UK practices have previously influenced executive remuneration governance in Australia, so it is always interesting to keep an eye on developments there. To this end, we report that in early March the UK National Association of Pension Funds (NAPF) wrote to the chairmen of the FTSE 350 companies to emphasise several of its corporate governance policy best practice principles that it expects to see applied in 2013.
The principles include that:
· Pay increases should be capped at inflation and be in line with the increases for the company’s wider workforce
· Incentive plan performance conditions should be truly stretching
· Incentives should focus more on the drivers needed to enact a company’s own individual strategies, with less emphasis on comparing performance to peer companies
· Remuneration committees should exercise more discretion on pay outcomes.
The NAPF letter follows the release in February by NAPF, Hermes Equity Ownership Services, the BT pension scheme and the Universities Superannuation Scheme of their ‘Remuneration principles for building and reinforcing long-term business success’. The four principles are:
1. Management should make a material long-term investment in shares of the businesses they manage
– Shares granted to executives should ideally be owned for at least 10 years whether or not the executive is still in the post, and it may be appropriate for a proportion of the shares granted to be held until retirement age even if the individual leaves the company
– CEO tenure should be increased rather than framing remuneration structures around short tenure
– Executives should be exposed to tail risk e.g. by requiring that shares can only be sold on a staggered basis. Owning shares post-employment encourages long-term thinking and the need for strong succession planning
– Clawback does not solve the problem of executives who make bad strategic decisions that only come to light after their departure
– But the board needs to monitor and guard against possible unintended consequences of long-term executive share ownership, including overly aggressive dividends policies, encouraging takeovers to crystallise awards and overly risk averse strategies to preserve share values rather than increase them
– Remuneration committees should consider paying part of fixed pay in shares, especially on recruitment and for salary increases above the norm.
2. Pay should be aligned to long-term success and the desired corporate culture throughout the organisation
– STI KPIs should be set with regard to the company’s strategic plan, and reflect executive objectives
– Companies should avoid a proliferation of KPIs to prevent gaming and complexity
– Quantum is now progressively more a factor in NAPF etc. views on pay.
3. Pay schemes should be simple, understandable for both investors and executives, and ensure that rewards reflect long-term returns to shareholders
– Setting a long-term course and measuring, explaining and incentivising progress annually may be a better way to encourage long-term value creation than the current system e.g. using an annual STI but no LTI, and with STI based on balanced scorecard metrics with remuneration committee discretion and with the reward paid predominantly in shares that are held for the long-term
– Companies should not make large awards to executives where returns to shareholders are below the cost of capital without full consideration of the circumstances around this and an explanation to shareholders.
4. Remuneration committees should fully explain and justify how their decisions operate to deliver long-term business success
– To ensure incentive outcomes are consistent with company performance, remuneration committees should be able to exercise judgment, having regard to the overall performance of the company when determining awards. In particular, the committee should consider how results were achieved and not just what was achieved – with awards scaled back if they are achieved via excessively aggressive accounting policies or by deferring investment in the business or by unnecessarily increasing leverage.
– There are also strong arguments for lower awards if executives have hit their performance targets but the company has suffered reputational damage or underperformed the market
– Shareholders need to be able to see remuneration committees exercising their authority when negotiating pay and being willing to make the difficult decisions.
These principles provide thoughtful input for Australian company policy consideration. While some of the alternatives may be very different from market practice, our recent Remuneration Forums have indicated that both investors and boards are willing to undertake a different path. These alternatives may be well worth considering.
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