This article takes dusts off our crystal ball, and presents our outlook for non-executive director and executive pay for 2013.

 

The Australian resource investment boom has peaked, and is no longer underpinning economic growth. This means the near term outlook for many industries will be impacted by the need for structural adjustment. Revenue growth for most of 2013 from domestic consumption, or business investment, will be absent. The focus will remain on cost control, productivity and operational efficiency.

 

Incentive plan measures and requirements

 

Many companies will continue to focus on capital efficiency, as they have for the past four years. But reduced financing costs will lower the cost of capital. So benchmark LTI capital efficiency requirements may validly be reduced. However, this may require a significant engagement effort to educate external stakeholders on why a lower cost of capital justifies lowering the benchmark for reward purposes.

 

Management will be under pressure to manage the business knowing that dividend yield has to be maintained, given that the share market continues to value higher yield stocks. To do this, management will be seeking to cut discretionary spending, at a time of mounting cost pressures from higher energy, labour, and transport charges.

 

Operating margins and cost controls will continue to feature in many short-term incentive plans. Expect to disclose much more detail to justify the STI outcome. Proxy firms have been demanding, and getting, the detailed KPIs and mechanics for STI payment for at least the CEO so that they can assess the reasonableness of STI payments.

 

Some companies will be in a better position than others to consider acquisitions and divestments. With lower debt financing costs, a strong currency, and more favourable equity markets, overall M&A activity should improve in the later part of 2013, into 2014. This has implications for incentive plan measures and benchmarks for companies in this position. Some may reflect this in the KPIs for short-term incentives. Others may factor it into the LTI EPS growth benchmarks impacted by initial dilution for acquisitions. Boards need to carefully consider the impact incentives can have on behaviour if their strategy actively contemplates the merger and/or divestment opportunities that may arise over the next 18 months.

 

More government regulation

 

The government has published draft legislation on clawbacks, disclosure of payments related to termination, and additional disclosures for “past, present and future pay”. The legislation will be effective for financial years starting on or after 1 July 2013. (see HERE)

 

The additional regulation presents many challenges that boards need to come to grips with.

 

While the legislation will only require disclosure of clawbacks, or their absence, in the event of a financial misstatement, many companies are already disclosing policies now. Ever increasing proportions of the ASX300 will voluntarily disclose clawback arrangements as external stakeholders revise guidelines to require it. So, while the chances of a financial misstatement are very slim, there will be pressure on boards to have arrangements and to disclose these on a voluntary basis. In turn, this will require changes to executive pay that may include extending vesting periods for STI and LTI payments beyond the point at which the performance requirements are satisfied. We expect that even companies with clawback arrangements in place will probably feel compelled to review these, and “improve” what is in place. Given that executives will resist change, implementation of any changes will need to be carefully handled. As it will take time to get everyone involved, including external stakeholders, across the line, make sure a decision on whether or not a review is required is near the top of your 2013 remuneration committee agenda.

 

The disclosure of payments given in connection with a person’s retirement from an office or position will include post-employment benefits, such as consulting fees. While this is not expected to be an issue for many companies, some may want to add an explanation to the amounts disclosed. This will require additional time and effort as remuneration reports continue to increase in length and complexity. While only required for the next reporting period, it may serve remuneration committees well to consider how such disclosures would look for the current year.

 

Which brings us to the additional disclosure of “past, present and future” pay. Each of these “simple” additional numbers will most likely need to be broken down into its component parts. Each will have to be explained. Each explanation will be related to policy outcomes. But the actual annual target pay that directors sign off each year as a result of policy is, after all this effort, still not revealed in any of the figures to be prescribed as  “past, present, and future” pay, or in the figures already required using the accounting standards. Fortunately, some companies have already provided excellent disclosures of actual annual pay and crystallised benefits. Before adding to shareholder frustration look at how some of these companies have handled it. Again, while not required until 2014, remuneration committees stand to learn a lot by having a practice run reporting on the new basis for the 2013 year. You may discover aspects of pay policy you can fix in time for when such reporting is compulsory.

 

If, as a director, this is beyond the pale or, indeed as an investor, it does not go far enough, you are welcome to take it up with The Honourable Mr Bernie Ripoll, MP, at our Remuneration Forum in March (see HERE). Mr Ripoll is responsible for the carriage of the legislation for the government, and after explaining why they are legislating this way, he will be very pleased to take your questions and comments.

 

Remuneration reporting and simplification

 

As illustrated above in relation to the disclosure of past, present and future pay, the government’s well-meaning initiative to simplify remuneration reporting has failed. Everyone that has had an input has only suggested more things to be disclosed.

 

2013 will continue to see lengthy remuneration reports. The length is driven not just by legislation, but additional information required by external stakeholders. There will be many companies experimenting with new formats to accommodate new laws that do not formally become effective until 2014. Remuneration committee directors will need, once again, to spend additional time coming to grips with the requirements, identifying and dealing with potential issues that could arise with the disclosures, and engaging with stakeholders to effect change and/or acceptance.

 

Pay deferral

 

While it originated with APRA regulation imposed on GFC-impacted banks and insurers, pay deferral has now become ubiquitous in large companies. Currently common in STI plans, deferral will probably also be extended to LTIs, by delaying vesting for an extra year after performance has been assessed (some stakeholders, such as ISS, already have this in their guidelines).

 

Driven by institutional investor checklists and governance guidelines, and new government disclosure regulation on clawback, expect the rate at which companies outside the ASX50 take up deferral to accelerate in 2013. Implementation issues associated with persuading executives to take home less cash in the year of implementation will impede the rush to take it up. But there will be no stopping it.

 

Investor focus on performance pay

 

ACSI has led a highly successful campaign to ensure STI payments are justified. Many ASX300 companies have experienced institutional investor wrath for providing easy bonuses on mediocre results. With more campaign success comes less institutional investor tolerance for unjustifiably generous bonuses.

 

In 2013, expect more pressure to disclose the detail of KPI targets, the results against those targets, and how these are translated into STI payments. If payments cannot be well justified, be ready with answers for improvements in the next financial year (and good luck with fending off a ‘strike’ on your remuneration report!).

 

Remuneration report “strikes”

 

It is clear that both institutional investors and board directors have gained confidence with the 2-strikes law. Institutional investors have almost universally admitted to Guerdon Associates that they will continue to assert their prerogative to vote “no” on remuneration reports. They are not following this up with a “damn the consequences” comment. Rather, they express confidence that they, and others like them, will not vote for a board spill if it comes to a second strike.

 

Directors are also becoming more confident. While not taking any chances with the potential for a “strike”, much less a board spill, they are better prepared, and more skilled, for engagement. Already smart people have learned fast from the engagement experience last year. And despite the grumbles about the additional time commitment and workload on matters that add far less value than other director activities, many have found that they actually enjoy the engagement process.

 

The upshot is that 2013 will see more open, more robust, and more confident engagement from both sides. For those remuneration committee chairmen who have not yet scheduled engagement time, we suggest you do so quickly, as your more enthusiastic peers are already in line.

 

The tyranny of distance

 

The confidence directors and investors have in each others’ ability to understand and debate remuneration reports dissipates with distance. Specifically, east coast institutional investors and west coast resources company directors. The gulf, of course, is not just about the 4000 km geographic distance and two time zones, although we suspect these are contributing factors. Institutional investors still, in the main, fail to get their heads around the unique requirements of resources companies that, while they may have elbowed their way into the ASX300, are often in immature growth phases. Resources company directors are, unfortunately, not familiar enough with investor executive remuneration guidelines and, perhaps as a result of that tyranny of distance, have not effectively engaged with their investors.

 

Unlike other sectors, mutual engagement and education is not showing signs of rapid improvement. To remedy this, Guerdon Associates, with proxy adviser CGI Glass Lewis, is sponsoring a special Perth Remuneration Forum for company directors and institutional investors to tackle some of the issues (see HERE). While we trust our Forum will help, still expect to see a disproportionate number of high “no” votes and continued mutual misunderstanding with West Coast resources companies in 2013.

 

Remuneration increases

 

The rate at which executive pay increased in the years to 30 June and 30 September last year continues to surprise, as historically pay increases tend to be in line with the ASX 200 accumulation index.  Not this time. CEO fixed pay increased 7.7% from 2011 to 2012 (see HERE). This rate of increase is unprecedented in uncertain economic times with low inflation.

 

The high rate of increase was due partly to companies that awarded smaller pay increases in FY11 playing catch up in 2012. There appears to be no mechanism to circumvent this process, short of a recession. So, expect to see another relatively high rate of CEO pay increase in 2013, despite continued modest earnings growth.

 

The other probable driver of CEO pay increases greater than we would expect to see in similar economic circumstances is more structural, and stems from the unintended consequences of legislative change. Since November 2009, government laws have restricted termination payments to 12 months’ average base pay. Combined with the justified expectation of short tenure, we suspect this has resulted in successful pressure to increase fixed pay. Squeezing the pay balloon at one end by legislative constraints will likely expand it at the other end.

 

Concluding remarks

 

2013 will be another hard year for the board remuneration committee and institutional investors. The remuneration committee will need to review pay policy in anticipation of the impact of the new disclosure requirements, so they can pre-empt the likely reaction of investors to these disclosures. Institutional investors will need to revisit their guidelines to ensure they engage in a constructive way to benefit owners, and decide whether their focus is to be on pay that has been realised, or pay yet to be realised, or how pay is actually managed.

 

So, from Guerdon Associates, good luck for 2013!

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