The Switzerland based UBS has introduced new executive pay measures in response to the global credit crisis, and their part in it, that respond directly to concerns raised by regulators around the world. This model of executive pay could therefore be the precursor of executive pay frameworks everywhere.
Most of the UBS pay elements are already well represented in Australia’s relatively well-governed companies. However, their new framework has a significant element that most Australian directors, investors and executives will be unfamiliar with – a “malus”. So, if the UBS remuneration framework is to become a model for the world on executive pay, board directors and executives should become familiar with this new word – “malus”.
This is not German for malice (although on implementation some executives may think otherwise!). Nor does it refer (at least in this usage) to a type of apple.
According to the actuaries in our Sydney office, a malus is an insurance term. People with insurance policies can receive a bonus in the form of a discount in the premium given on the renewal of the policy if no claim is made in the previous year. This is the opposite of a malus. A malus is an increase in the premium if there is a claim in the previous year. Bonus/malus systems are very common in vehicle insurance, also called No Claims Bonuses in Britain and Australia.
Malus is also a German word, sometimes translated as “penalty”. Could this be where executive pay is heading?
UBS seems to think so, and is applying the principle. UBS was among the first major global banks to recognise losses in the billions as a result of the sub-prime crisis, and, as reported by us HERE, identified remuneration as one of the key contributing factors.
Since recognising the losses, they have been one of the leaders in revising governance processes, making public critical external reviews of how its risk management and governance systems failed, and committing to shareholders on their resolution. In addition they have recovered bonuses paid to executives who benefited from the measurement and payment for the wrong results.
A few days ago UBS released a document outlining its revised executive remuneration policy. This makes very interesting reading.
Not only does the policy reflect some elements of the recent missive the UK’s Financial Services Authority fired off to UK bank CEOs, it is also likely to reflect the thinking by the Financial Stability Forum (FSF), based next door in Basel. The FSF and the International Monetary Fund (IMF) are the global bodies nominated by the G20 charged with recommending a global regulatory response to the global financial crisis, including executive pay regulation (see HERE). Prime Minister Rudd has indicated that Australia will support these recommendations.
Importantly, for all our readers, there is a fair chance these regulatory changes will extend beyond the Australian financial services sector, given that Treasury had already been reviewing regulatory changes on executive pay for the Minister of Superannuation and Corporate Regulation, Nick Sherry (see HERE). So, assuming that UBS has good insight into the coming global regulatory changes, what have they come up with?
The UBS executive remuneration framework comprises:
- A cash bonus plan with “malus”
- A 3 year equity based long term incentive plan, and
- An equity holding requirement
Under the equity holding requirement, 75% of any LTI shares that vest (after taxes) are required to be held for an unstated period. Australia’s major banks and many other companies already have shareholding requirements.
Under the LTI plan, participants receive a certain number of restricted performance shares. In contrast to UBS’s old plan that contributed to their disastrous results, some or all of the shares may only vest after three years. The final vesting depends on two performance criteria:
- Achieving pre-defined economic profit (EP) targets
- Achieving relative total shareholder return (TSR)
Again, this LTI arrangement is typical of Australian listed companies.
But it is the cash bonus plan that is the most interesting, and potentially the most contentious.
While we would still classify this as a STI plan because it is contingent on annual performance results, it is designed to encourage performance sustainability and is, in effect, a hybrid STI/LTI plan.
Under this plan, variable incentive payments are based on operating results with risk- and capital-adjusted financial performance (group/division) and non-financial goals (namely leadership and adherence to values) taken into account. Any previously announced cash bonus compensation would be booked to a participant’s account before a distribution is made. If the balance is positive, up to a maximum of 33% of the account is paid out. The remaining balance is carried forward to the next performance year and is exposed to future performance outcomes.
A negative award, i.e. a malus, will be recognised in the cash balance in the case of:
- A financial loss at the group or business division level
- A large adjustment to the group’s balance sheet
As such, the plan provides a multi-year reflection of performance and compensation. This is designed to ensure that the financial impact of decisions and actions taken in one period impacts the variable compensation over a longer period of time.
A malus to an individual participant will also be recognised in the case of:
- Misconduct with regard to compliance issues
- A breach of risk parameters
- Non-adherence to other quantitative and qualitative core objectives as expressed within individual target agreements and performance measurements
The cash bonus plan establishes a buffer between the determination and payment of variable compensation. It promotes sustainable performance by ensuring future results are considered. Even if an executive leaves the company the balance will be kept at risk for a period of three years in order to capture any tail risk events.
Did UBS read some prior articles of ours (see this one written last month for example HERE)? In past articles and in our consulting with clients we usually refer to this as a bonus bank.
In the UBS context, a malus is the opposite of a bonus – it is a deduction made from a deferred bonus account for poor performance. UBS describe malus as a “negative award” (see page 7 of the UBS document located HERE).
Guerdon Associates have developed and applied bonus banks before. As a result, we are keenly aware of the practical problems in their application.
The main one is the retention and attraction of executives. For example, in the face of global financial system meltdown, whereby poor performance may not be directly attributable to the individuals concerned, those banks still paying bonuses will be able to poach executives who have years of banked and accumulated bonuses wiped out. We are already seeing this played out to an extent in London and New York, where some banks are scrambling to assure staff that bonuses will still be paid in order to retain talent, but are being damned by shareholders in the process.
For bonus banks to work every competitor has to have one.
While UBS is to be commended in many respects for its response (however belated), it may be playing a high-risk game of “let’s resolve one operational risk by replacing it with another”. Or it is playing a style of “prisoner’s dilemma”, trusting that its peers who have also been hurt by the crisis will follow its lead for the good of all? But perhaps, as we said at the beginning, they have more than an inkling of the global regulatory guidelines to be announced sometime next year.© Guerdon Associates 2022 Back to all articles