Should a good leaver’s long-term incentive be pro-rated?

This article considers principles and a checklist for the board review of leaver remuneration.

It is widely accepted the objectives of a remuneration framework are to attract, retain and motivate the executives (strangely, something that the ASX Corporate Governance Council’s new recommendations have overlooked – see HERE).

The purposes of the total remuneration opportunity with components of fixed pay, short term incentive (STI) and LTI include:

  • Pay market based fixed pay for the position;
  • Ensuring executive focus is on board-approved annual objectives, both financial and non-financial; and
  • Ensuring executives make decisions and invest for the future to maintain and grow a sustainable long-term business.

Boards and remuneration committees spend much time on succession planning for CEOs and senior executives and, on cessation of employment, necessarily consider the treatment of the variable components of pay.

A fundamental question often asked is, should the good leaver’s unvested incentives be pro-rated? And, to what extent?

Here are some guiding principles:

  • A company’s interests are best served by the CEO, and other executives, focusing on both the annual and long-term board-approved strategy and objectives.
  • Strategy will typically include capital investments for a sustainable, long-term future for the company. The capex is for performance improvement and returns.
  • LTIs are granted annually as one component of the executive’s total remuneration opportunity. Sound corporate governance dictates there should be no barrier to succession planning and a continuing focus of the executive on the longer-term objectives. This implies that, on cessation, unvested LTIs will remain on foot, be tested against performance requirements and vest accordingly.
  • Companies may have policy positions like:
    • Default forfeiture of all, or a portion of LTIs on cessation of employment; and
    • Not granting an LTI in the year of cessation.
  • These policy positions present governance and behavioural challenges. Where executives have notice periods of up to 12 months and know the default position is a loss of some or all unvested incentives, their focus can turn to maximising short-term outcomes. In this context, executive tenure with a company is typically no more than 5 or 6 years. Executive decision-making can turn to a focus on maximising short-term cash earnings. How often do boards hear that executives do not value their LTI? This is not surprising if there is a policy position whereby it is lost on cessation of employment. What does an executive focus on during their tenure – 5 STI payments or 1 LTI vesting? No wonder things fall in a heap after an executive’s departure.
  • If executives know their LTI will remain on foot and be tested in the normal course, provided they are a good leaver (which itself needs to be carefully defined), they will give more weight and focus to the long-term objectives than what might otherwise be happening.
  • Policy disclosures on treatment of unvested incentives on cessation of employment require much thought. It can be easy to default to the proxy adviser and some investor positions of full or partial forfeiture. Those positions are often not fully considered from a governance and behavioural perspective.
  • A default policy position for incentives remaining on foot to be tested in the normal course, with board discretion to forfeit having regard for the circumstances, is founded in sound governance and behavioural science.
  • Proxy advisers, institutional investors and boards will often say that the LTI is structured to retain key people. It will not be retentive if executives know they will lose all or some on cessation of employment.

Here is a checklist for sound remuneration and termination governance. What remuneration best:

  1. Fosters long-term decision-making by senior executives and removes the potential for a stronger focus on the STI outcomes?
  2. Removes one of the barriers to effective succession planning?
  3. Puts more value into the LTI and can change the view of executives that unvested LTIs have little or no value?
  4. Improves the retention effect of the LTI because it is valued by the executive?
  5. Makes the company internationally competitive for talent?
  6. Ensures any negative discretion is not a termination benefit?
  7. Increases the alignment of executive and shareholder interests?
  8. Enables malus should it be required?
© Guerdon Associates 2024
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