Executive remuneration – back to the future?

 Executive remuneration – back to the future?

So is it time for a real rethink on executive remuneration?

Has executive remuneration become hotter than hell? Is it all too complicated, convoluted and controversial?

Investors, proxy advisers, regulators and even the general community are all sceptical (if not incensed) when it comes to executive remuneration. Have we hit rock bottom?

Are we paying too much for the pursuit of profit at the expense of broader societal, reputational and environmental goals? Or are we paying too much for ‘the soft things’ or ‘the day job’ at the expense of returns to investors? Have we got to choose?

The great disconnection

We find executive remuneration between a rock and a black diamond.

As many (not just in the financial services industry) have attempted to heed the great expectations of the Hayne Banking Royal Commission and APRA’s response together with the rise of the socially aware and ethical investor, there has been a greater attempt to balance financial performance (the ‘what’) with wider environmental, social and governance performance (the ‘how’), particularly in incentive remuneration.

This has thrown into the spotlight the fundamental disconnect between:

1. some investors (although probably less so the more sophisticated), proxy advisers, Government and the community – who see incentives as bonuses for outperformance,

versus

2. most executives – who now consider at least some part of their incentives as ‘at risk’ remuneration (but ‘at risk’ in the sense of losing if you do not perform, rather than ‘to be earned’ for outperformance).

Beyond any obvious misalignment with shareholder experience, much criticism of executive remuneration is that rewards frequently appear to be paying for ‘day job’ outcomes. Especially in the short term incentive. Proxy advisers, in particular, are watchin’ you.

Most investors will acknowledge that providing a safe workplace is a key objective in a company’s ‘social licence’. Retaining and motivating employees reduces the cost of employee turnover and recruitment to the betterment of the bottom line. Shock me! - Improving the perception of a company with customers is probably to the long term good of that business. Doing your bit for the environment, be it reducing your carbon footprint, waste production, water usage or land remediation is not only targeting the long term sustainability of your business. There is nowhere to run as environmental ills increasingly become a corporate reputation issue (with laggards being named and shamed) which will only increase focus over coming years as 2030 looms.

So are these ‘day job’ issues for a CEO and his executive team? Or key organisational objectives that should be rewarded?

The answer is they are two sides of the coin.

Is there a solution?

As a radical thought – eliminate short term incentives. (Or as a less radical thought, dial them back significantly). This may take some of the heat out of the issue on an annual basis as executives won’t be seen taking home six and seven figure ‘bonuses’ for their ‘annual efforts’ so regularly. This would also reduce the time and effort put in every year to setting the STI scorecard.

Easy as it seems, this requires some organisational maturity. You still need to set goals for the year. And hold management to account to deliver on those goals. It just takes away the remuneration noise attached. However, proxy advisers will hate this shift. It will provide less ability to second guess Boards on target setting and criticising remuneration outcomes with the benefit of hindsight.

Removing STI will also have implications for fixed pay.

Unmasked, fixed pay will have to go up to provide ‘full’ compensation for the day job (which currently probably relies on an element of STI paying out most years in most industries) so that management does not feel betrayed. This will be a one-off adjustment. But it will be material and may be met with a very strong ‘thou shalt not’ when voting on the remuneration report.

It may also remove the deferred equity component of STI. This too will be controversial, as deferral is seen to provide alignment with shareholders and something to clawback should the original STI award be built on shifting sands.

Removing deferral makes the issue of including an element in remuneration that is long term aligned with shareholder outcomes critical as well. Perhaps it is time to move away from the annual grant of equity and look at a multi-year ‘mega-grant’ (ie stop annual grants and front load the equity). While at first blush this may look like a ‘get all you can take’ grab – it in fact places management’s skin in the game and provides a major disincentive from walking away. Any way you slice it, it would also be very expensive for potentially poaching peers to buy out. 

While controversial (again) if not subject to a long term performance measure (and we all know executives view TSR as Russian roulette!), a longer term time based grant of shares will help shoulder some of the load (even if alongside a performance tested LTI component). It will provide a retention hook (no more walking away like a thief in the night) and alignment with shareholders as it remains ‘at risk’ of declining future share price and distributions.

Whilst we acknowledge the average tenure of an ASX100 CEO may mean that many will not enjoy more than a full term of one grant – a very large upfront grant that is restricted in equal tranches over 4, 5 and 6 years (or even longer) may help placate stakeholders that this is not just an exercise in ‘gimme more’. It may, again, take away some of the noise associated with annual grants (and approvals) of LTI.

It would also be left on foot should an executive leave before the end of the restriction period as a good leaver, providing ongoing alignment with shareholders. Changes to the tax laws about to come into effect will mean this can be done without punitive tax outcomes.

And maybe there is room for good old discretionary bonuses in a year in which the executive team and company have a killer year.

Back to the future – most definitely.

Does this resonate with you? Will it give the Chair of your remuneration committee reason to live? Simpler? More streamlined? Less susceptible to unforeseen events that can render otherwise reasonable targets on STI or LTI unachievable? Or way exceeded? Is this a last chance?

This is not for the innocent. However, someone needs to take the first step. Or do we live in a world without heroes?