The seemingly biggest issue with executive pay relates to the tenuous link between pay and performance, and the resultant quantum of pay received. Whilst performance measures may exist, many of these schemes are questionable as they seem to deliver unwarranted levels of pay in good and bad times.
The seemingly biggest issue with executive pay relates to the tenuous link between pay and performance, and the resultant quantum of pay received. Whilst performance measures may exist, many of these schemes are questionable as they seem to deliver unwarranted levels of pay in good and bad times. Let’s consider the standard pay approach:
Total Fixed Remuneration represents the pay linked to the present value or market rate of the role
Short Term Incentives is linked to the achievement of annual business and operational results
Long Term Incentives is the reward for long term shareholder value creation
It is the Long Term Incentive element of executive pay that causes the biggest problems because:
- Shareholders are not convinced that pay is really linked to performance
- Perception that executives can manipulate the scheme to achieve performance hurdles
- Performance targets are ‘soft’, do not represent pay for ‘above average’ performance and in many cases do not translate into long term value creation
- Performance period of three years is not considered to be 'long term'
- Difficulty in setting performance criteria which extends past three years
- Suitability of performance metrics such as Total Shareholder Return (TSR) and Earnings Per Share (EPS) as effective measures of value creation.
In lieu of these issues, other incentive models are being considered which include:
- Granting restricted shares without performance conditions
- Replacing the Long Term Incentive award with a larger Short Term Incentive award with significant deferral
- Ceasing Long Term Incentive awards and offering higher fixed salaries, supplemented with small, discretionary bonuses.
However, a ‘one-size fits all’ approach to executive remuneration is not the answer. Boards need to stop acceding to investor and shareholder preferences when designing packages. The focus should be on choosing the right remuneration approach to drive business strategy which will encourage buy in and support from shareholders.
BDO Remuneration Approach
BDO’s approach to incentive plan design diverges from the traditional executive remuneration framework of assessing Total Remuneration as a combination of fixed pay, annual cash and long term share incentives. Instead, we have regrouped these elements into three new categories referred to as ‘Pay Categories’. These are:
1. Fixed Pay Category which is pay linked to the present value or market rate of the role
2. Incentive Pay Category which consists of two elements being the:
- Short Term Incentive Pay element which is the incentive for the achievement of short term business and operational goals
- Long Term Incentive Pay element which is the incentive for the creation of sustainable long term business value i.e. delivering business strategy
3. Reward Pay Category which is the reward for creating value for shareholders. Reward Pay is linked to shareholder returns like TSR metrics. It reflects pay for results.
Many companies do not employ the ‘Long Term Incentive' under Pay Category 2 and in many instances, confuse this Incentive Pay Element with the Long Term Reward in the ‘Reward Pay Category’ (number 3). We refer to plans in the Reward Category as Shareholder Return Plans and not Incentive Plans as there is virtually no line-of-sight in Shareholder Return Plans i.e. executives do not know what direct actions need to be taken to create or increase shareholder value at a rate that this will out-perform the competition.
Total Shareholder Return
The findings of a study completed by Equity Methods LLC indicate that long term incentive payouts are influenced more heavily by short to mid-term share price volatility rather than sustained long term Total Shareholder Return (TSR) performance. The study also investigated whether a performance period of at least five years could help facilitate the preferred outcome as compared to using a three year period. The analysis raised questions about the appropriateness of three years as a performance period for relative TSR plans and reflected that five years was far better suited to measure sustained long term TSR performance.
Despite the limitations of utilising Shareholder Return Plans in executive pay programmes, shareholders still require these measures as a barometer of executive success however the question of whether TSR should be utilised for the purposes of the incentive scheme needs to be considered carefully for each individual company for example:
- For Large, mature, companies (ASX 100) performance can be viewed in relative terms
- For Mid-tier companies, a mix between absolute and relative TSR could be considered to balance the volatility shortcomings of utilising relative TSR. Rewarding on both absolute and relative TSR does provide two complimentary lenses to demonstrate the link between performance incentive and long term results (outcomes) over the performance period
- For juniors it generally makes more sense to consider the progress made, and the absolute level of performance.
There is no golden rule or ‘silver bullet’ – it has to be ‘fit for purpose.’
The current maximum short term incentive opportunity as a percentage of the Total Remuneration package per the BDO Top 900 Board and Executive Remuneration Report (https://www.businessnews.com.au/executive-salaries/purchase-report) is nationally at an average maximum of 23% of the Total Remuneration Package Opportunity i.e. a maximum 60% as a percentage of the Total Fixed Remuneration package. In this regard, we would prefer to see a greater proportion of the Total Remuneration package being geared towards the mid to longer term i.e. 3 to 5 years, with a smaller proportion of total pay being focused on the short term however, there can be no ‘one-size fits all’ approach. The scheme needs to be ‘fit for company purpose’ and accordingly the ‘market’ in addition to other factors needs to be considered in the schemes design. These include:
- The size, nature and profitability of the company
- Risks and challenges facing the business
- External market factors such as the change of your target customer base
- Business and economic conditions
- Supply and demand of executive skills and the criticality of the skill set to the business
Unfortunately and faced with increased scrutiny of their pay programs, many companies are looking to stay out of ‘harm’s way’ by adopting a common approach which can lead to less than favourable results as it fails to support a companies unique circumstances and therefore, falls short on increasing long term value creation.
What do institutional investors want?
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 should support the company’s approach however when they stray from best practice, it must be fully explained.
The BDO Approach to remuneration governance provides for a consultative approach to ensure an appropriate balance between ‘incentives for performance’ and ‘rewards that are aligned with shareholder results’. We incorporate accounting, taxation and remuneration design expertise in a complete ‘end to end' process to create a remuneration approach that drives above-average performance, attracts and retains top talent, and engages and informs stakeholders.