This article dusts off our crystal ball and presents our outlook for director and executive pay for calendar year 2017.
The economy and pay
It appears that the economic cycle is turning. Higher commodities prices, employment, business investment, effective interest rates and eventually inflation will shift more capital into growth stocks and away from yield stocks. While this may take some years to roll through, it has implications for executive pay adjustments, which, if you can see through the fog of distorting regulations and guidelines, remains a matter of supply and demand. That is, more investment into growth and commodities companies will mean higher executive demand, and higher rates of pay in those industries. Conversely, relatively less investment in real estate, infrastructure, health care, and consumer staples will see reduced executive demand, and lower rates of increase in executive pay than last year.
The economic adjustments have implications for the nature and type of incentive arrangements. Generally speaking, higher growth opportunities are best facilitated with a shift in the remuneration mix to a higher proportion of shorter term incentives. However, getting in early and staking out shares of growing market segments carry risks that can be offset with deferral into equity. Capital efficiency measures, while always a good proxy for economic value added, may be subject to too much “noise” for companies pursuing high growth that includes acquisitions. EBIT growth and sales margins may tend to take on more importance in these growth sectors.
Vehicles of pay
More market volatility, and higher interest rates, will make equity compensation more expensive than our recent lower growth, low interest rate and lower volatility past. That is, all else being equal, executives will receive fewer rights, options and share appreciation rights (SARs) for each dollar of remuneration. All we can say is that miners and energy companies, and others, had their chance (see HERE). This will be offset, to an extent, by commodities industries being able to pay a bit more cash than they could have afforded in recent lean years.
We have seen several recent examples where advisers suggested their high growth clients consider share options and SARs. Unless you are a private company, you may want to reconsider. Capital will be flowing into higher growth companies. P:E multiples will be high, with growth fully factored into share price. In the war for talent that is already happening within these industries it may be wise to consider better vehicles of payment.
Lower growth companies focusing on capital efficiency and yield will need to consider payment vehicles that do not discourage dividends. Unfortunately, most use vehicles that ignore dividends. We have seen little evidence of boards, their advisers or their investors waking up to this, and do not expect much change in 2017.
Less investor trust facilitating the road to simplification
Last year’s beginnings of a broader discussion of “risk tolerance and incentives”, which was a welcome development given 7 years of focussing on “risk minimisation and incentives” has been derailed. A 2016 proxy season of high “no” votes demonstrated, to an extent, how ill equipped both boards and investors are in communicating and understanding complex “risk and return” alternatives, and how these are, or are not, supported by executive remuneration frameworks. The mantra of “simplification” has taken hold. This will see the dumbing down of incentive structures. This is already evident at the smaller end of the ASX 300, and will be moving its way through to the ASX 200 during 2017 and over into the next few years. Expect to see fewer incentives based on sustainable longer term performance, (i.e. LTIs), and more incentive paid for short term results, dressed up with deferral to simulate an LTI.
The curtailment of trust, especially by proxy advisers and investors, arising form the last proxy season will have an impact over 2017 and 2018. This will not be overcome by a sudden increase in proxy advisers and investor governance resources. They will remain constrained in their competence to understand complex business and remuneration issues during one of the OECD’s shortest proxy seasons. The easiest way out is for boards to dumb down the remuneration framework applicable to executives and work on the remuneration report to explain only what is necessary to get boxes ticked. Mind you, given the diversity of investor guidelines, that is still a fair few boxes.
The simplification process will show in more stark relief the relatively high 2017 rates of “catch-up” pay increase in some industries that will need to be explained. It is always a challenge to demonstrate sudden changes in supply and demand when not all disclosures are out. Let’s hope investors and proxy advisers have a soft spot for miners and energy producers.
The maturing of the market in understanding the application of relative TSR measures continues. That is, there is an acceptance among investors that relative TSR is good for some companies’ long term incentive plans, and not for others. 2017 should see more boards considering whether, or if, the form of relative TSR incentive remains an appropriate incentive, and compare it to alternatives. More companies will reduce or replace incentives contingent on TSR.
The consideration of non-financial measures for long term incentives is likely to take a step back as a result of the CBA’s attempt to introduce one last year. Despite this, boards should not discount this alternative altogether if it is “fit for purpose”. Such measures, if fit for purpose, and configured and disclosed appropriately, are likely to be supported by the majority of institutional investors, proxy advisers and regulators (such as ASIC and APRA).
There were more IPOs in the previous 2 years, and more planned this year, of companies with high growth potential. Their emphasis is often to rapidly escalate revenues for early market share, while generating enough cash internally to support this. These new darlings for capital will focus on EBIT and sales, and less on capital efficiency measures. While fit for purpose, their boards will need to engage with investors to educate their hard pressed governance officers of measures they are less accustomed to seeing in LTIs.
Lower growth industries (consumer staples, banks, insurers, and manufacturing) will maintain a focus on capital efficiency.
Pressures on STI measure disclosures have seen an improvement in not only disclosures, but also the measures used. More boards are getting this right, and setting an example for the still many laggards with work to do. These have become a target for proxy advisers and investors as more issuers have “broken ranks” and are disclosing more. STI performance measurement sophistication, disclosure and review will all show improvement in 2017. Remuneration committees should look over the shoulders of their best-in-class competitors and see how it is done, and catch up.
More ASX 300 companies were stung in financial year 2016 than in 2015 with high “no” votes, despite more boards engaging. Clearly, something went awry. Hence, we expect last year’s heightened level of engagement to increase yet again. Companies should be sensitive to investor wariness. Feedback from last year was that investors responded to issues in disclosures that were not flagged in engagement sessions. Likewise, directors felt blind sided by proxy advisers and investors votes driven by issues they did not raise or sufficiently discuss at engagement sessions.
More companies in 2017 will conduct a 2-step engagement process: one to discuss likely changes in remuneration, and the other to discuss actual 2017 outcomes. Issuers should be wary of wasting proxy advisers’ and investors’ time, and hence their goodwill. While it is not uncommon for proxy advisers and issuers to suddenly take issue with an aspect of remuneration that has not changed from prior years, step up engagement if you have changed something in your remuneration framework.
2017 will see more boards seek out proxy solicitation advice from specialists in this field. Take their advice.
Board fee increases
Overall rates of 2017 non-executive director (NED) remuneration increases will be similar to that of executives (see below), noting that many boards do not yet adjust fees annually, preferring to “double up” every two years. Therefore, there will be a broader range of director fee rate increases than executive pay increases. That is, some increases will seem small, as these boards adjust annually, while others will be large, as these boards adjust every 2 or more years.
There have been instances of high increases in NED fees, particularly in APRA regulated entities, and these increases have been unrelated to executive pay increases. The drivers of generational change, higher workloads and complexity, and need for greater board diversity underpin these larger “outlier” increases. So far, there has been no notable investor pushback, providing sufficient explanations for the NED increases are provided.
Despite the absence of concern with individual director fee increases, there has been some investor push back on NED fee pool increase resolutions. These have been instances of large pool increases with an insufficient explanation on how the increase will be utilised.
Despite the ease, tax effectiveness and other advantages of providing director fees in the form of equity, few companies undertook to do this in 2016. There is no indication that this is about to change for 2017. Meanwhile, proxy advisers and investors will continue to focus on the extent of NED shareholdings while the means to more easily meet these requirements goes begging.
Executive remuneration increases
The rate of increase for 2016 is likely to be similar to prior years, with an expected median fixed pay increase of between 3% and 3.5%. However, this masks what we expect to be significant variation by industry and company as the cycle turns. Industries that may have “held back” in recent years will have their turn, and will see larger than usual increases, while the industries favoured in recent years will hold increases down. So expect to see many more instances of pay increase outliers than in prior years.
Overall rates of executive remuneration increases will also be closer to “same incumbent” increases, as executive turnover has slowed. This means that levels of pay are not going to be dragged down by new internal appointments on pay rates lower than their predecessors. This tends to coincide with each change in cycle, and presages higher rates of increase in the years immediately beyond 2017.
Significant movement is expected at the lower end of the ASX 300 as it changes membership, with stock re-ratings having an oblique effect also on executive remuneration.
2017 will be an interesting year as we witness the beginning of a change in business cycle also reflected in more diverse range of remuneration increases. Executive turnover will continue its decline, removing a drag on executive pay. Demands for “simplification” will see changes in remuneration frameworks, with smaller listed companies leading the way. The remuneration mix will head back to more short term pay, but more companies will be more rigorous in setting STI performance requirements and deferral. Mutual trust between issuers and their investors (and their proxy advisers) will be at a low ebb, and will see renewed attempts by issuers for more meaningful engagement. However, investors and their proxy advisers will remain constrained in their resourcing to cope with the unusual, complex, or, to an extent, just changed, remuneration practice.© Guerdon Associates 2022 Back to all articles