the stake at risk.

Unfortunately, the Australian government’s failure to remove cessation of employment as a trigger for tax on equity plans, more than anything else, has contributed to executives not being held to account for their legacy. Yet board remuneration committees can still address this issue. Guerdon Associates have developed various equity based reward vehicles and methods that do not trigger tax on cessation of employment, and so can be applied in long term incentive plans that work the way they are supposed to work.

2. Hold vested equity incentives for a specified period

Incentive plans that vest immediately on achieving a performance test outcome are the most common form of executive incentive plan. But they may just encourage short-term actions that are designed to ensure the maximum value of incentive reward vests, whatever the consequences. For example, an EPS growth target could be manipulated by deferring maintenance on capital equipment. The executive, approaching retirement, makes it his/her swan song, and departs with an inappropriate bonus. Instead, defer the vesting, at least in part, and preferably in equity. Another approach is to have only a proportion of the reward vesting each year (say 20% a year for 5 years). Over several years the executive has a sizable wealth stake dependent on sustainable company performance.

This method has been prescribed by the UK’s FSA, and adopted by the US remuneration czar, Ken Feinberg, appointed to oversee bailed out banks, insurers, car manufacturers and various other US companies.

3. Limit the disposal of aggregated holdings and establish a trading policy

While there may be grant-specific holding requirements post vesting, executives could save all their aggregated holding to unload at once. This invites risk. This is what happened at Bear Stearns and Lehman Brothers before they collapsed.

Most of the larger ASX-listed companies now have disposal restrictions on vested executive equity incentives. If your company does not, Guerdon Associates suggest that you put this on your agenda, if only to ensure compliance with new ASX rules (see HERE).

Remuneration committees could also consider how much of the equity held by executives can be sold each year, e.g. executives cannot sell more than 10% of aggregated equity as at the beginning of the year (given grant-based restrictions). However, to ensure continued attraction and retention, the committee may want to consider exceptions on a case by case basis.

4. Fix regular dates for equity grants

Front-end gaming is not common in Australia. Known in the US as spring-loading, it appears more evident in small ASX listed companies in the resources industries. This occurs when executives influence the timing of equity grants prior to good news. Such a practice leads to the decoupling of payouts from actual long-term performance.

The remedy is to make equity grants at a set time each year. It continues to surprise us that many ASX listed companies do not do this. So while the instances of spring-loading are probably rare, remuneration committees should ensure that grant dates are fixed on a regular, planned basis to minimise the potential for misbehaviour.

5. If using TSR or share price as a measure, use averaging

Basing vesting on a measure of TSR or share price can invite misbehaviour. We suggest that the price used for TSR calculations be averaged over a suitable period (see HERE).

6. Apply robust hedging policies

While ASX Governance Council guidelines require companies to disclose their equity plan hedging policies (see HERE), the policing of such policies needs careful attention.

7. Review the pay mix

All the major external stakeholders consider the mix of short-term to long-term incentives. A pay mix where the percentage of total remuneration focussed on short-term results is more than for long-term results raises a red flag.

Remuneration committees need to consider the time and risk horizons of the business, and adjust the pay mix accordingly. If there is both high capital intensity and asset longevity, then a CEO pay mix probably should be heavily biased to the long term.

8. Review performance measures and associated performance periods

Associated with a review of the pay mix, the remuneration committee should take a hard look at the performance measures and the performance periods they apply to.

High levels of capital intensity would indicate that measures of capital efficiency are critical. If high levels of capital expenditure and asset longevity accompany this, then the performance period should also be long term. Put together, this would imply a long term incentive plan based on economic profit or cash return on investment.

Make sure that these long term measures are meaningful. That is, they relate to the key drivers of shareholder value and can be directly influenced by executives. Unless your company has directly comparable peers, and/or is in a commodities-driven business, relative TSR is probably not a viable measure. Drop it and move on.

9. For high asset longevity and capital expenditure consider reward for stewardship

Many companies in the resources industries have investment decisions that assume decades of productive life. Todays executives inherited the legacy of their predecessors. And the impact of their own decisions will be passed on. Therefore, some remuneration committees may want to consider reward systems that support recognition of stewardship of a culture of sustainable earnings through generations of leaders. In effect, a US-style supplementary executive retirement plan, with value tied to company stock. Each leader will have to shoulder the responsibility and duty to sustain and build upon the wealth created by predecessors.

10. Incorporate risk management

Long term sustainability is about management of risk, not risk minimisation. It is about risk optimisation over time. Higher returns incorporate higher risk tolerance. But fiduciary duties require NEDs to ensure adequate capital buffers to survive the inevitable downturns and occasional disappointments.

The remuneration committee therefore needs to explicitly consider risk management in executive remuneration. Reflecting the points made above, this can be achieved in a number of ways:

• Performance measures that include risk adjusted costs of capital

• Performance periods aligned with risk horizons

• Payment vehicles that balance upside rewards with downside risk (e.g. the mix of options versus shares)

• Separating the performance measurement period from the time it takes for reward vehicles to vest (e.g. 3-year performance with 4-year vesting)

• Hold through retirement policies

• Anti-hedging policies and enforcement

• Trading policies and controls

11. Review and clawback

Consider a review and clawback policy. This is easier if the vesting of a reward is deferred until some time after the performance period has ended. Then, with the benefit of hindsight, review the consequences, if any, of the methods applied to achieve that performance level.

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