Executive Remuneration Design in Australia: Best of Both Worlds?

Simplicity is often a key aim of remuneration framework design (or at least in the dreams of many Remuneration Committees).

Achieving simplicity is, when push comes to shove, easier said than done. Stakeholders, in all their guises, pull in so many different directions that remuneration frameworks invariably end up bastardised to try and appease the loudest voices. And any proposal that moves too far towards simplification, as was found with a bump by Origin Energy this year, results in an eruption of hostility.

Long term incentives (LTIs), increasingly tested over three or four or five years, are adored by external stakeholders and generally undervalued by executives. This is because LTIs are notoriously unpredictable and with increasingly longer performance periods become more so.

The external stakeholders’ drug of choice when it comes to LTIs is relative total shareholder return on the basis that it is the best reflection of shareholder outcomes. However, as anyone who thinks on this point to point measure too deeply knows, shareholders can have bought and sold and bought again (numerous times) over the performance period to maximise their returns. Executive LTIs do not work that way.

Company financial targets, such as earnings per share or return measures, while well intentioned present their own issues as all are liable to be gamed in some manner and/or may drive suboptimal behaviours. This is particularly true when external stakeholders have a view that targets should only increase year on year (where have all the good times gone?), rather than be set based on future expectations of sectors or industries over the performance period.

And uncertainty of vesting leads inevitably to increases in quantum over time so that the payday when they do vest makes up for the times that they don’t.

Boards and remuneration committees spend enormous amounts of time trying to strike a balance between designing remuneration structures that attract, retain and motivate executives (and let’s face it LTIs that nearly never vest are not very attractive or motivating) and that do not offend external stakeholders – resulting in overly complex arrangement.

While these limitations of LTIs are known, they continue to be a staple of incentive design in the listed environment, with many external stakeholders perceiving them as a good enough proxy to align “pay for performance”.

But it does beg the question, could we have the best of both worlds?

A number of companies have recently sought to swap the performance tested LTI (or a portion of it) with a more simple form of remuneration – a discounted grant of restricted equity (CBA, Origin), with some other companies already having it as an ongoing feature of remuneration design (Alumina, SEEK). This type of restricted equity is common in the US (and increasingly so in the UK and Europe) and is a simple way of aligning executives and shareholders through shared ownership of the company, while providing a more meaningful retention mechanism as executives lose the equity if they leave the company before the end of the restriction period. While LTIs should in theory already provide this hook, the reality is for the reasons set out above – they simply do not. 

Before we all jump on the bandwagon, as can be seen in the votes on CBA and Origin’s proposals, the Australian market remains sceptical of grants of restricted equity to executives (CBA receiving a strong vote against its remuneration report just short of a “first strike”, and Origin withdrawing its original proposal to replace the LTI with restricted equity only) as it is seen as delivering more money to executives with no guarantee of improved performance.

However, this seems a fairly one dimensional view. Short term incentives exist to help drive delivery of the objectives for the forthcoming year. Long term incentives should provide alignment with building long term shareholder value and provide a retention hook for key executives. A long term restricted equity grant:

• is at risk of loss if an executive quits or is dismissed and is at price risk throughout the restriction period it loses value (and remuneration levels are decreased) if the share price falls;

• reduces overall remuneration opportunity levels (that big fat money) as the certainty of a restricted equity grant compared to a traditional performance tested LTI should demand a discount – recent Australian and overseas experience would suggest somewhere around 50% of the prior LTI opportunity would be appropriate; and

• would fulfil some of the remuneration objectives of retaining key talent and motivating them to maximise long term shareholder value.

So where does this leave Boards who believe restricted equity would simplify their structures, and be more valued by executives – are they at odds with external stakeholders’ expectations? The ballot or the bullet?

The key is to bring all stakeholders (internal and external) on the journey. Replacing an LTI with restricted equity in one step is likely too much change, too quick. However, introduction of a new element, alongside fixed cash pay, STI and LTI, in the form of a material equity grant in trade off for a portion of the LTI (and potentially STI), as Origin proposed, may be more palatable and open the door to a larger shift in remuneration structure over time.

It will also likely require Boards to face into external stakeholder concerns and have those difficult conversations that may end with agreeing to disagree. Persistence and determination are also important. You have to finish what ya started. While it is common in the US to use restricted equity in remuneration frameworks and has become more common in Europe of late, the Weir Group, for example, suffered a defeat in introducing restricted equity to their LTI plan in 2016, but were successful in introducing this element at their 2018 AGM.

In our view, restricted equity has a place in simplifying, and reducing, executive remuneration. However, it may not be right for all companies nor in all circumstances. Boards should consider:

• what is the purpose of restricted equity in your remuneration framework? What would it mean for fixed pay, STI and LTIs (eg if restricted equity is more certain, should STI/LTI opportunities be reduced, or more challenging targets be set to ensure they are delivered only for true outperformance)?

• are you swapping out highly uncertain STIs/LTIs for something certain? If so, what discount would be fair? 50%?

• what is an appropriate vesting horizon (Weir Group in the UK has a 7-year vesting horizon, whereas Origin proposed 3,4 and 5 years)?

• what markets do you compete for talent in (restricted equity is common overseas so may be welcomed by overseas based executives and candidates)?

• how will you manage executive performance (is your performance management system robust enough)?

The Australian market diverges from overseas practice in its reluctance to embrace restricted equity as part of the armoury for retention and reward. One of the greatest roadblocks being convincing external stakeholders that while performance tested incentives are important, ongoing shareholder alignment and meaningful retention mechanisms are too. And that a grant of equity that goes down in value reduces remuneration levels.

As uncomfortable as it can be, right here, right now may be the time to continue to challenge the external narrative on restricted equity – but not by overhauling your framework, but a slow and steady change agenda. Done right, you just might get the best of both worlds.