Article

Executive Remuneration Working Group

Publication of Final Report

27th July 2016

The independent Executive Remuneration Working Group (the Working Group) was established in the Autumn of 2015 by the Investment Association in order to assess whether the complexity of current remuneration structures is inhibiting executive directors from acting in the long-term interests of companies and their investors. Yesterday, the Working Group published its final report, drawing on 32 roundtable discussions involving over 360 individuals.

The Investment Association have stated that they will review the Principles of Remuneration in order to consider the recommendations of the report.

The two key themes of the report are increasing flexibility in remuneration structures and rebuilding trust between companies and shareholders. These themes are supported by ten recommendations.

Increasing flexibility through rebuilding trust

Companies need greater flexibility to implement the most appropriate remuneration structures for their business needs and strategy. A breakdown in trust between companies and shareholders is currently standing in the way of companies taking a more flexible approach to executive pay.

Recommendation 1: There should be more flexibility afforded to remuneration committees to choose a remuneration structure which is most appropriate for the company’s strategy and business needs.

Rebuilding trust will allow investors to feel comfortable in supporting companies that choose a different approach, while giving remuneration committees confidence that investors will consider the rationale behind the proposed structure.

Identifying concerns with executive pay

The report lists a number of issues with existing executive pay arrangements:

  • Executive pay arrangements have become increasingly complex, making it difficult for participants, remuneration committees and shareholders to understand.
  • This complexity has contributed to poor alignment between executives and shareholders, sometimes leading to levels of remuneration which are very difficult to justify.
  • Companies feel forced into a one-size-fits-all Long Term Incentive Plan (LTIP) model. The Working Group believes this LTIP model is not suited to all businesses and does not allow for the fact that it may not be possible to set meaningful long-term targets in all businesses.
  • The Working Group argues that as restrictions such as malus, clawback and holding periods have been introduced to incentive plans, executives have increasingly discounted the value ascribed to incentive awards. The report argues that this ‘discounting’ by executives has led to increases in overall levels of remuneration.

Proposed remuneration structures

The Working Group has identified three structures that companies could consider implementing. As part of the debate other structures were explored and rejected; these included the performance on grant structure (under which participants receive a grant of shares awarded based on performance achieved over the previous three years) and share option plans. However, the Working Group specifically state that this list should not be seen as an exhaustive or approved list of structures.

The report also includes guidance on shareholding guidelines and how to manage potential payment for failure.

Long Term Incentive Plan: this is the existing LTIP model, which for many companies provides a useful way of linking executive pay to the shareholder experience as well as elements of long-term strategy. Given the average tenure of executive directors, the Working Group suggest that a three year performance period and a two year holding period is not too long from the point of view of the participants while still promoting longer-term alignment.

Deferral of bonus into shares: bonus deferral is seen to be suitable for companies with short term business cycles. In this structure part of the bonus would be paid in cash but a large proportion would be paid in shares which vest over a significant time period. The report does not specify what the significant time period should be but guidance is given in respect of restricted shares (see below). There would be no additional long-term award under this approach.

Restricted Share Awards: the Working Group views restricted share awards as helpful for companies which find it difficult to set meaningful long-term targets due to the nature of their business. There would be no performance conditions and the report suggests that staggered vesting over years three to five would be a sensible vesting structure. Restricted shares clearly have more certain outcomes than a conventional LTIP model and therefore the report notes that the award of shares must be discounted to reflect this. A discount factor of 50% for moving from an LTIP to restricted shares is given as a guide although it is acknowledged that the discount will depend on the particular circumstances.

Payment for failure: the report notes that restricted shares in particular can create the potential for failure to be rewarded. However, rather than recommend the use of an underpin which they argue could potentially result in executive directors discounting the value of the award, the suggestion is that the remuneration committee should use discretion to manage any potential issues. Companies may of course decide that an explicit underpin may be desirable.

Shareholding guidelines: the interim report suggested that shareholding guidelines should be set at 500% of salary. It has been recognised that this is not appropriate for all companies, particularly smaller companies. After considering various options the Working Group are in favour of setting the guideline at the level of the maximum annual variable pay, with directors required to hold up to 50% of the post-tax vesting of any shares until this guideline is achieved. It is also suggested that there should be a post-employment shareholding guideline and that this should apply for one year.

Strengthening remuneration committees and their accountability

The Working Group highlights the importance of ensuring remuneration committees can demonstrate to shareholders that members possess the skills and experience necessary to operate effectively.

Recommendation 2: Non-executive directors should serve on the remuneration committee for at least a year before taking over the chairmanship of the committee. The Financial Reporting Council should consider reflecting this best practice in the UK Corporate Governance Code.

Companies need to demonstrate that the remuneration committee has the full support of the board. The Working Group recognises the importance of a strong working relationship between the chairman of the remuneration committee and the chairman of the board. Whilst noting that the Corporate Governance Code requires the roles of chairman of the board and chairman of the remuneration committee to be held by different individuals, the Working Group recommends that companies ‘consider the benefits of the chairman being a member of the remuneration committee or at least attending its meetings.’

Recommendation 3: Boards should ensure the company chairman and whole board are proportionately engaged in the remuneration setting process. This will ensure that the decisions of the remuneration committee are agreed by the board as a whole.

Whilst recognising the role that remuneration consultants play in supporting the remuneration committee, the Working Group believes that some committees are overly reliant on the advice provided by remuneration consultants. The Working Group highlights the need for remuneration committees to demonstrate a capability to make decisions independently:

Recommendation 4: Remuneration committees need to exercise independent judgement and not be over reliant on their remuneration consultants particularly during engagements with shareholders. To ensure independent advice is maintained, the remuneration committee should regularly put their remuneration advice out to tender.

Improving shareholder engagement

The Working Group reports that concerns have been raised that shareholders and proxy advisors are not willing to listen to the rationale behind remuneration proposals. There is a perception that investors are overly reliant on proxy advisors and are unwilling to accept arrangements that deviate from the norm.

Recommendation 5: Shareholder engagement should focus on the strategic rationale for remuneration structures and involve both investment and governance perspectives. Shareholders should be clear with companies on their views on, and level of support for, the proposals.

The Working Group emphasises that investors should analyse remuneration structures in a joined-up manner, considering both the governance and investment perspective. However the report recognises that investors are faced with an increasing volume of consultation and are frustrated that companies sometimes treat consultation as a validation of decisions, leaving insufficient time for discussion.

The Working Group’s sixth recommendation requires companies to understand the need to listen and respond to shareholder views and shareholders to provide clear feedback and on proposals so that companies can judge the likely level of support. The Working Group encourages shareholders to make voting records accessible.

Recommendation 6: Companies should focus their engagement on the material issues for consultation. The consultation process should be aimed at understanding investors’ views. Undertaking a process of consultation should not lead to the expectation of investor support.

Increasing transparency in the target setting process

Annual bonuses – there is currently a level of distrust and suspicion about bonus payouts which regularly payout at 70% to 80% of maximum. The report acknowledges that there has been a significant improvement in the number of companies providing details of retrospective bonus targets which has been a direct result of shareholder pressure. But the Working Group would like companies to go further and explain how the targets are set, whether against budget levels or against consensus targets, which will allow companies to show how robust the target setting process is and how challenging the targets are.

Recommendation 7: Remuneration committees should disclose the process for setting bonus targets and retrospectively disclose the performance range.

Discretion – the Working Group have noted that remuneration committees currently believe that shareholders are unlikely to support the use of discretion and that in any case would only ever support downward discretion. In order for shareholders to feel able to support discretionary adjustments the company needs to have a responsible track record. To build up a degree of trust, remuneration committees need to clearly justify all decisions and any use of discretion and demonstrate that they are willing to apply discretion both upwards and downwards appropriately.

Recommendation 8: The use of discretion should be clearly disclosed to investors with the remuneration committee articulating the impact the discretion has had on remuneration outcomes. Shareholders will expect committees to take a balanced view on the use of discretion.

Addressing the level of executive pay

Concerns over quantum were consistently raised during roundtable discussions and, while this was not part of the initial remit, the Working Group consider that the issue cannot be ignored. Quantum is considered to be a matter for boards but the board must consider how the level of pay is justified and this should be relative to internal and external reference points. The report suggests that the internal reference point should be the ratio between the remuneration of the CEO and the median employee pay and that this should be publicly disclosed.

The expectation is that more flexibility will lead to simpler remuneration structures and more certain outcomes for executives, resulting in less discounting of remuneration awarded which should lead to a reduction in overall remuneration levels.

The report highlights the importance of remuneration advisors adhering to the provision in the Remuneration Consultants Group Code of Conduct which requires them to be ‘sensitive to the potentially inflationary impact of market data’.

Recommendation 9: The board should explain why the chosen maximum remuneration level as required under the remuneration policy is appropriate for the company using both external and internal (such as a ratio between the pay of the CEO and median employee) relativities.

Recommendation 10: Remuneration committees and consultants should guard against the potential inflationary impact of market data on their remuneration decisions.

Deloitte view

We welcome the report by the Executive Remuneration Working Group and the debate this has generated around the issue of complexity in executive remuneration structures. We have long advocated that a one size fits all approach has not been helpful and that remuneration structures and policies should be designed to support each company’s specific circumstances and long term strategy. The focus on flexibility is one which we strongly support. However, we are also very mindful of the challenge this presents to companies given the reluctance of investors to consider and support alternative structures where there is a clear and compelling rationale for doing so.

We therefore support the recommendations in this report with respect to strengthening the accountability of the remuneration committee and improving shareholder engagement in order to rebuild trust between companies and shareholders.

We also support introducing a requirement for the chairman of the remuneration committee to have at least one year’s experience on the committee before becoming chairman. We note that the Financial Reporting Council have stated that they will consider this recommendation as part of a wider set of measures that could be taken to address public concern.

The three proposed structures provide sensible alternatives but we are unclear as to why share options have not been included as a potentially useful structure. Rather than giving individuals the full value of the shares, only receiving value where the share price has risen can create better alignment with shareholders.

We welcome the focus on the use of discretion to adjust payouts, both up and down, where vesting formulae result in payouts which are not considered appropriate and we believe that encouraging remuneration committees and shareholders to accept this as a fundamental part of the remuneration process is the right approach.

We agree that the disclosure around the target setting process and the retrospective targets on which the bonus was based, while generally much better, could still be improved. We continue to believe that there needs to be more rigour in the target setting process and more scrutiny by investors once the targets are disclosed.

On the issue of quantum, while this was not part of the remit of the Working Group, the report includes the recommendation that the board should disclose the pay ratio between the CEO and the median employee pay. While this approach would provide a snapshot, we believe it may be too simplistic and we think that there may be broader ratios and qualitative disclosures that could illustrate how the remuneration spend is spread across the business.

In respect of an annual binding vote on the remuneration report we believe there may be helpful alternatives such as the one raised in the report where a binding vote would be required in the following year after receiving less than 75% of votes in favour. But we also believe that we need an increased focus on the responsibilities of investors to ensure that they exercise the voting powers they already have in respect of the vote on policy and the ability to vote against the re-election of remuneration committee members. Investors should at a minimum publish their voting policies and votes and ensure that they respond to shareholders in a timely manner. In our view this would also support the changes recommended in this report.

We note the recent proposals from the new Prime Minister. While the recommendations in this report support some of these proposals, we consider that the issues of inequality and the wider considerations of corporate governance and social responsibility, raised by Theresa May, will require solutions based on a broader perspective and a more holistic approach.

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