UK: Rethink on Boardroom Pay

The National Association of Pension Funds and Hermes Equity Ownership Services have called for a major rethink on executive pay and its alignment with the long-term performance of the company.

The report, published on behalf of a number of pension fund investors, sets out four key principles aimed at encouraging companies to review and amend their remuneration arrangements in the lead up to the new binding vote on future remuneration policy. A copy of our July 2012 briefing on the new proposed remuneration reporting requirements is available here.

 1. Management should make a material long-term investment in shares of the businesses they manage

Companies are encouraged to re-evaluate current remuneration arrangements and align executive pay more closely with the interests of shareholders through longer-term share ownership. Ownership obligations should increase with seniority, such that the bulk of an executive's variable remuneration flows over time as a result of owning shares.

Shares acquired by executives should be held for at least 10 years, and in some cases until retirement age, regardless of whether or not the executives still hold office; the belief being that exposure to longer-term risk will encourage longer-term thinking. The report provides examples of possible unintended consequences of executive share ownership, which boards should guard against, such as overly aggressive dividend policies and the encouragement of takeovers to permit accelerated disposals.

 Remuneration committees are strongly encouraged to consider awarding a proportion of an executive's base salary in shares, as well as any significant salary increases. Clearly, this would only be possible with the consent of the executive concerned and if this forms part of a company's binding remuneration policy.

 2. Pay should be aligned to long-term success and the desired corporate culture throughout the organisation

 There is concern that too much focus is on short to medium performance, with an over-emphasis of EPS and TSR performance, and insufficient regard to the strategy and time frame over which such strategy should be achieved. Remuneration committees are recommended to consider the design of future performance conditions, the starting point being the company's strategic plan, and then set key performance indicators which best reflect executives' objectives.

 NAPF and Hermes note that there have recently been a number of large cash and share-based awards with short retention periods and no clear link to performance which they consider to be inappropriate.

 3. Pay schemes should be simple, understandable for both investors and executives, and ensure that rewards reflect long-term returns to shareholders

 Part of the complexity around remuneration structures may be due to the focus on metrics and targets rather than behaviours and outcomes.  It is felt that executives participate in too many long-term incentive arrangements with varying performance conditions and, as a result, may not motivate executives where there is no clear line of sight as to what they need to achieve. Setting a long-term course and measuring, explaining and incentivising annually, with a balance score card of metrics based on key performance indicators, may be a better way to create long-term value.

 4. Remuneration Committees should fully explain and justify how their decisions operate to deliver long-term business success

 Remuneration committees are encouraged to exercise discretion when reviewing overall performance in relation to the vesting of awards and should consider reducing the extent to which awards vest (potentially to nil) where performance targets have been achieved by inappropriate methods; for example, aggressive accounting or high leverage or if the company has suffered reputational damage. Using a balanced score card of metrics combined with the exercise of appropriate judgement as a way to assess not only performance but how it was achieved is recommended.

Conclusion

As shareholder powers are about to be strengthened as a result of the new binding vote on the future remuneration policy, companies will need to be more proactive when engaging with their shareholders to ensure that their remuneration policies receive the requisite level of support. Companies should now be reviewing their current remuneration arrangements to ensure that they meet the requirements laid down by their shareholders and those shareholders' representation bodies. Already, we have seen certain companies extending the period over which the performance targets are to be tested and implementing minimum holding periods following the acquisition of shares.

 NAPF and Hermes will now be hosting a number of seminars to bring together remuneration committee chairs and shareholder representatives in order to discuss the above remuneration principles. In addition, the report is to be refined so that it will offer what is described as an authoritative guide on companies' pay practices. As companies re-evaluate their current remuneration policies, consideration will need to be given to the refined remuneration principles, together with other institutional investor guidelines, when drafting their new remuneration policies.

For more information please contact Paul Ellerman, Mark Ife or Matthew Emms in our remuneration and incentives team.