The lot of Australian board directors seems to have become decidedly more difficult in recent times, with CLERP 9 raising investors’ expectations of board performance.  Among the reforms is the requirement that shareholders have a non-binding vote on director remuneration reports.  But will this new requirement actually result in improved remuneration practices, or limit the rate of pay reform that Australia has experienced without it?

Over the past 15 years Australian director and executive pay practices have evolved for the better.  In fact, compared to other Western countries, these pay practices should please investors.  Director pay is, in the main, structured to ensure directors focus on their fiduciary duty without being overly distracted by the consequences of board decisions on their personal annual reward or retirement income.  Executive long-term performance pay is, generally, reliant on truer shareholder value measures than counterparts in the USA, Canada, and the UK.  Australia was among the first Western countries to adopt international accounting measures requiring share based reward to be more validly accounted for and disclosed.  Regulatory and compliance burdens on Australian executive and director remuneration are relatively light even with the advent of CLERP 9, allowing more flexibility and lower compliance costs.  And to top it all, our directors and executives are, relative to other Western country counter parts, good value!  

So, you may think, Australia does not rate too badly.  On balance it does not – but that does not mean that executive pay practices should stop evolving.  If anything, executive pay reform must accelerate.  This is because it is a competitive world, and lately the US, Canada, Germany, the UK and many other countries have taken active steps to improve executive and director pay practices and disclosures.

In reviewing recent Australian remuneration disclosures of Australia’s top 200 companies, what is clearly evident is a pay practice that belies Australia’s economic coming of age over the past two decades.  That is, Australian executives are rewarded for taking the safe route.  With over half a CEO’s pay guaranteed in salary and benefits, a quarter for annual performance, and about 20% of pay as reward for longer term performance, there is just not enough at stake (on either the upside or the downside) for Australian executives to stick their necks out.  Compare this with our competitors for capital and talent.  Only a third of a UK CEO’s pay is guaranteed, and in the US it is much less than 20%.

In calculating a risk and reward trade-off, our CEOs could be forgiven for preferring to do only what it takes to keep their jobs, and that’s all.  In contrast, a UK CEO is oriented to taking more calculated risk every year because the majority of his/her pay rides on his/her performance. While it is an exaggeration to say that the US CEO is oriented every year to break the bank at the corporate roulette table, the scale of entrepreneurial risk taking seriously considered and often taken can be breathtaking.

You can readily see the results.  Over 10 years US shares have delivered the highest return (for higher volatility), followed by the UK, with Australia bringing up the rear.

So, while many Australian companies may have many of the performance measures right, they are nowhere near offering executives enough carrot to make exceeding targets economically meaningful.

Should Australia continue to encourage our CEOs to minimally satisfy (the current model), deliver an optimal return balanced by reasonable risk (the UK model), or go for broke (the US model)?  Given that investors diversify their stock holdings to minimise risk, the correct answer is one of the last two alternatives, and most certainly not what we have right now. 

How to get from here to there will not be palatable to many.  While there may be some flexibility on the part of some executives to accept lower guaranteed pay in exchange for much enhanced at risk pay, behavioural economists tell us that human beings do not volunteer for more risk – even for much greater reward.  Therefore, the most likely method of achieving more entrepreneurialism is simply to pay more and make sure that the increase is in the at-risk component of pay.  And herein lies the conundrum.  To better carry out their fiduciary duties and give investors what they want (that is, better overall returns), directors may be challenged on the means to get there.  That is, the non-binding vote on remuneration may face opposition if it means substantially lifting the level of executive pay opportunity. 

This solution may be readily acceptable if investors acknowledge that as the world’s 8th wealthiest economy (on a purchasing power parity basis) Australia ranks lower than 20th in executive pay.  Further, by lifting the cap on the pay of our best and brightest and ensuring it is even more meritocratic, this remedy may go some way to correcting the brain drain that is currently limiting Australia’s economic potential.
 
Investors in Australian public companies should be pleased with how our executive and director pay practice and disclosure has evolved over the past 15 years.  But to improve investment returns and overall growth we must tip the economic balance to ensure CEOs and their executives have more to lose by not being entrepreneurial.  Ensuring a higher proportion of executive pay is at risk will go some way to achieving this.  Negotiating the path to get there will test the leadership skills of many directors.  But it is a necessary task that will ultimately greatly benefit their shareholders.

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