On 23 August, Guerdon Associates hosted a Director’s Briefing webinar featuring Ed John, Executive Manager, Stewardship, for ACSI.

This summary highlights the key points made during the discussion.

Performance requirements for variable pay

The Briefing provided a good opportunity to discuss ACSI’s continuing belief that incentive pay should be for stretch performance, rather than being variable reward becoming an expectation for senior executives. This view may contrast with those of other proxy advisors.

ACSI has noted an investor preference for incentives to be awarded only for outperformance, and investors want to see runs on the board. The concern for ACSI is not with companies that have performed well for a long time and delivered value to superannuation fund members, but with companies that may appear to pay incentives where performance is poor or some cases where it appears from the outside that executives are being paid simply for showing up. For ACSI, the context and how the hurdles interlink is important.

A director noted that in the listed environment, the question is if the incentive structure is set for outperformance or effort, whereas in private equity it is all about outperformance. The budget setting process becomes a fundamental task for an organisation, as if target is achieved that is what executives get paid to do. If incentive plans are really about creating long-term value, the process of setting budgets and targets should be given high priority by a board.

Ed mentioned that the median STI payout as a proportion of the maximum opportunity is still around 80%, and the distribution does not follow a bell curve. The question becomes where does the incentive ‘bucket’ start – does it start full, or does it start empty and fill with strong performance? Investors often think about it as a bucket to be filled whereas ACSI sees a perceived culture of executives in some companies feeling entitled to receive incentive awards at 100% of target as a given (or something that is only reduced in very exceptional circumstances).

Annual director elections

ACSI is supportive of exploring annual director elections in the Australian market, as the standard is common in the US and required in large UK listed companies.

Ed noted that, from the shareholder perspective, it is difficult to assess board performance or individual performance from the outside looking in, and in some companies in the past there could be a cultural element where the 3-year election cycle precluded an active review of director performance. There have also been cases where directors have received substantial votes against due to the fact they are the unlucky ones to be on the ballot in a particular year as opposed to those being the most accountable for performance issues.

When ACSI started this conversation with companies, directors who had sat on UK boards championed annual elections because they said it improved their conversation around board performance.

Some boards in Australia leave deep dive self-reflection around individual director performance until the board was required to support an individual’s re-election. While in the culture with annual elections, it was more of an active conversation on skills and succession.

Ed noted that when annual elections were introduced in the UK, there was a concern from both directors and investors that it could make organisations focus too much on the short-term, but this concern has not borne out.

While ACSI does not have a fixed view on director tenure, there is a concern that with many long-tenured directors on a board, several could retire at the same time.  ACSI’s focus is on board renewal to ensure new skills, experience and industry knowledge in being added over time.

ACSI has no fixed view on director tenure but would like to see active board renewal.

Board diversity

ACSI has noted significant improvements in gender diversity at board level, with the conversation broadening into other areas of diversity around skills, experience, and backgrounds. ACSI expects this will have larger focus in Australia in the coming years.

Geographic diversity is important and ACSI is open to companies having to offer differentiated NED fees to attract people from the right cohorts in certain markets.

Voluntary resolutions

ACSI encourages voluntary ‘say on climate’ resolutions in high-risk industries as a sign of leadership, but do not expect every ASX 100 company to have one.

ACSI also expects companies to seek shareholder approval for CEO equity grants even if the company is buying shares on market. Voting against the remuneration report can be a blunt instrument for investors if the concern is with only the LTI. So, providing a specific vote on the CEO equity grant is valuable – and, in ACSI’s view, expected as an indication of good governance that many ASX200 companies have already adopted.

NED equity

ACSI does not support paying NEDs in options with an exercise price or other equity instruments with leverage (including structures with performance measures that have to be achieved for vesting). However, ACSI does support paying NEDs in share rights or shares that provide for alignment with investors.

For companies that seek to attract directors in markets where paying in options is more common (like the US), ACSI will evaluate on a case-by-case basis.

Non-financial performance measures

ACSI was not supportive of a prescriptive 50:50 split of financial and non-financial performance measures for APRA-regulated entities (or any others for that matter). The balance of financial and non-financial metrics should be determined with regard for the company’s objectives and strategy. The board will determine the incentives that create the right behaviours, then would describe them and how they can be measured.

Ed also offered a prize for the person that could come up with a better name than ‘non-financial’, noting that one director described them as ‘pre-financial’ as they are issues that often become financial in a year or two.

While measures of non-financial performance are important, it is not clear to ACSI that every non-financial issue has to be linked to incentive plans. For example, should executives be paid an STI to comply with regulatory standards? No.

ACSI has seen other companies outside the financial services sector introducing non-financial measures in LTI plans, for example based on strategic initiatives. It will support proposals where there is a clear rationale and link to company strategy, and the metrics are measurable. ACSI has had concerns where there is a lack of detail around milestones or how performance will be assessed.

Where objectives are clearly articulated and linked to company strategy, ACSI is supportive of including carbon reduction metrics in STI or LTI plans which is a growing trend in ASX200 companies. ACSI is not prescriptive for companies to include certain metrics in their plans – metrics should always be company specific and should be measurable.

While ACSI is not prescriptive on weightings of non-financial performance measures, it expects boards to provide a sense check and potentially reduce formulaic vesting outcomes in the event that non-financial objectives have been achieved but financial performance is poor (or vice versa) – that is, it expects to see balanced outcomes.

Retention grants

On the topic of grants made during COVID where boards used discretion to pay retention grants based on managing risk, Ed noted that it is a challenging area and that investors may react negatively to remuneration arrangements that include the word ‘retention’. The structure, rationale and articulation of such arrangements are important to ACSI if they are to be supportive.

ACSI will also have regard for historical vesting outcomes, for example if a company has paid high STI awards every year in the past 9 years, it is unlikely to be appropriate to award retention grants after the first year that outcomes are below target.

Long-term equity grants

ACSI can be supportive of long-term equity plans without specific performance hurdles – such as those adopted in the major banks. However it expects those boards to apply scrutiny to all awards and to see a reduction in quantum compared to an LTI grant to reflect the higher certainty of vesting.

There is also a question around what will happen once the quantum of such pay packages start increasing in the future as reduced quantum for greater certainty this was one of the attractions of these schemes for boards and investors.

Target setting

For STI targets that were set at the beginning of the year and are no longer achievable if circumstances change, ACSI is looking for transparency and a clear rationale to be provided if hurdles are amended during the year. It was noted that the question is typically around boards exercising positive discretion to reduce hurdles and rarely to make hurdles more challenging in the event of unexpected tailwinds. ACSI will look at the individual circumstances and wants to engage with boards to understand the rationale. In that regard, it helps if the board has a track record of making sensible decisions.

For LTI targets based on financial measures such as EPS, ACSI will evaluate how challenging the hurdles are with regard for analyst consensus estimates as well as a range of factors including historical performance. If there is a big gap between hurdles and consensus estimates, ACSI expects the board to engage and explain the rationale.

Fixed pay increases

A useful sense check for boards when considering fixed pay increases for executives in FY24 is to look at what is happening to the wider workforce and enterprise agreements.

If there is a pay freeze for the management team it is probably not the year for companies to increase the director pool.

ACSI may expect new CEO appointments to come in at a lower fixed pay compared to their predecessor, especially if the previous incumbent has a long track record of high performance.

The upcoming AGM season

Ed thinks FY23 may prove to be a difficult year with choppy results, and it is important how that performance outcomes – both good and bad – are reflected in rewards. ACSI has already noted a couple of cases where the goalposts have shifted with boards exercising positive discretion to award incentives. There might be a few companies that have not read the room correctly on that.

ACSI has an open-door policy to engagement and meets with boards throughout the year, sometimes around AGMs and notice of meetings being published. ACSI values engagement with boards and seeks to establish a shared interest in performance over the longer term. ACSI values a ‘no surprises’ approach to dialogue with boards.

As ACSI exists for superannuation funds that may be invested in a company for 10-20 years, ACSI starts from the long-term perspective and does its own fundamental analysis of how companies perform on ESG issues.

The focus on the longer term also informs the engagement and voting recommendations on remuneration matters. ACSI will be updating its Governance Guidelines at the end of 2023, we will update you as their policy focus changes.

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