Regulators prompt remuneration changes

EXECUTIVE remuneration has hit hard times in the past three quarters. A recent survey of S&P/500 companies in the US found a 7 per cent decrease in median pay packages for chief executives.

Australian executive remuneration is likely to head in the same direction, driven by the recession and new policy constraints.

The actual remuneration of executives has been hit by the global financial crisis in several ways. Many executives have accepted temporary or ongoing cuts to their base remuneration, largely to retain cash in the business and save other jobs in the company.

Many incentive plans are now 'underwater', with either the incentive benchmarks unachievable in the current economy or the actual incentives provided in non-cash forms (as options and shares) not having immediate value in a depressed market.

Some executives will struggle with their tax liability for past incentives because the options or share-based incentive cannot be sold to cover the liability.

Historically, employees have paid tax on the discount on shares or options when they are exercised or the employment ceases.

Since the May federal budget, executives now face the prospect of the provisional tax-style taxation at the time employers grant shares or options.

Boards have been warned by shareholders and stakeholders to avoid the temptation of re-testing executive incentive schemes for the current reporting period. Boards are facing intense pressure to rein in future executive pay and its design.

This places immediate pressure on boards to manage talented executives upon whom they rely to improve the fortunes of the company when the best the board can offer is more demanding workloads, fewer resources and fewer rewards.

These market conditions in themselves are a catalyst to rewrite the executive remuneration rulebook. However, remuneration setting is slipping beyond the control of the board and its remuneration committee, and even the influence of shareholders.

The struggle for control of remuneration - as a response to perceived risk taking underlying the global financial crisis - began with the Obama administration's intention to cap the salaries of the top five executives of companies receiving TARP (Trouble Asset Relief Program) bail-outs.

Over our summer, the UK finance minister established a review to examine how banks are managed and how pay affected risk taking.

International policy emerged at the April G20 meeting in London when the communiqué endorsed the new principles on pay and compensation developed by the financial stability forum.

The forum, to be replaced by the financial stability board, which will monitor implementation while focusing on compensation in the regulated financial sector, is expected to influence executive pay beyond the financial sector.

The forum articulates principles that include a preference for compensation structures that are consistent with long-term company goals and prudent risk taking. The structures must be transparent to shareholders, stakeholders and regulatory supervisors.

This international policy influenced the principles-based pay guidelines issued for discussion by the Australian Prudential Regulatory Authority (APRA) in May, which will affect banks, insurers and other financial institutions.

It proposes the governance of remuneration by a committee of independent directors accountable for compliance. The design of remuneration should align risk and remuneration and will apply to employees who effect decisions related to risk for deposit holders, policyholders or owners. This includes executives and sales staff.

At the same time, the Productivity Commission, with Alan Fels, has sought public submissions to its 'Executive remuneration in Australia' inquiry that will report in December. It refers to the G20 sentiment and complements the APRA pay review.

The Productivity Commission asks five questions. It asks about trends in executive remuneration and international practice. It deals with three substantive aspects of remuneration design. First it questions whether the existing remuneration oversight, provided by the Corporations Law and ASX Listing Rules, is adequate.

Second, it queries the role of large institutional investors to influence executive remuneration. Finally it asks whether there are any mechanisms that better align the board and executives interests with shareholders and the community.

The May budget not only tackled the tax treatment of equity-based pay but also the quantum of executive payouts. A proposed change to the Corporations Law would limit a payout to one year's base remuneration for all executives named in a company's remuneration report, unless shareholders support a higher amount. This is a significant departure from the seven times annual remuneration rule that now applies and occasionally is used as a de facto long-term incentive.

APRA and the Productivity Commission will report later in the year.

In the meantime, some non-government institutions have drawn up principles to guide executive remuneration.

The Australian Institute of Company Directors issued its 'New guidelines for boards on executive remuneration' in February. It guides boards to: tighten governance of remuneration policy and stress test pay options; rethink remuneration design to incorporate longer term performance and clear performance hurdles; discourage risk taking and short-termism; and properly manage termination payments.

The recent Australian Shareholders Association 'Executive remuneration policy' provides the most detailed guidance to date, including the proposition that CEOs should have a pay structure with more remuneration at risk (up to 100 per cent of base salary) weighted to long-term incentives.

Senior executives should be weighted to short-term incentives. Incentives should be accessed only by demonstrating superior, objective performance.

Remuneration governance and remuneration design are at a watershed. Inevitably they will change. Remuneration committees will mark out their independence from executives when designing pay schemes. The design of CEO and executive remuneration will be differentiated. It is likely that CEOs will have performance hurdles that focus on long-term sustainability and growth as well as some short-term goals tied to surviving the recession.

Up until the May budget, it was predicted that boards would design long-term and short-term incentives that relied upon vesting options and shares at critical performance periods and holding some in escrow to coincide with long-term goals.

Policy makers in APRA seemed to suggest similar design principles.

However, the recent budget decision to tax up-front equity-based pay may prompt boards and executives to rethink reliance on incentives and recalibrate the size of base pay.

The practice of using termination payments as alternative long-term incentives seems a thing of the past.

Given the mixed messages of the May budget and the international and APRA design principles - and policy uncertainty while the Fels inquiry works throughout 2009 - it is likely boards will exercise caution this year before approaching shareholders with their remuneration report.

n Alison Gaines is global practice leader, board consulting, at Gerard Daniels.