This article dusts off our crystal ball and presents our outlook for director and executive pay, and also for board renewal, for 2014.

The US and European economies are recovering. The first cuts have been made in quantitative easing while the $A-$US exchange rate is likely to continue to be lower than in recent years. Inflation pressures may give rise to higher wage demands. The Australian economy is successfully transitioning and should grow more strongly in the second half of 2014 after a tepid first half.

Most companies have managed the economic transition well, and have strong balance sheets. Capital markets remain stable and strong, although recent wobbles because of concerns about emerging markets may indicate that the road ahead may yet have a few twists and turns. The supply of credit and capital for expansion is in the best place it has been for years. Many companies are poised for mergers and acquisitions, but as some companies disappear, replacements will emerge from the backlog of prospective IPOs that will come to market.

IPO companies need to shore up their executive remuneration

We are constantly amazed that so many prospective IPO companies miss an opportunity to provide investors with assurance that the management team going to stay on to see through a transition to a public company, and will not take the money and run as soon as their IPO stock comes out of escrow.

If you are appointed to the board of a prospective IPO company, consider developing and disclosing in the prospectus a remuneration framework that does not leave an incentive gap between stock coming out of escrow and a performance-contingent long-term equity plan. There should be some overlap so that management retains “skin in the game” at all times.

With many IPOs likely to qualify for ASX 300 status shortly after listing, ensure an ongoing remuneration framework that does not get you into trouble with institutional investors at the first remuneration report vote. There are too many activist hedge funds seeking opportunities to short sell recent IPO stocks that may face ‘governance’ issues. Deny them an opportunity by ensuring an executive remuneration framework aligned with investor interests that extend beyond the prospectus’ forecasts.

Review change in control provisions

In a year of heightened company takeover activity it may be circumspect to review change in control provisions. Be particularly wary of equity that could vest on the smell of a merger or acquisition. There have been instances of this in the past whereby a merger or acquisition did not eventually take place (perhaps because of FIRB intervention, or other uncontrollable factors), but equity vested to executives in full. Retain discretion to consider all factors and decide the timing and extent of any vesting in relation to changes in control.

Review what is in and what is out on incentive measures

Carefully define what is included and excluded in incentive measures. Be particularly wary of excluding write-downs and impairments. Investors do not like executives to be rewarded if value is written off, particularly if this is associated with goodwill for recently acquired companies. Ensure there is transparency and rigour in performance measures. If using a capital efficiency measure specifically address the capital usage in development projects. Is that capital in the denominator? Is this reasonable given the time period over which capital efficiency is being measured, and board expectations of continuous re-investment for future growth? Is this transparent and robust?

More government regulation changes

Be prepared for changes to government regulation. Already the new federal government has recognised the damage that the 2009 changes to employee share scheme taxation have done in limiting new venture start ups (as predicted by us at the time – see HERE). Therefore it is reasonably likely that some changes will be made. However, it is also reasonably likely that the changes will be applicable to riskier, potentially high growth companies, rather than established ASX 200 companies. Therefore, if as a director you are engaged in more entrepreneurial and speculative ventures, maintain a watch on the opportunities this may provide in pushing along your start up plans and hiring those skilled people the business needs with stock options or similar.

A revised ASIC class order exemption from the Corporations Act disclosure, licensing and hawking provisions for employee incentive plans should allow companies to more cost effectively consider and implement equity plans.

It is also clear that the two strikes rule has had mixed results. While, to the surprise of many, the resulting engagement between directors and investors on executive pay matters has had mutually beneficial outcomes for the ASX 300 companies with institutional investors, it has clearly been misapplied by some shareholders for matters other than executive and director pay, especially for smaller companies. So, while it needs review, there are no signs of this yet from the Abbott government.

Reference market expectations when setting incentive targets because investors will

The great paradox of investor guidelines is that the best management would be rewarded least. The great inequity is that we tend to reward volatile results much more than good results.

Consider this. One company achieves a consistent and high internal rate of return. Its competitor has, on average, lower and far more volatile internal rates of return. The former has moderate TSR growth. The latter has TSR growth that gyrates from high negative to high positive. When this TSR performance is ranked against a comparator group, the first company would receive moderate if any relative TSR equity grants vesting. The second company would probably have higher average vesting rates. On a risk adjusted basis the first company clearly delivers a better return over the long term. But its management is rewarded less. Why is this? It is because investor guidelines dictate that relative return be rewarded without taking into account relative risk.

Consider another vexing example. The board sets an annual incentive performance benchmark for earnings based on its required long-term internal rate of return. It recognises that short-term annual results are in large part due to the legacy of prudent and shrewd prior year investments. The benchmark it sets is more than a line in the sand. It is carved in stone. Analysts’ forecast earnings growth is higher than this benchmark in some years, lower in others. Yet proxy adviser and investor guidelines in effect require short-term targets to be equal to or higher than consensus forecasts. There are no guidelines that support or recognise consistent setting of earnings targets relative to a long-term internal rate of return. Instead, they again reward volatility.

There is no doubt that investor and proxy adviser guidelines, and board responses to these, have resulted in a systemic inequity that needs courage, openness, and intelligence from both sides to overcome.

There are no signs that this will happen in 2014.

So the easy road, as directors, is to check your setting of incentive earnings and other targets against consensus forecasts. Be prepared to amend these if your targets are “too low”, or risk a poor proxy adviser assessment. If you have courage, and the company is configured to deliver a strong and consistent return over time, try a “carved in stone” approach, be prepared for a negative initial assessment, and keep at it in successive years to win investors over.

In regard to ubiquitous relative TSR requirements, consider additional LTI tranches contingent on other measures. If your company is suited, consider TSR relative to another benchmark, such as a bond rate, CPI growth, crude oil price or GDP growth. Or consider the ultimate: risk adjusted relative TSR. The latter is not hard to understand if done the right way, and is certainly a lot fairer to those quiet management achievers who otherwise take it on the chin whenever they are compared to a bunch of cowboys.

If this issue is as important to you as it is to other directors and investors, come along to our Remuneration and Governance Forum, co-sponsored with CGI Glass Lewis (11 March in Sydney and 17 March in Perth).

Engagement

The larger companies have clearly mastered the art of engagement between directors, investors and proxy advisers. But below the ASX 100 there is still a lot more to do.

Investors and their advisers clearly need to put more expertise and time into evaluating director and executive pay in these companies. In particular, they need to be more cognisant of the issues associated with the form and nature of pay required for the success of higher growth and more volatile companies, especially in the resources, technology and biotech sectors. Directors in these companies need to engage, listen, and respond to their investors and their advisers . For both sides there are clearly better methods to remunerate, communicate and evaluate this remuneration.

Pay deferral, forfeiture and “clawback”

Pay deferral originated with APRA regulation imposed on GFC-impacted banks and insurers but has now become ubiquitous in large companies. While deferral is currently mostly associated with short-term incentives, it will probably also extend to LTIs, with an additional year’s service required for vesting after performance has been assessed (some stakeholders, such as ISS, already have this in their guidelines).

Driven by institutional investor checklists and governance guidelines, and new government disclosure regulation on clawback, half of the ASX 200 took up deferral in 2013.

Implementation issues associated with persuading executives to take home less cash in the year of implementation has moderated the rush to take it up. But there is no stopping it.

Companies already with deferral, and those considering it, need to review the forfeiture provisions attached to the deferred payment. If final vesting is contingent only on continued service, think again. New ASX Governance Principles will require companies to disclose on an “if not why not” basis if they have a remuneration “malus” (forfeiture of pay assessed as due on meeting an initial assessment of requirements but otherwise deferred) or “clawback” (recovery of remuneration already paid and received by an employee) policy.

Some investor and proxy adviser guidelines already require this.

A well-managed and monitored “malus” system is good risk management. Good risk management is also consistent with another ASX Governance Council requirement for a board risk committee. In 2014 disclose if you have such a system, explain how it works and why it is in place. Ticks all around. And it is good practice.

Board skills matrix disclosure and board renewal

Another ASX Governance Council recommendation that will apply for company financial years commencing on or after 1 July 2014 is to disclose information on the mix of skills and diversity that the board is looking to achieve in its membership. A board skills matrix can help with this. However, disclosure of such information could open a can of worms because, if you have developed the skills matrix properly, it may telegraph new areas of focus that you would prefer the market and your competitors not to know about just yet.

But there is no doubt that the development of a skills matrix through a rigorous and confidential board evaluation and renewal process is immensely valuable. So proceed with the process, and then assess how much is to be disclosed.

To discover how other boards are tackling this, and what investors prefer, we will be reviewing this at our Remuneration and Governance Forum, co-sponsored with CGI Glass Lewis (11 March in Sydney and 17 March in Perth).

Disclosure of incentive targets

ACSI’s highly successful campaign to ensure STI payments are justified has had an effect. ASX 100 companies are getting much better at disclosing KPI targets. But there is room for improvement.

In 2014 expect more pressure to disclose the detail of KPI targets, the results against those targets, and how these are translated into STI payments. Directors should not be complacent. Even if there was an improvement in your disclosures last year, review them again for further improvement. It is an area where investors raise the bar each year.

On the other hand, there is a trend for many companies not to disclose prospective LTI targets on the grounds that this could be construed as guidance. Investors do not like this. But directors are advised to stand their ground, as there is precedence and legal constraints on your side. But do not forget to disclose LTI targets retrospectively, or you will (rightly) get into trouble.

Executive remuneration increases

The rate of increase in executive pay moderated from 2012 to 2013, with median CEO fixed pay increasing by 3.3% (see HERE).

The rate of increase for 2014 is likely to be higher, particularly in the latter half as the economy picks up, with an expected median fixed pay increase of 5%. However, this masks what we expect to be significant variation by industry and company.

Director fees

The rate of increase in non-executive director (NED) fees moderated from 2012 to 2013, with median NED fee increasing by increasing by 2.2% (see HERE).

Director fee increases will be moderate, despite higher inflation, supply pressures to meet diversity targets and a shortage of qualified independent directors for planned IPOs. Expect median fee increases of 3%.

However, special mention should be made in regard to large superannuation funds. If government proposals for more independent directors are implemented the search for and placement of suitably qualified independent directors, plus additional disclosure requirements on pay imposed in 2013, will see pressure on director fees in this industry. Expect fee rates to increase much more than 4%, and the rate of increase to be highly variable across funds well into 2015 and perhaps beyond.

Concluding remarks

2014 will be another challenging year for the board nomination and remuneration committee, and for institutional investors. But it will be better than last year.

 Engagement skills will trickle down to smaller companies. Disclosures will improve. Activity will pick up, as will executive pay in the latter half. Boards will be more rigorous in setting incentive targets. Board renewal will exercise the minds and focus at many more companies, driven in part by strategic opportunities, new disclosures and supply issues.

There is a lot for the nomination and remuneration committee to do.  So, from Guerdon Associates, good luck for 2014!

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