There are still uncertainties, and more volatility is still possible, but the global economy is stabilizing.  While western economies will continue to experience slow growth, Australia’s Asian neighbours will continue to power ahead.  Locally, this will entrench a three speed economy. Companies exposed to Asia and commodities will enjoy high demand for their products and services.  Sectors with strong fundamentals, such as health and education, will continue their good runs.  But other sectors with operations concentrated in the south east of the country will have a tougher time of it. 

 

Finance is and will continue to be easier to come by than in the recent past, but at a cost.

 

Regulation is a quagmire, and becoming worse.

 

But more problematic for most companies, and taking top spot from capital management issues, is human resources.

 

This article takes these trends into account in dusting off our crystal ball, and presents our outlook for non-executive director and executive pay for 2011, and what needs to be done to facilitate achievement of tough shareholder earnings requirements and expectations.

 

The big issue for the foreseeable future – human resources

 

Throughout the GFC most Australian companies kept one eye on the future as they wrestled with the immediacy of capital restructuring – they hung on to their employees.  In hindsight the judgement exercised by most boards and management has proved to be right. 

 

The long term skills shortage is beginning to bite hard.  Company operations, prior to being delayed by bad weather in much of the country, were impeded by skill shortages.  The skill shortages have been exacerbated by poor government immigration policy (not helped by opposition posturing during the 2010 federal election) and reaction to business needs.  In addition, government policy in industrial relations, taxation, remuneration, safety, education and training, and regulation generally (see below) raise additional barriers to effective recruitment, remuneration, employee mobility, and productivity.

 

While many are focussed on recruitment, it is probably employee productivity that is the key to meeting company earnings targets.  Understandably, this suffered the most both pre GFC, as companies geared up for capital investment with a consequent lag in employee productivity, and during the GFC, as companies focussed on capital restructuring with expensive equity injections, while hanging onto staff in the face of volatile earnings.  But over these years some companies’ human capital management practices have become lazy.  Many companies have already invested in new technologies that have the potential to increase human productivity but others have not awoken to the possibilities. Yet others are structurally moribund, not capitalising on opportunities to focus their people on higher value work while outsourcing lower value work to cheaper human resources offshore.

 

Added to this mix is the new ASX listing requirement that boards report on diversity objectives and progress (see below).

 

If it is not already, this diversity needs to become a board issue.  Traditionally humble board remuneration committees are punch drunk, still reeling from recent legislative assaults, and steeling themselves for more (see below).   But for many companies it may be time to review the remuneration committee’s charter.  Look ahead. Move beyond compliance.  The fact is that the remuneration committee is probably one of the most significant areas of board focus where value can be added, change adopted, and expectations raised.

 

And as a second step – keeping in mind the overarching goal of improving employee productivity, start measuring it.  Set targets.  Review management plans for achieving it.  Approve pay plans that reward this.  Make sure not only that human resources is not the reason for meeting earnings expectations, but for exceeding them.

 

Hence the challenge for board remuneration committees is get off the compliance treadmill.  There is value there to be had.  Seize it.

 

What to do about that regulation treadmill – the board remuneration committee challenge

 

It is becoming difficult to see how any board remuneration committee can have time to do anything but focus on compliance, but precious time needs to be found to concentrate on aspects of material consequence for their company. 

 

Were it so easy…

 

In recent times remuneration committees have had to respond to government regulation requiring the committee to:

 

·          Amend policies so that they no longer receive their fees in company shares due to tax regulations that made fee and salary sacrifice for stock impracticable

·          Amend all employee equity plans to eliminate, curtail or amend share option plans to better comply with new taxation (see HERE)

·          Comply with new committee membership and pay risk management requirements if the company is APRA-regulated (see HERE)

·          Ensure all new executive employment agreements comply with new termination pay provisions (see HERE)

·          Figure out what can be done with existing executive remuneration within the framework of pre termination pay regulation contracts

·          Scramble to review the impact of new tax for temporary expatriates on shorter term assignments (see HERE)

·          Develop new KMP and insider trading polices that take account of blackout windows, among other things

·          Consider diversity policies and measure and report on diversity progress (see HERE)

·          Review and perhaps change committee membership if an ASX300 company (see HERE)

 

If new government regulation proceeds (see HERE), the remuneration committee will need to:

 

·          Ensure mechanisms are in place to claw back pay once it is paid in case there is a financial restatement

·          Directly appoint all external advisers where their advice may peripherally touch on the remuneration of KMP

·          Receive that advice personally, and then forward it to management for review, comment, implementation, or action as required

·          Review all remuneration advisers with a view to ensuring advice only comes from unconflicted advisers (i.e. those that are not employed by management), or run the risk of investor ire when fee disclosures are made

·          Ensure KMP do not vote undirected proxies on remuneration resolutions

·          Ensure all proxy holders vote directed proxies on remuneration reports

·          Change the company constitution to comply with “no vacancy” rule requirements

·          Individually have a good sit down chat with the whole family to explain how dad/mum/uncle/aunt/cousin/brother/sister/son/daughter/step child/grand child and Great Aunt Agatha could have said board member branded a criminal if they exercised certain proxies, hedged their superfund’s investments in the company, or voted on a remuneration resolution.

 

That is not quite all.

 

The government’s response to the CAMAC report (our bet is in late March/April, so that responses can be sought from stakeholders over their Easter break…) will probably require a bit of change in how the remuneration report is constructed.

 

Short of volunteering to transfer to the audit committee for a rest, what can the remuneration committee do to avoid suffocating under the regulatory avalanche?

 

1.     Seek advice.  You will need two primary advisers:  management, and an external remuneration adviser.  While you should be concerned that you may be overwhelmed with clerical duties associated with contract administration under the government’s exposure draft of legislation, we cannot see that the prescriptive aspects of the law will get through the combined forces of the business and investor groups howls of protest, a minority in the lower house, and (until June at least) a finely balanced Senate.

2.     Establish a firm process and policy that recognises and manages the conflicts of interest associated with all your advisers, external and internal.

3.     Ensure each agenda has one prominent item that focuses on the enormous value that can be unlocked from more effective human capital management, and that measures progress on its productivity

 

With the overwhelming workload implications of additional regulation we hesitate to suggest that board remuneration committees do one more thing in response to regulation.  But we will.  Consider an active, director level government relations process.  We have observed the same names trying to take on a heavier load, with various representative bodies having to cope with more using the same resources.  Please consider helping them, and thereby yourselves and your shareholders.

 

Non executive director pay

 

Ok.  We were wrong.  As an internal exercise we review our prior predictions each year.  We have always been right.  Until now. 

 

We observed the huge regulatory build up on NED workload.  We also observed the challenges faced as board’s resolved capital restructuring issue in the wake of the GFC.  We observed the significant differences between NED pay and executive pay, and a widening gap in the multiple of CEO to chairman pay that exceeded historical norms.  So we figured that NED pay had to go up to compensate.  It did not (see HERE).  Not even a smidge.

 

We were right in that many companies moved to increase their fee cap, given their headroom was limited.

 

So this year.  Yes.  There will be an adjustment in NED pay.  But it will be inconsistent.  So overall movements will be modest.  Perhaps in 2012 there may be more consistent growth.

 

“Independent” consultants

 

Last year saw many listed companies appointing “independent” external remuneration consultants.  Given the disclosure requirements that will survive the government’s re-drafting of the exposure draft legislation, and the likelihood that investor and proxy advisory firm guidelines will be amended to take this into account in the following proxy season, we expect that this trend will accelerate.  This will become evident as some companies start to disclose in this reporting season in advance of the new disclosure requirements.

 

For those remuneration committees yet to appoint an independent remuneration adviser:

 

·          Consider current conflicts of interest in sources of advice

·          Define independence requirements for an external adviser that goes some way to managing these conflicts

·          Appoint, or re-appoint, an external adviser that meets these requirements

·          Consider a committee process to best utilise this advice.

 

Performance measures

 

Finance is now available and in greater variety, and becoming more so.  But it will still remain expensive.

 

We were right in prior predictions during and post GFC that the focus was on capital management in terms of capital efficiency and cash flow.  Operationally this required many companies to trim their sails, and watch their expenditure and use of working capital.

 

Capital management will remain important, with key decisions on fat balance sheets that are not delivering the required returns still to be grappled with.  The performance measures applied to management will have to balance the extent to which directors think some excess capital can be returned safely to shareholders, and how much extra earnings they can wring out of human and fixed assets.

 

The result could see some companies refocus on earnings per share growth, if they see opportunities more in earnings growth, or stay with a return on the overall or weighted average cost of capital if they see further opportunities for better capital management.

 

Most companies outside of the resources sector will have adopted multiple LTI measures.  We note that many financial institutions have retained relative TSR as a measure despite APRA guidelines highlighting the possible undesirable and perhaps unintended consequences of using just relative TSR.

 

Some “softer” measures may re-appear or take greater prominence as a result of two factors:

 

·          Environmental, social and governance (ESG) factors guiding investment decisions of some institutional funds.  While this is primarily an overseas trend, it has maintained pace during the recent global slowdown.

·          Greater confidence that capital aspects are under control. The impediments to growth, or if you are not in a resources related industry, maintaining current earnings, is scarcity and productivity of human capital

 

In addition, given the emphasis to report on diversity, and the fact that some companies are seeing diversity as part of the answer to ease skill shortages and lift productivity, diversity measures will need to be seriously considered in management performance and reward plans.  While these are important, they should be measured and rewarded within an “envelope” of financial results.

 

Shareholder engagement

 

This is a big issue: the two strikes rule, despite the protestations of business leaders, will become fact in the 2011-12 year.  The challenge has been laid down for companies to win the communication battle with as many shareholders and other stakeholders as possible.  While much has been achieved on this front, boards of Australian listed companies will still be doing more to engage with their shareholders and the proxy advisory firms.

 

We have continuing concerns whether the system can cope.  Australia only has two proxy advisory firms and they, as well as other bodies such as ACSI, have resourcing constraints. So the many boards ramping up their engagement to test revised executive pay arrangements will have to book their consultation windows early.  In particular, companies at the smaller end of the ASX 300 often have remuneration challenges that defy use of boilerplate methods to respond.  These need to be understood.  But it may be hard to get a look in.  While the smaller companies are part of investor benchmarks and hence investment targets, they will not command the same attention from these stakeholders as the ASX50.

 

It may be worthwhile for the remuneration committees of the ASX committees ranked between 101 and 300 to engage a remuneration adviser who is in constant touch with these stakeholders.  It can save time, and a good adviser would also find time to test a non standard approach with stakeholders in association with their regular contact.

 

Levels of executive pay

 

Last year the overall ASX 300 chief executive pay increase was 2% in fixed pay and 5% in total remuneration (see HERE).  But is was a mixed bag with almost 40% of CEOs receiving a decrease overall.  Overseas sourced executives have been easier to recruit because of the GFC, and the high local currency makes them cheaper, so contributing to moderate increase levels.

 

This year will see a slightly greater increase.  But the level of increase will be constrained.  Many companies are still struggling to get decent returns, and while returns will improve, it would be difficult to justify to shareholders any significant increases in pay in light of this.  Bonuses, as with last year, should be the source of most increases.

 

Levels of stock grants will not increase.

 

A trend to different structures, while not pronounced, should be discernable over the next few years.  More companies are deferring bonuses in equity.  This requires a bit of cost and administration (we would not bet on the government implementing facilitating regulation!), which has so far confined its adoption to the larger companies.  To pay for bigger, but deferred, bonuses, long term incentives are being reduced.  While this may be an overseas imported “governance initiative” on the back of the GFC, its often misguided application in the Australian context requires each board remuneration committee to proceed with caution.

 

Concluding remarks

 

Last year was a better year for companies, just.  This year has its challenges.  Not least will be preparing for and responding to regulation.  But there remain opportunities to add value by tweaking performance measures, and focussing on employee productivity.  NEDs may have to put in more leg-work engaging with stakeholders.  The remuneration committee will have to rely on new, more independent, external advisers.  While this may not be welcome, grasp it as an opportunity and make headway on higher value opportunities.

 

So, from Guerdon Associates, good luck for 2011!

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