This time each year we dust off our crystal ball to provide our outlook for director and executive remuneration. The ball is very cloudy this calendar year of 2021 – indeed we would not be surprised if future historians dub the COVID-19 years “the Great Uncertainty”.
The economy and pay
The Australian economy, although shaken by COVID-19, appears to be strengthening, with the Reserve Bank of Australia forecasting 2021 GDP growth of 3.5%. The economy is expected to hit its pre-2019 GDP level by mid-year, which is 6 to 12 months earlier than initially expected. This has been assisted by quantitative easing, with government bond purchases increasing money supply.
The Bank indicated that lower interest rates will probably remain beyond 2024. This will reduce headline returns required for the same risk-adjusted returns. This may present some communication challenges for boards setting reasonable capital efficiency and EPS growth targets aligned with these risk-adjusted returns, as they try and educate less financially literate external stakeholders influencing remuneration report and equity grant votes. The cheaper money for longer will also provide fuel for M&A activity, as private equity (including superannuation fund partners) seek out arbitrage opportunities to buy rather than build reliable cash flow in a high asset inflation environment. Energy and telco utilities come to mind. This will be compounded by the removal of federal government JobKeeper support, revealing naked zombie companies as the tide goes out. These will mostly be private companies, given the disclosure transparency and capital raisings of listed companies. Nevertheless, there will be bargains to be had. It would behove boards to review equity plan change-in-control provisions to ensure management are aligned with the best interests of shareholders such that PE companies get less of a bargain.
The quantitative easing will impact exchange rates. But the FX advantage will likely evaporate over time under the weight of US dollar declines based on the US Federal Reserve’s determination to keep rates low for longer. Coal, wine, oil and gas exporters suffering from excess capacity and low demand are not likely to do well (although oil and gas will likely improve from prior). Some agribusinesses, such as meat exporters, are suffering from low levels of supply as a hangover from drought. Other major Australian exporters in agribusiness and metalliferous mining companies should do well given bumper production and high global demand.
Unemployment, while declining, will remain above the 20-year average. Average wage increases will remain low. It follows that so will executive pay. In fact, given higher executive turnover during the pandemic and replacement with internal appointments, market levels of fixed pay increases should remain below that of average employee pay increases. To an extent, the rate of fixed pay increases will be influenced by 31 December and 31 March FY21 FYE disclosures, which will reveal a higher proportion of ASX 300 company executive fixed pay freezes than usual. This lag effect will be a drag on fixed pay increases in calendar 2021.
Last year CEO fixed pay barely moved with an increase of 0.3%. Forty-eight percent did receive an increase, 25% were frozen, while 27% received a decrease, according to disclosures (see HERE). Given that some fixed pay increases occurred after the FY2020 FYE, we expect the proportion with reduced fixed pay is actually higher, based on our separately maintained COVID-19 pay adjustments database (see HERE).
Most appointments to executive positions have been internal promotions. The trend increased in 2020 as companies became risk averse with COVID-19. This is expected to continue.
Given the ravages of COVID-19 will not allow many ASX 300 companies to re-attain 2019 peaks until well in 2022 or 2023, the same is likely to hold for executive fixed pay. Low levels of average weekly earnings increases, and negative proxy adviser and investor sentiment, should keep a tight lid on pay adjustments. So expect modest, or no, executive fixed pay increases in 2020 on an overall basis.
However, there will be significant variation by industry and company, depending on the extent of COVID-19 headwind or tailwind and exceptions in industries that are hot for talent. For example, there are no signs that the money pouring into high technology will slow, despite bubble like valuations. Fixed pay increases will remain above average.
All sectors and the industries within them face as much uncertainty coming out of COVID-19 as going in. That is, those that received a free kick and coasted on COVID-19 tailwinds, such as electronics retailing, most technology companies, pharmaceutical and healthcare companies and others, will have to develop incentives plans to prepare for a soft landing. Others hit hard by COVID-19 will have to judge the extent and rapidity of recovery, and fine tune incentives accordingly. For some plans will need to accommodate and reward agility and responsiveness. For others, it may pay off to reward riskier bets that use the cheap money and high stock valuations to make those acquisitions and investments now to get the jump on regaining more than their original market share. For most industries, new technology has revealed new horizons, while for some it also presents competitive threats. This raises the stakes for most industries.
Unfortunately, most standard incentive frameworks are not very good at encouraging big bets, agility, and risk-taking.
Executive incentives – ESG factors
Demands from large institutional investors to pay more heed to ESG factors are persistent and growing. BlackRock wants companies to disclose plans for how they will adapt to a net zero economy, while State Street has elevated diversity to new heights of concern such that it will be a factor in director votes from 2022 (see HERE). Australia already is a world leader in terms of paying for ESG and other non-financial outcomes (see HERE). APRA’s new CPS 511 regulation will see even greater emphasis on non-financial factors, at least for APRA regulated significant financial institutions (see HERE).
Again, incentive frameworks fail. The great majority of incentive frameworks do not accommodate the longer term and sustained spend required to transition to a net zero economy, reduce scope 2 emissions or deal with the likelihood of a permanent +1.5 degree or more warming of the planet and the customers upon it. This is further complicated by the many external stakeholders who would rather have a buck today than the planet tomorrow. Assuming a continued policy void by the federal and some state governments, this presents a dilemma for company boards and management. So far it has been accommodated by recognising ESG progress in annual incentive scorecards. Attempts to recognise the need to move to net zero in long term incentives has not received support from significant external stakeholders despite the likes of BlackRock and others. However, as banks, insurers and superannuation funds are clearly exposed to climate risks, and the APRA regulation as it currently stands requires the LTIs of covered financial institutions to reward non-financial requirements, further precedents may be set this year if not certainly next.
However, traditional incentive frameworks do not accommodate strategies that take more than 3 years to bear fruit. Guerdon Associates will consider the APRA regulation and alternative frameworks in the coming issues of our newsletters. But do not expect a great proportion of companies to present innovative incentive solutions in 2021.
Following compliance failures in financial services and the Hayne Royal Commission’s finding that boards failed to exercise their discretion to forfeit executive incentive payments, all banks and most other larger financial services companies have adopted consequence management frameworks. In effect, these are structured guidelines that identify to whom malus and/or clawback should apply, and to what proportion of the incentive.
The outcome, as observed in bank remuneration reports, are descriptions of the extent that executive and the broader employee populations have had pay docked, and/or services terminated.
Larger non-financial services ASX-listed companies have also started to develop and apply similar frameworks. Those that have not will gradually follow suit, as will become evident in some 2021 disclosures. Unfortunately ASIC’s release of its finding on remuneration governance in 21 of the ASX’s largest listed companies (see HERE) was put on ice given that the COVID-19 pandemic diverted ASIC resources away from providing one on one briefings to the companies that participated. Moreover, given the passage of time since the research was undertaken, ASIC is wrestling with the best way forward. In the meantime, Information Sheet 245 (see HERE), provides some guidance.
A logical way to address the Great Uncertainty accompanying COVID-19 and its aftermath would be to make provision for more discretion in incentive plans. Despite the logic of positive as well as negative discretion, it will only be acceptable to external stakeholders if such discretion is negative.
This has implications for remuneration framework design that several of our clients are incorporating. Other ASX-listed entities that have not considered this will need to contend with undesirable choices as the Great Uncertainty of 2021 and 2022 unfolds.
As several companies found last season, paying an executive incentive while pocketing JobKeeper payments was not acceptable to proxy advisers and many investors. Despite some industries pocketing government support delivered over decades via other means (diesel rebates spring to mind), and the fact that some companies could have delivered better financial outcomes by not accepting JobKeeper and not employing people, there is no way external stakeholders will change their views. In fact, they have hardened. There is now an expectation amplified by global government and social media commentary, that profitable companies should pay back any COVID-19 specific support prior to considering executive incentive payments. Some ASX-listed companies have already flagged they will. Hence, we would not expect any boards to approve executive payments in 2021 which have benefitted from any JobKeeper payments, except for those that have paid it back.
Restricted shares have been around for 100 years. They are a grant of shares, or Restricted Share Units, that vest with continued service, or over time, and are not subject to explicit performance requirements. All of the world’s largest technology companies provide them. Many of the ASX 50 provide restricted shares to executives and other employees fortunate enough not to be disclosed as Key Management Personnel. About 25 FTSE 500 companies have restricted shares for executives. Last year saw new grants by a few well-regarded ASX-listed companies of executive KMP restricted shares, or RSUs, including CBA, Origin Energy, Boral, Vicinity, and Zip, with mixed results.
There are several reasons to consider executive restricted share grants for some companies. Likewise, there are many companies and situations whereby restricted share grants are unnecessary, and/or difficult to justify. This will be an area of focus for us in forthcoming articles. But, for now, applications of restricted share grants to executives facing the Great Uncertainty may be legitimate and appropriate. For those considering this path, be aware that proxy advisers and investors lag in their thinking, not yet connecting such things as market, technology and ESG uncertainties with alternative remuneration frameworks that work better for aligned long term outcomes.
Nevertheless, we expect a few more restricted share plans in 2021 and following years.
Proxy advisers and institutional investors will continue to have a moderating influence, but their policies will remain suitable only for the slow-growth, less volatile ASX 200 companies. The proportion of these in the ASX 200 are diminishing under the weight of market gyrations and new technologies. But it is difficult to see how proxy advisers can easily amend or invest in their business models to become more nuanced in making judgements on whether to support remuneration policies and executive equity grants.
Despite this, remuneration structures that moderate risk necessarily have to differ from those that focus on entrepreneurial growth. Both sorts of structures have been and will continue to be evident given the dispersion of investor money spilling into both buckets.
Board fee increases
The FY20 median increase in remuneration was 0.43% for chairmen and 1.63% for other NEDs from disclosures (see HERE).
Given the Great Uncertainty, FY21 NED fee increases should be similar, between 0.5% and 1% for chairmen and NEDs. However, there will be a significant variation in ranges of increase. A significant proportion of the ASX 200 benefitted from COVID-19 tailwinds. With growth comes complexity and the need for skilled and knowledgeable NEDs. For technology companies this will often require overseas-based NEDs in markets providing more lucrative fees for less work in the same time zone. These same companies will take a lead in providing equity in lieu of cash fees as is de riguer in the US technology sector, but currently only emulated by a few non-technology ASX 300 companies.
Other boards have had to temporarily work extraordinary hours to respond to market challenges during COVID-19. So some will receive fees reflecting extra exertion outside of policy. Most will not.
There is no indication that rates of NED increase will change significantly.
2021 will be a challenging year. This will not just be because many executives and directors will face another year of frozen fixed pay. Rather it will be about developing and implementing meaningful executive pay frameworks that work; that adapt to uncertainty, that align executives’ needs with those of the company and its shareholders, that respond to short-term opportunity and challenges, while dealing with company viability for a term beyond the usual 3-year long-term performance measurement cycle.
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