Amid the tumult of regulatory change, board remuneration committees should maintain focus on matters critical to shareholders.  While being diverted on box ticking compliance matters is understandable, the principles underlying good remuneration governance could be left behind in the confusion.

This article seeks to redress the balance, and provide directors with a checklist of five primary principles for effective remuneration governance.  The principles reflect remuneration governance considerations discussed by Guerdon Associates in past newsletters over the years that have since become better recognised, and may actually provide the foundation for principles-based regulation in several countries.  But the regulation should not be considered as important as the principles themselves.

Principle 1: Pay for performance

The long debate on executive remuneration is heading to the conclusion that, yes, of course it should be tied to performance.  But the debate has gone further, and crystallised that it should be on long-term value creation. Incentive-based pay can be undermined by remuneration practices that set the performance bar too low, or that rely on benchmarks that trigger bonuses even when a company’s performance is sub-par relative to its peers.

To align with long-term value creation, performance-based pay should be conditioned on a wide range of internal and external metrics, not just share price.  Various measurements can be used to distinguish a company’s results relative to shareholder expectations, while taking into account the performance of an individual, a particular business unit and the company at large.

Performance based pay that relies too heavily on short term metrics may create perverse incentives that emphasise short term gains over the building of long term value.

This principle calls for a more diversified approach to setting performance targets, utilising a wide range of internal and external metrics.  Remuneration committees should review the breadth and depth of performance metrics used for incentive rewards.  Over-reliance on only a few measures may create risk.

Principle 2: Structuring remuneration to account for timing of risks

Some of the decisions that contributed to the global financial crisis (GFC) occurred when people were able to earn immediate gains without their remuneration reflecting the long-term risks they were taking for their companies and their shareholders.  Overseas financial services companies, in particular, developed and sold complex financial instruments that yielded large gains in the short-term, but still presented the risk of major losses.

Companies should seek to pay top executives in ways that are tightly aligned with the long-term value and soundness of the company.  Asking executives to hold shares for a longer period of time may be the most effective means of doing this, but directors and experts should be flexible to determine how best to align incentives in different settings and industries.  Remuneration conditioned on longer-term performance will automatically lose value if positive results one year are followed by poor performance in another, obviating the need for explicit claw backs.  In addition, companies should carefully consider how incentives that match the time horizon of risks can extend beyond top executives to those at operational levels.

Principle 3: Remuneration practices should be aligned with sound risk management

At many companies, remuneration design unintentionally encourages excessive risk-taking, providing incentives that ultimately (in a few spectacular recent examples) actually put the health of the company in danger.  Meanwhile, risk managers too often lacked the stature or the authority necessary to impose a check on these activities.

Remuneration committees should conduct risk assessments of pay packages to ensure that they do not encourage imprudent risk-taking.

Principle 4: Align the interests of executives and shareholders at cessation of employment

Golden parachutes were originally designed to align executives’ interests with those of shareholders when a company is the potential target of an acquisition.  Often, they have been expanded beyond that purpose to provide severance packages that do not enhance the long-term value of the company.

New regulation on excessive termination payments combined with taxation of unvested equity at termination will not negate a remuneration committee’s duty to carefully consider all aspects of remuneration at cessation of employment.  The committee should reexamine how well termination provisions align with shareholders’ interests; whether they truly provide for performance incentives.  To date the practice in Australia and the rest of the world has not been to maintain incentives post employment.  In many instances the absence of these incentives may have contributed to poor post cessation performance and poor successor selection or briefing and support.  Whilst Australia’s likely share scheme taxation may remove the most obvious solution to this problem because it prevents effective use of post-employment incentives, the remuneration committee should seriously consider the range of other alternatives outside of equity to create meaningful “sustainability incentives” which have effect after employment.

Principle 5: Insist on transparency and accountability in the process of setting remuneration

Many poor remuneration practices may have been avoided if remuneration committees practiced greater independence and shareholders had more clarity.  In too many cases, remuneration committees are not sufficiently independent of management, while companies were not fully transparent in explaining their remuneration packages to stakeholders and shareholders. 

Having remuneration committees comprised only of independent directors would assist greater independence.  They should engage their own independent external experts.  These experts must be independent of management and not be in a position to provide separate services to management.

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