27 September 2016 by Andrew Ninian
Rebuilding trust between companies, investors and beyond
Issues surrounding executive pay are never too far away from the glare of the national media and this year’s AGM season has been no exception. The media and political spotlight appears to have shone more brightly than ever before, with stories on pay making front-page news.
There has been a wave of high-profile investor revolts resulting in a number of companies receiving significant votes against pay package proposals. Two FTSE 100 companies even had their remuneration reports voted down by shareholders and a FTSE 250 company had its remuneration policy rejected.
Although much of the media scrutiny has focused purely on the levels of pay and the headline grabbing figures, the issues shareholders are concerned about go beyond quantum. Shareholders have been disgruntled by the lack of clarity around bonus targets, the link between pay and company performance, and substantial increases to remuneration potential.
Alongside investor concerns, Theresa May’s leadership bid for the Tory party heavily revolved around inequality and the need for greater trust between businesses and society as a whole. Our now Prime Minister has laid down her vision of how to rebuild trust around executive pay with three key policy ideas and objectives: one, give shareholders binding rather than advisory votes; two, improve transparency of bonus targets and pay multiples; and three, simplify bonus pay with longer-term alignment between the company and shareholders.
Against this backdrop, the Executive Remuneration Working Group – established by the Investment Association to address issues about the complexity of executive pay structures – published its final report and recommendations in July. Since its inception in 2015, the working group has focused on providing a market-based solution to the growing concerns of companies and investors over the current levels of executive pay and its complexity.
The seemingly ever more complex nature of executive remuneration has contributed to poor alignment between executives, shareholders and companies, which has sometimes lead to unjustifiable levels of remuneration. The working group brought companies, investors and asset owners together to provide recommendations on how the current structure of remuneration can be simplified to realign their interests.
The working group’s final recommendations and its blueprint for the future are based on extensive market-based engagement, including over 30 roundtables discussions with 360 individuals, comprising company chairs, remuneration committee members, executives, HR and reward directors, company secretaries, asset managers, asset owners, representatives from government departments, think tanks, trade associations, regulators, lawyers and remuneration consultants.
A central cause of remuneration complexity is that companies feel they are forced to adopt a one-size-fits-all LTIP (long-term incentive plan) model. This means organisations are using the same form of long-term performance measurement (performance targets set over three years). This single system, although intended to link long-term performance with shareholder experience, does not always reflect how a business works, or allow for the fact that it may not be possible to set meaningful long-term targets in all businesses.
It is essential that there is greater flexibility for companies to ensure that their remuneration structures are appropriate to the needs of their business and in the best interests of shareholders. Remuneration structures need to be workable within each individual company’s context, market and strategy.
The working group has set out a number of recommendations that consider how a more flexible system can be implemented. Central to this kind of approach is for trust to be improved between remuneration committees and investors. These recommendations encompass a range of behavioural and structural changes that are needed to improve the system. It is hoped that for those companies where the remuneration committee considers that the current LTIP model does not work, there will be alternative options available to them. The working group recommends:
Strengthening remuneration committees and their accountability – Investors need to be confident that remuneration committees have the ability to make the right long-term decisions for the company. To do this the chair and members of the remuneration committees need to have the appropriate knowledge of the business. The recommendations focus on ensuring that the remuneration committee chairs have a year’s experience on the committee before taking on the role and ensuring that the committee is not over reliant on their advisers.
Improving shareholder engagement – The working group has identified a mismatch in expectations between companies and investors in the engagement process. Companies too often treat the consultation process as a validation exercise rather than understanding the need to respond to shareholder concerns. There is also a perception that investors are sometimes not being clear about their views to companies, or are not representing the views of the institution both from a governance and investment perspective. Therefore, engagement should focus on the strategic rationale for remuneration structures and companies should consult to understand investor views rather than have an expectation of investor support.
Increasing transparency around target setting and use of discretion – Currently there is cynicism about high bonus payouts and the use of discretion which has eroded trust between companies and investors. The working group therefore recommends that transparency around setting of targets, particularly for the bonus, and the use of discretion is improved to rebuild trust in the system.
Addressing the levels of executive pay – Part of the breakdown in trust between shareholders and companies has been the ratcheting of pay over recent years. The rising levels of pay have been partly driven by the growing complexity of the system of pay, and the working group believes that simplification of these structures will go some way to addressing this. However, remuneration committees and consultants’ desire to ‘chase the median’ has also had an impact on remuneration levels. Boards should explain why they have chosen the maximum remuneration using external and internal relativities (including pay ratios).
The Investment Association, the trade body for the £5.5 trillion asset management industry, provides its members with a corporate governance research service called IVIS. IVIS produces reports on companies in the FTSE All Share Index, as well as the top 50 companies in the FTSE Fledgling Index, to ensure that investors have the information they need ahead of them voting at an AGM on issues such as executive remuneration and share capital management.
The IVIS service analyses companies against a set of industry principles ranging from remuneration to ESG issues. These principles, along with the FRC’s UK Corporate Governance Code, act as the foundation of every IVIS report’s findings and they allow the Association to be independent and objective in the way that it assesses the companies it covers.
Following the working group’s report, the Association is considering which areas of its own principles of remuneration will need to be refreshed in line with the group’s recommendations and will look to publish any changes in the autumn.
The recent intervention from our new Prime Minister shows that investors and companies need to work together and address the concerns about executive pay. The investment industry expects UK listed companies to work with it to tackle the lack of public trust that has resulted from the UK’s complex pay regimes.