26 January 2018 by Lorraine Young
Investment Association sets best practice for senior executive pay
At the tail of last year, the Investment Association (IA) published the annual update to its pay principles for listed companies for the 2018 AGM season.
The principles of remuneration and guidance for remuneration committees reflect current best practice in setting senior executive pay. The IA has sent a letter to chairs of these committees with the updated guidance.
These changes are described as ‘incremental’ after the more significant review for 2017. The IA considers the principles to be relevant to all listed companies, including those on the London Stock Exchange’s smaller Alternative Investment Market (AIM), although they are predominantly for main market companies.
The association has 250 members based in the UK who manage around £7 trillion of assets globally.
In 2017 many large companies had to put their remuneration policy to the required three year shareholder vote. This would have focused minds on having remuneration policies that are acceptable to investors.
For those involved in setting remuneration policy in 2018, there are a number of points to focus on.
Further restraint on levels of executive pay is expected, following a move by some of the largest UK listed companies to address levels of pay by reducing the potential variable remuneration awards and limiting overall pay in their 2017 remuneration policy renewals.
The IA wishes to see this trend continue in 2018. It encourages companies to take into account the wider social context of executive pay, rather than benchmarking alone.
In a similar vein, the IA expects companies to disclose the pay ratios between the CEO and median or average employee as well as between the CEO and the executive team. As we noted last issue, this is not a requirement for the 2018 reporting season. However, the IA wishes companies to do this voluntarily.
“The IA is looking for more transparency on bonus targets to ensure pay is in line with performance”
Elsewhere, the IA is looking for more transparency on bonus targets (both financial and non-financial) to ensure pay is in line with performance. The IA also wishes to see incentive arrangements aligned with the delivery of the company’s long-term strategy and will continue to support companies which implement this.
On pensions, the IA notes the disparity between executive director pensions and those for other workers, and stresses that the contribution rates should be the same for the two groups.
Two new requirements have been added to the principles. Any relocation benefits should be disclosed at the time of appointment and only be paid for a limited period, and annual bonus targets should be disclosed within a year of payment. If the bonus is to be more than 100% of salary then a portion of it should be deferred.
The long-term incentive plan (LTIP) section has also been reorganised to give a clearer picture of investors’ attitudes to particular schemes.
When advising remuneration committees, it is easy to get buried in the detail of the guidance.
The general guidance covers levels of remuneration, executive and non-executive shareholdings, performance adjustment, malus and clawback, discretion, pay for employees below board level, taxation, contracts and severance, recruitment of executive directors, reward for failure, shareholder consultation, and special awards and ex-gratia payments.
Elsewhere, the fixed remuneration section covers base pay, pensions, benefits, and allowances as part of fixed pay. The variable remuneration section covers annual bonuses and long-term incentives (including LTIPs versus restricted share awards).
The long-term incentive section covers every aspect of plans, from performance conditions and grant size, to dilution and change of control provisions. If you are involved in introducing a new share plan this is essential reading, even if the remuneration committee is using consultants.
The guidance comments that when consulting investors, remuneration committees should provide details of the whole pay structure, not just the proposed changes. It points out that consultation does not mean that companies will get automatic acceptance of their proposals.
Overarching the guidance are three principles on remuneration policies, remuneration structures and levels of remuneration. These are worth revisiting periodically as they set out the framework within which the guidance should be considered.
Policies should provide long-term value creation through transparent alignment with the agreed corporate strategy.
They should support performance, including the underlying sustainable financial health of the business, and promote sound risk management for the success of the company and the benefit of its stakeholders. This clearly reflects the Companies Act provisions on directors’ duties to promote the success of the company and the increasing focus on all stakeholders, not just shareholders.
Although non-executive directors (particularly those on the remuneration committee) should oversee executive pay, the whole board and the chair should be appropriately engaged in the process.
Remuneration committees should exercise independent judgment and not be too reliant on remuneration consultants. This can be quite a challenge as understanding trends and the market is tough without input from external advisors.
“One strategy is to use of the same consultants but for the remuneration committee to be advised by a different partner to the executives”
However, recommendations from the consultants should be debated and tested, rather than nodded through. There can be a potential conflict if the consultants are working with both the executive and non-executive teams.
One strategy I have seen work well is to use of the same consultants but for the remuneration committee to be advised by a different partner to the executive management.
Clearly care is needed not to create artificial division – all should be working towards the same goal – but it can give the remuneration committee some comfort they are able to get an independent opinion on proposals which may have been devised with input from both the executive with the consultants.
We did this for a large company but it is unlikely to be affordable for smaller organisations, where the directors will need to satisfy themselves that the proposals are fair for all shareholders. Reference to the IA principles and guidance can be useful in such cases.
This section of the principles also suggests that non-executive directors should serve on the remuneration committee for at least a year before taking on the role of committee chair and have sufficient skill and experience to manage the remuneration setting process.
This is fine as a principle but there may be times when it is not practicable to follow it. Hopefully, it remains as a recommendation and does not become mandatory.
The structure should be appropriate for the specific business, and efficient and cost-effective for the longer-term strategy. No particular structure is recommended or preferred, although it is stressed that simple is better than complex.
Many incentive plans have become byzantine. When devising new structures or plans it would be helpful to keep simplicity in mind, which also promotes transparency.
It can save a lot of time and cost during the life of the plans if the company is able to manage and administer them without constantly having to pay advisors to interpret the rules and assist with the performance measurement.
Structures should be designed to reward sustainable business performance and deliver long term value, but this may not always be what drives executives – or, to be fair, some investors.
There has been a real focus on short-term performance in recent years, which can sometimes come from fund managers and influence executives. There are now efforts for this to be balanced against longer-term outcomes, with initiatives like the viability statement having to be included in annual reports.
Structures should allow for malus and clawback in appropriate circumstances. Executives are also encouraged to build up a high level of personal shareholding to ensure their interests are aligned with shareholders. The shares should be kept for a time after they leave the company.
“Executives are encouraged to build up a high level of personal shareholding to ensure their interests are aligned with shareholders”
Lastly, dilution limits should be respected. In smaller companies, where incentive plans are introduced and directors are unfamiliar, they can get too enthusiastic and give generous awards in the first couple of years, only to discover that they have reached the limits envisaged by investor guidelines in about year three and then be stuck about what to do after.
It is therefore vital when implementing new plans to keep the limits in mind, model awards over the life of the plan, and continue to monitor the headroom available throughout.
Undeserved and excessive remuneration is discouraged. The board should explain why the maximum remuneration level chosen is appropriate. Remuneration committees are also expected to exercise discretion to avoid excessive payouts.
The whole board should be aware of the pay and conditions in the rest of the workforce and consider the impact of the total level of remuneration for all employees on the finances of the company, its investment and capital needs and dividends.
The letter to remuneration committee chairs and the updated principles and guidance can be found on the IA’s website, alongside all the IA guidelines for listed companies.