Remuneration committees have a new resource to help manage the risks engendered by executive incentives. The Directors and Chief Risk Officers Group (a network of board members, chief risk officers and C-suite leadership from over 2,000 companies across 115 countries) has published a set of guiding principles for remuneration committees on how to govern the link between pay, performance and risk.
The Directors and Chief Risk Officers Group principles fall under five key categories as follows. To conclude, Guerdon Associates has prepared a checklist based on the Directors and Chief Risk Officers Group set of guiding principles.
The remuneration committee should be directly responsible for the corporate-wide remuneration philosophy and also the remuneration structure of the senior management team.
It is impractical for the remuneration committee to directly govern the remuneration of employees beyond this, according to the principles, which recommend indirect governance (ensuring the right resources and processes are in place and interacting with HR, risk management and audit infrastructure) to govern the remuneration of other key employees and ensure they are aligned with the corporate-wide remuneration philosophy. As an aside, it will be interesting to see if the Banking Royal Commission currently under way (see HERE) will have a similar view.
The principles recommend the following:
- Do not pay predominantly for individual outcomes as collaboration can suffer and incentives may not be aligned with owners and other stakeholders.
- Use risk-adjusted KPIs and a balanced scorecard or integrated reporting approach. Consider the value of performance both financially and via feedback from stakeholders including customers, suppliers, creditors, investors, regulators, rating agencies and analysts.
- Understand the flaws of TSR (doesn’t measure risk well, records past performance not drivers of future performance, share price may be driven by imperfect information)
- Avoid significant use of options (no downside risk, increases in volatility increase rewards)
- Where benchmarking is used, ensure pay is also fair
- Defer significant incentive pay for multiple years, especially for the gatekeepers (CRO, General Counsel, CFO etc.)
- Incentive pay should remain at risk for three years after an employee departs
- Introduce clawback provisions (not just malus, but genuine clawback where realised pay can be retrieved from executives)
- Use discretion to ensure pay outcomes reflect performance, especially as regards non-financial indicators such as culture
The principles recommend the following:
- Whole of board input (rather than from just the remuneration committee) should be sought on performance reviews and compensation design for the CEO and executives being considered to succeed him/her.
- A statement should be issued assuring the remuneration framework is “fit for purpose and a discussion published explaining how it aligns with strategy and reflective of risk-adjusted performance
The principles recommend the following:
- Remuneration committee members should be independent and have expertise in risk, finance, contracts and engagement with remuneration consultants.
- At least one remuneration committee member should also sit on the audit and risk committees.
- Remuneration committees should not include the chairman, who generally has a close relationship with the CEO
- Experts such as the head of HR of the general counsel may be needed for discussions with remuneration consultants
Remuneration risk governance should be an ongoing process including formal collaboration, feedback, review and escalation channels among board committees and social networks. All board committees should be aware of changes within their remit that may affect remuneration frameworks (for example, a change to accounting standards that may affect the probability of meeting KPIs).
The feedback loop is a key part of resiliency and involves asking questions of the CEO, CRO, CHRO and CAO to test a new remuneration structure after its implementation.
This principle is considered the most important, because it fosters resiliency (the ability to respond to unexpected threats or opportunities) – a failure to adhere to it will reduce the effectiveness of practices implemented in line with the other four principles.
The principles can be accessed in their entirety on the Directors and Chief Risk Officers Group website HERE.
Remuneration committee risk management based on the Directors and Chief Risk Officers Group guiding principles – the checklist
|1. Directly manage the corporate remuneration philosophy and the remuneration structure of the senior management team.
|2. Ensure appropriate resources and processes are in place to monitor culture and engage with HR, risk management and audit teams for oversight.
|3. Ensure corporate outcomes factor into incentive payments and avoid payments based predominantly on individual outcomes.
|4. Integrate risk considerations into KPIs and use a balanced scorecard or integrated reporting approach rather than focusing on one metric.
|5. Integrate stakeholder (customers, suppliers, investors etc) feedback into payment outcomes.
|6. Understand TSR’s pros and cons.
|7. Avoid option use where possible.
|8. If benchmarking against the market, keep internal and community relativities front of mind
|9. Defer incentive pay for multiple years, even if the employee departs.
|10. Introduce genuine clawback provisions.
|11. Use discretion to adjust outcomes to ensure payments truly match outcomes.
|12. Ensure the whole of the board makes a final decision on remuneration for the CEO, not just the remuneration committee.
|13. Explain in disclosures why your remuneration strategy aligns with the company’s strategy, addresses risk and is “fit-for-purpose”.
|14. Ensure only independent directors sit on the remuneration committee.
|15. Appoint directors with expertise in risk, finance and contracts, as well as experience engaging with remuneration consultants.
|16. Instigate “cross-pollination” between board committees, such that at least one remuneration committee member also sits on the audit and risk committee/s.
|17. Avoid appointment of the chairman to the remuneration committee if there is an alternative.
|18. Where required call in expert advice from HR or the General Counsel for engagement with remuneration consultants.
|19. Implement a feedback loop to measure the performance of new remuneration structures, investigating:
|– What behaviour was expected when the pay plan for an individual or group was devised?
|– What behaviour was realised by this individual or group?
|– What changes were made that might have caused a divergence?
|– What changes were made to address this divergence?
|– How might someone game our compensation plan?
|– Does our pay plan confer the same message as our corporate value statement or does pay send contradictory messages that may override our desire for behaviour?
|– When above-expectation performance has been realised, what were the reasons that things went so well?
|– When below-expectation performance has been realised, what were the reasons for that?
|– What were the sources of any unexpected volatility in risk-adjusted KPIs?
|– What measures indicate that our risk culture is consistent with our expectations?
|– Does the feedback from the organization’s social network indicate behaviours consistent with our expectations?
|– What avenues are available for escalation of concerns regarding behaviour and have they been utilised?
|– Are all KPIs risk-adjusted and do they continue to be relevant for our goals?
|– How are KPIs independently validated?
|– Where there has been a risk event, was our compensation plan a leading driver? What role did our compensation philosophy and plan play?
|– What continuing education do members of the Compensation Committee and senior executive team undertake with regards to risk-adjusted pay governance?
|20. Agree on a ratio for incentive pay to base pay and percentage increase for total pay for any one individual or group that, if reached, will mandate a review of the relevant plans.
|21. Build sunset clauses into remuneration plans that force remuneration committees to seek areas for improvement.