Additional government regulation is forcing boards to be more active in executive pay to the extent that the board is taking on some of the functions they once delegated to management.  There is no choice.  In particular, the two strikes law will require that the board somehow makes room for managing pay, alongside more material matters.

 

And management, as well as directors, do not like it.  Not a bit.  But, just as management are used to auditors poking around in their accounts, they will eventually get used to directors and their external advisers messing with their remuneration.

 

It is at these times of early management resistance that remuneration committees need to assert more control over executive remuneration.  That is, question more, seek genuinely independent advice and, if necessary, push back more.

 

While the agendas for most remuneration committees are full, we think there are three areas of focus that are critical to executive remuneration “fairness” and “responsibility”.  Focusing on these principles will most likely mean that the two strikes law does not become the big board issue you have to deal with. 

 

The 3 point checklist is:

 

1. Truer pay for performance;

2. Addressing red flags raised by external stakeholders; and

3. Risk management.

 

Read on to know how to address these.

 

Validate the pay-for-performance relationship

 

Every company claims to live by “pay-for-performance”, but how many boards have actually taken the steps needed to ensure that it is true? 

 

Real pay-for-performance needs to satisfy the “three Rs”: provide the right level of pay for the right amount of the right performance. 

 

Often directors default to a combination of historical practice and prevalent market practice to set the key drivers of their pay-for-performance programs, rather than undertaking the hard work of independent determination and validation.

 

Setting the right level of pay has too often been an externally driven exercise, relying predominantly on data gathered from surveys and peer company remuneration reports.  Remuneration critics have long cited over-reliance on “competitive positioning” as a key factor in escalating executive remuneration levels.  Companies cannot eschew competitive analyses altogether – remuneration should be properly assessed in a competitive context – but too many companies let market data drive their remuneration decisions rather than merely influence them.  Internal equity and organisational structure, company and individual performance, succession planning, and retention concerns, can and should all be considered when remuneration committees set pay.

 

The selection and calibration of performance metrics is a complex and critical task that deserves meaningful time and attention at the committee level.  While consistency is important, too many companies use the same metrics year after year regardless of changes in their company’s circumstances or overall business conditions.  Moreover, across the multiple incentive plans, there may be too much or too little focus on particular areas of performance (e.g., too much focus on profit at the expense of managing the balance sheet).  Performance measures should be:

 

·          Central to the company’s business strategy and market differentiation

·          Strongly and demonstrably correlated to value creation for shareholders

·          Capable of being impacted by management actions in an appropriate timeframe (i.e. short-cycle metrics for annual incentive plans, longer-developing metrics for multi-year incentives)

·          Complementary from one plan to another and take account of risk

·          Able to be accurately measured and monitored.

 

The goal setting process needs to consider more than just management’s annual budget and 3-to-5 year business plan.  Setting threshold, target, and superior performance levels should consider a comparison to historical performance levels, peer performance, and future expectations of investors. 

 

Finally, the committee should periodically back-test its incentive plans to determine whether the targeted pay-for-performance relationship was actually achieved.  If the stated remuneration philosophy targets median competitive pay with the potential to earn top quartile pay for “superior” performance, back-testing analyses should be able to prove that relationship.  The analysis can provide committees with important insights for setting future performance requirements.

 

Address red-flags

 

When faced with the prospect of being strong-armed by the proxy firms and other stakeholders, many remuneration committees baulk at changing their pay programs.  But defending them can be enormously costly in terms of political capital and goodwill with shareholders.

 

Committees should take a long, sober look at all pay and benefits practices and decide which pieces of the overall program are truly worth a scrap with watchdogs and activists.  For example, a company that maintains relatively high pay levels is likely to face much less hostility from external stakeholders if it insists on high levels of performance and enforces modest termination payments, bonus deferral in equity, a clawback policy, and meaningful ownership guidelines.

 

At a minimum, committees should eliminate the obvious targets in their remuneration policy.  As boards try to convince shareholders and regulators that additional oversight and intervention is not necessary, continuing executive pay largesse just provides fuel for critics.

 

Do not forget risk

 

Finally, we would be remiss if we did not mention risk.

 

In many respects, risk is already an implicit part of nearly every remuneration committee discussion and decision.  Variable pay is used to address the risk of high fixed costs, vesting restrictions are added to equity grants to address the risk of unwanted turnover, and clawbacks are adopted to address the risk of windfalls from excessive operational risk taking, for example.  However, we believe committees would benefit from turning the implicit consideration of risk into an explicit agenda item.

 

In summary, executive remuneration will continue to be used as a test of good corporate governance and director independence for the foreseeable future.  The two strikes law will demand that these matters receive attention.  Remuneration committees cannot rely on competitive practice to justify pay levels that are not warranted by performance, the continuation of pay that is no longer considered reasonable, or pay structures that fail to manage risk.

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