On 21 April 2016, the Investment Association’s Executive Remuneration Working Group published their Interim Report on executive remuneration in UK listed companies. They considered whether current remuneration practices are restricting company management from acting in the best interests of the companies and their shareholders. This update provides a brief summary of the Interim Report.
Introduction from the Group Chairman
The Group’s starting position is that the approach to executive pay in UK listed companies is “not fit for purpose” and does not align shareholders’ and directors’ interests. Further, the recent growth in executive pay, often caused by a blind adherence to median comparators, has led to a loss of public confidence. Finally, the Group is concerned that remuneration committees are increasingly outsourcing their role to consultants which leads to a lack of accountability on executive pay.
The Working Group believes that to restore confidence, there must be greater transparency; alignment of directors and shareholders interests; as well as greater accountability of remuneration committees. Therefore, the Group is seeking further input on:
- Transparency – seeking retrospective reporting of targets which will help to build trust between shareholders and companies.
- Shareholder Engagement – a greater disclosure of targets in relation to remuneration would see greater shareholder engagement with the remuneration process.
- Accountability – remuneration committees must be made more accountable. They must exercise greater discretion and move away from formulaic remuneration setting to ensure it is in line with business targets. Consultant’s fees for all services should be disclosed, not just fees for remuneration committee advice.
- Flexibility – Companies should use a remuneration model tailored to their business. The current reliance on one model has caused “remuneration creep”.
The remuneration committee should set clear and justifiable targets as part of the remuneration package.
Part 1 – Key Proposals of the Working Group
The Group believes the wide use of the three year LTIP model means many companies are overlooking other structures which may potentially be a better fit. The Group feel the mainstream LTIP model can sometimes lead to unintended results. It is designed to set long term goals and yet often, due to the problems of making an accurate three year prediction, executives feel a lack of control over their performance against these targets. This LTIP model also appears to have led to an increase in executive pay due to uncertainty over the LTIP pay-outs.
The Working Group suggests that simpler remuneration models could allow companies to target a wider range of strategic issues. However, it is recognised that the LTIP model is the main choice for a reason. As such, the Group are not suggesting its wholesale abandonment, instead they suggest companies re-assess whether another approach may be more suitable for them.
Therefore the Working Group recommends that structures should be aligned with:
- “The interests of shareholders – reward for creating shareholder value which should be linked to the shareholder experience
- The performance of the company– reward for contribution to good company performance and penalty for failure
- The implementation of the company’s long term strategy – reward for successfully implementing the strategy
- The interests of other employees in the organisation – remuneration structures for executive directors should be able to be applied to other employees in the organisation
- Wider corporate and social responsibility goals”.
Further, that “structures should be simple – meaning that they should be easily understandable for the participant, remuneration committees, investors and other stakeholders”.
Part 2 – Discussion on Alternative Structures
As a result of the above, the Working Group has looked into alternative remuneration models. They determined that certain aspects of remuneration are accepted. As a result, the focus of the Group is on alternative long term incentivisation arrangements.
The LTIP sees share awards granted which will vest over three to five years so long as targets are met. This would be suitable for companies with a long term strategy. Respondents felt that it worked best where there is engagement with participants and clear targets which remain constant over time.
- Deferral of bonus into shares
Any bonus would be partially paid in cash and the majority of it in shares vesting over a long period. This structure would be suitable for companies with short business cycles or difficulties setting long term targets. While lacking a distinct long term element, participants will develop a shareholding and therefore, similar interests to shareholders.
- Performance on grant
Awards made based on performance over previous three years. This structure is similar to the LTIP but it allows the remuneration committee to take a retrospective view on company performance and make awards accordingly.
- Restricted share awards
Annual grant of restricted shares vesting over time, based on continued employment. This supports a long term outlook in participants as the long term performance of the company is tied to their remuneration. This is a simple system as there are no performance targets beyond general company performance.
Part 3 – Consultation on Parameters
Finally, the Group considered some issues around implementation of the range of other potential remuneration models. Particularly, in the Interim Report they looked at: how to translate the value of LTIP awards; length of holding periods; need for shareholding guidelines; accountability; and how to reduce payment in the event of failures.
- Discount rate – many of the alternative models make pay more certain as there are no future performance conditions. As such there would be a need for a “discount” to be applied to current remuneration values.
- Length of holding periods – the current norm is a five year period. While the Working Group is aware shareholders are unlikely to want to reduce this period, the Group is open to views on whether a phased vesting approach over year's three to five would be acceptable.
- Shareholding guidelines – the Group states a 500% of basic salary holding is appropriate for large companies. Ultimately though, this figure is at the discretion of each company as it is dependent on basic salary, company circumstances and share price.
- Avoiding payment for failure – the Working Group recognises some models with less variable remuneration may lead to higher pay-outs in circumstances of failure. Therefore, the Group suggest the potential use of clawbacks by remuneration committees.
- Accountability – some of the models will lead to a less formulaic method of calculating remuneration. This will require greater engagement from and use of discretion by the remuneration committee. This will necessitate greater involvement of shareholders to listen to the remuneration committee’s reasoning and hold them to account.