1. ‘Say on pay’ and governance
Better governance around executive pay is gaining support, with ‘shareholders’ becoming more active in the remuneration affairs of the business. This shift in focus should in turn reduce the incidences of problematic pay practices.
Further, remuneration committees will continue to proactively increase engagement with shareholders before annual general meetings and importantly, make changes to their pay programmes as a result of this engagement.
2. Executive pay and income inequality
Pressure is mounting to disclose how much the Chief Executive Officer makes each year as it directly compares to the average employee (relative to other organisations of similar size and industry).
The rationale behind this is that the ratio of CEO Pay to the employee provides transparency and context whilst placing some ‘boundaries’ on escalating remuneration rates at the CEO level.
Independent research indicates that Chief Executive Officers in the US, UK and Australia are paid the following multiples of the median employee wage.
||up to 150 times
From the 1st January 2017, listed United States organisations will be required to disclose the ratio of pay of their chief executive’s annual total remuneration to the median annual total remuneration of all company employees. UK companies are also subject to a variant of the CEO pay ratio rule, requiring the disclosure of the Chief Executive’s remuneration compared with employees. In Australia companies don’t have to disclose this ratio, however pressure is mounting for this to change.
3. Total Shareholder Return
Total Shareholder Return (TSR) has become one of the most prevalent measures used in incentive plans globally however, there is a view that TSR based plans are not the ‘silver bullet’ aligning pay and performance.
In September 2015, CGI Glass Lewis, one of two most prominent proxy advisory services in the world (the other being Institutional Shareholder Services), published a white paper “Executive incentives: motivate me?” in conjunction with Macquarie Securities Australia. The research analysed the relationship between the use of relative total shareholder return (RTSR), earnings per share (EPS) and return measures which included return on equity and return on invested capital, for Long Term Incentive (LTI) awards and the organisations eventual financial and TSR performance.
The results of this research indicated that the use of Relative TSR neither drives superior performance nor does it incentivise the behaviour to do so. The findings of this research challenges the use of Relative TSR as an appropriate LTI performance measure, other than to enable alignment with shareholder outcomes.
As a result, CGI Glass Lewis? expects companies with the Relative TSR measure incorporated in their incentive plans to provide additional thorough explanations and rationale for using this measure in its remuneration reports, including those mechanisms used to prevent unwarranted vesting in years of poor shareholder return?.
What does this mean?
It means that Remuneration Committees need to conduct a thorough review of the efficacy of their TSR-based incentives so as to determine the right balance of alignment and line of sight by using TSR in conjunction with other incentive metrics (return measures) for their organisation and strategy.
4. Corporate Sustainability and Environmental, Sustainability and Growth (ESG) Reporting
The current use of non-financial metrics in incentive plans indicates that many Australian organisations do not have a true all-encompassing understanding of corporate governance which seeks to secure the organisations long term sustainability by understanding and mitigating all threats against it, many of which are non-financial. Similarly, an organisation’s executives should be incentivised in terms of this broader spectrum of risks.
What does this mean?
This means that executive pay schemes should incentivise management to focus on long term sustainable growth which involves identifying appropriate Environmental, Sustainability and Growth metrics (ESG), and linking these metrics to salary packages.
What are we currently seeing in the market?
Many of the metrics utilised tend to approach ESG issues from a risk mitigation perspective rather than from a value creation perspective. For example, a number of organisations provide a link between remuneration and sustainability under the category of say, safety performance. They utilise this because the metric is visible, easily measured, and can be tied to shareholder value through lower penalties, fewer accidents and the mitigation of environmental risks.
However, these metrics are ‘lag indicators’ and therefore tend to focus on past performance rather than focusing on metrics that incentivise and reward executives for investing in improved future performance that exhibits a worthy sustainable management system.
5. Allocation Methodologies
Over the past few years there has been a move from granting equity based on ‘fair value’ - which is the accounting value to using a binomial method like black Scholes to ‘face value’ which is market value.
Market value is the current price of the share, whilst fair value or the accounting value, is often lower than market value because it takes into account factors such as foregone dividends and other hurdles.
Proxy advisors support the face value methodology as they maintain that the fair value methodology understates the value of performance rights or shares because it discounts the value of the share. This means that the use of fair value results in an additional number of grants being allocated to the executive, which the proxy advisors believe that the executive is not entitled to.
This is best demonstrated through an example:
|Current Share Price
Let’s assume the following:
- The executive is entitled to a long term incentive amount of $1 million;
- The accounting value using a binomial method values the share at $2-00;
- The company’s current share price is $4-00 which is the face value of the share.
Under the fair value method the executive will receive 500,000 rights, yet under the face value method - which is what proxy advisors are advising, the incumbent receives 250,000 rights. The fair value of the 250 000 rights is $500 000 which is a reduction in the executives grant of $500 000. Over 50% of ASX 100 companies are now using face value.
6. ‘One Size fits all’ Pay Programs
Faced with increased scrutiny of their pay programs, many organisations are looking to stay out of ‘harm’s way’ by adopting a ‘one size fits all’ approach. It lowers the levels of explanation, justification and therefore provides a lower risk of outside scrutiny.
Unfortunately this approach can lead to less than favourable results as it fails to support the organisations unique circumstances and therefore falls short on increasing long term value creation.
Institutional investors have no objection to remunerating highly successful executives, but take exception to high levels of pay for average or below average performance. The CGI Glass Lewis paper states that:
“Each listed company should design and apply specific, fit-for-purpose pay policies and practices that are appropriate to the circumstances of the company that will attract and retain and motivate to grow the company’s long-term shareholder value”.
Where those specific policies and practices are consistent with best practice, proxy groups will support the company’s approach however, where it departs from best practice it needs to be fully explained.
Shareholder activism is more entrenched because it is yielding results and Remuneration Committees are engaging more proactively with shareholders ahead of AGM’s.
The flipside of all these changes is that many Remuneration Committees seem to be setting the bar even higher than what proxy advisors require, where a simple ‘yes’ majority is just not good enough.