The outlook for director and executive pay in 2010 – 2011

Things may be looking up for the Australian and global economies, but the lingering after-effects of the global financial crisis will be with us for some time.  In fact, some of its impacts on director and executive remuneration may outlive this new economic cycle.  This article dusts off our crystal ball and presents our outlook for non-executive director and executive pay for 2010 into 2011.

Regulation and NED pay

Regulatory change is here.  And there will be more to come. 

New APRA prudential standards on executive pay become effective on 1 April (see HERE).  The standards require that all APRA-regulated financial institutions:

  • Have a board remuneration committee and that this committee be comprised of non-executive directors, have three members as a minimum, and that a majority of these members be independent

  • Commission any external advisers in a manner that ensures their engagement and any advice received is independent

  • Have a written remuneration policy that supports the long-term financial soundness of the company, and its risk management

  • Ensure that performance-based payments reflect the outcomes of business activities and the cost of capital in generating profit, and the effective time horizon for the full impact of management’s actions to be assessed

  • Oversee the remuneration policy applicable to employees other than top management who are engaged in risk or financial management, as well as for other non-executive employees who individually or collectively could affect the financial soundness of the institution.

Guidelines accompanying the new standards promote bonus deferral in shares, accompanied by clawback discretion.  In addition, they discourage the application of relative TSR as a sole measure in long-term incentive plans. 

The guidelines also suggest that board remuneration committee members should have sufficient experience and expertise in remuneration, as well as enough industry knowledge, to assess the risk associated with policy alternatives.

While the impact of the APRA regulation will be focussed on the financial services sector in 2010 and 2011, we expect that there will be some spill-over into non-financial services sector companies over time, with significant implications. 

In effect, the standards require non-executive directors to delve into operational matters that have traditionally been the preserve of management.  They require a level of engagement that is more time consuming and demanding in terms of knowledge required, reputation risk and personal liability.  As a consequence, this greater “professionalisation” of non-executive directors will serve to reduce the supply of board candidates, and boost demands for increased monetary compensation.

The same themes can be seen arising from the Productivity Commission recommendations (see HERE).  The “two strikes” recommendation, even in its modified ‘two strikes and re-election resolution’ form, in combination with the other recommendations, serves to emphasise expectations of director remuneration expertise and time commitment considerably beyond the pre-GFC standards.  Yet none of the Productivity Commission recommendations, including removal of the “no vacancy” rule, serves to effectively increase the supply and expertise of non executive directors.  There are no recommendations, for example, on increasing the education opportunities on remuneration matters for NEDs.  Nor is there any recommendation that serves to cut through the COAG mess obstructing the rationalisation of state based liabilities that limit the supply of potential NEDs.

The immediate result in 2010, extending into 2011, will be significant increases in NED fees in order to encourage the right people to serve on boards, particularly on remuneration committees.  In that context, we have noticed that a significant proportion of companies across all sectors do not have enough headroom in their fee pool to cope with an increase in NED pay, or to provide a reasonable buffer to cope with the removal of the “no vacancy” rule, the need to find successors for retiring baby boomers, and the very real impetus to increase the number of women on boards.  Hence 2010 and 2011 will see a variety of moves not only in NED fees, but also corporate and professional initiatives in sourcing and educating directors.

“Independent” consultants

The new APRA standards applying to financial institutions, and the Productivity Commission report and recommendations, have emphasised that any external advice sought by board remuneration committees should be independent of management.

Hence we expect that boards will tend to migrate away from the multiple service line firms that focus most on big fees in other areas, in favour of specialist independent executive remuneration advisory firms.

Performance measures

While economically things are looking up, we expect performance measures will continue to focus on the efficient application of capital (as predicted at this time last year – see HERE).  Credit from traditional market sources will still be constrained and expensive.  For those companies that have not taken the opportunity to raise additional equity capital it will be all about doing more with existing capital.   The solution is the same for companies that did top up their balance sheets in anticipation of tough times that have turned out (so far) not to be so bad after all – they will either have to return expensive equity or, more likely, require management to get a better return from it.  Expect that these companies will be seeking mergers and acquisitions.  If you are one of these you may have to reconsider performance metrics.

For companies that see growth opportunities (organic or via M&A), plain profit growth measures will be appropriate, albeit with more focus on cash flow than accounting profit given on-going credit constraints.

We are also likely to see more companies adopting multiple LTI measures.  While this trend has been with us for some time, it may accelerate given that the APRA guidelines highlighted possible undesirable and perhaps unintended consequences of using just relative TSR.

As noted last year, larger, capital intensive companies are more often using capital efficiency measures to drive value.  This is likely to continue in a tight credit environment.

Payment vehicles and tax

The Board of Taxation is a month away from releasing its review of whether separate tax deferral arrangements should apply for employee share schemes offered by start-up, research and development and speculative-type companies.  It is difficult to conceive of a solution that will allow such cash-constrained companies to continue with the use of share options as a reward vehicle that is consistent with the rules now applying for other companies.

While we hope for a solution, at this stage we believe that share options will go the way of the dodo.  With them will go a major source of encouragement for Australian based entrepreneurs  and venture capitalists to create potential sources of wealth for Australian investors.  They (the entrepreneurs) may as well live and list their companies in Hong Kong, San Francisco or London where options are still taxed as we used to tax them, and venture capital is more plentiful.

Australian large listed companies will replace options with share rights and shares. Loan-backed shares may provide the incentive upside that share options have, but it is unlikely that they will gain favour with investors.  While particularly good for shareholder alignment, share-settled share appreciation rights (SARs) do not appear to be getting much traction, possibly because their advantages are not well understood .  This is a shame because, applied the right way, SARs allow boards to ensure that their management is motivated by the upside potential of their company, cash is conserved, tax is deferred, minimal dilution occurs, and shareholder alignment is achieved.

The government is under mounting pressure to change its position that unvested equity grants are taxed on termination of employment.  The “hold equity through retirement” approach we have long advocated has taken root and, it seems, is supported by most everyone except Treasury and the ATO.  Governance groups, the AICD, and APRA, among many others, have been urging the government to reconsider taxing unvested equity at termination so that equity incentives better encourage management to think and act in the long term interests of their shareholders. And the Productivity Commission has specifically recommended change along these lines.  We trust that the political will can see a way of aligning with corporate advice, to the benefit of the economy. 

Shareholder engagement

This is a big issue: even if incentive and remuneration design does not change markedly, the challenge has been laid down for companies to win the communication battle with as many shareholders and other stakeholders as possible.  Already, boards of Australian listed companies have been progressively doing more to engage with their shareholders and the proxy advisory firms as shareholders flexed their muscle on remuneration report votes.  Now, on top of this, is the prospect of a board spill and reputation damage when the government acts on the Productivity Commission’s revised “two strikes” recommendation in this election year.

But can the system 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 that have yet to ramp up their engagement to test revised executive pay arrangements might need to book their consultation windows early, or lose out on January 2011 vacation time.

Levels of executive pay

Last year the overall ASX 300 chief executive pay increase was 1.5%.  The Productivity Commission said it was actually negative in real terms.  But while overall pay increases were indeed “modest” because bonuses did not pay out, the level of fixed pay increased over 13%.  So, with target bonuses based on a percentage of fixed pay, expect a significant lift in total remuneration as the economy improves.

Many executives, like their union counterparts, are seeking catch up on pay freezes that will exacerbate the rate of pay increases.  And then there is the continuing boom in certain sectors (e.g. energy, mining, engineering and construction services) that was only briefly interrupted by the GFC.  It is also possible that executives will desert the regulated banking sector to make more with other people’s money in the unregulated financial sector.  The war for talent will continue.  Emerging companies will continue to steal executives from the mid levels of the giants, while the giants will continue recruiting offshore.  Companies will get bigger and, according to the Productivity Commission analysis, pay levels rise about 4% with every 10% increase in company size.  Yet with the bigger size and complexity, Australia, as we have witnessed in the past, cannot develop local talent fast enough, nor it seems, import enough migrant executives to fill the empty chairs except by progressing up the executive pay spiral.  The talent war will continue to have a compounding effect on executive pay levels that, while subdued in 2010, will continue strongly into the foreseeable future.

Concluding remarks

So last year was a bad year. NEDs are going to have a hard time of it juggling the need to attract and retain talent both on the board and in executive ranks, while demonstrating that the resultant pay outcomes are reasonable in the face of shareholder activism and government regulation. The new employee share scheme taxation rules are likely to severely limit options to ensure executives are aligned with shareholders.  And in many cases NEDs will have to rely on new, more independent, external advisers and put in more leg-work engaging with stakeholders. 

© Guerdon Associates 2024
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