The 2009 update to the ABI Guidelines on Executive Remuneration will be a disappointment to many investors. The amended guidelines fail to deal with some of the key structural deficiencies in executive pay practice and guidance – a contributory factor to the downturn – although the ABI has inserted 53 words to emphasis the need to take risks fully into account when devising pay policies and practices.
The opening section of the guidelines set out the principles, and here an addition to the text highlights the need to ensure that risks are fully taken into account:
Boards are responsible for adopting remuneration policies and practices that promote the success of companies in creating value for shareholders over the longer term. The policies and practices should be demonstrably aligned with the corporate objectives and business strategy, taking risks fully into account, and reviewed regularly. [addition is underlined text]
In the guidelines on the Remuneration Committee and their responsibilities, the opening sentence of the main provisions now includes a reference to risk:
Remuneration Committees are responsible for ensuring that the mix of incentives reflects the company’s needs, establishes an appropriate balance between fixed and variable remuneration, and is based on targets that are appropriately stretching, verifiable and relevant and which take account of risk. [addition is underlined text]
Later in the main provisions, in a paragraph dealing with arrangements for other senior executives, the ABI suggests a link to the Enhanced Business Review:
Remuneration Committees should also pay particular attention to arrangements for senior executives who are not board members but have a significant influence over the company’s ability to meet its strategic objectives. In this context, they should have oversight of all associated risks arising throughout the firm as a result of remuneration. Boards should consider disclosure of these risks and how they are managed in accordance with their obligations under the Enhanced Business Review. [addition is underlined text]
While the additions certainly improve the guidelines, they do little to address areas of key concern highlighted here previously. The review of best practice called for in the NAPF’s letter to FTSE 350 Chairmen evidently remains outstanding.
No effort has been made to address the nature of the individual participation limits typically used in share plans, which have the disturbing potential to encourage boom and bust cycles, a factor indeed recognised by the ABI in a letter to remuneration committee chairmen in September 2008:
Where a company has underperformed and seen a significant fall in its share price, this should be taken into account when determining the level of awards under share incentive schemes. In such circumstances, it is not appropriate for executives to receive awards of such a size that they are perceived as rewards for failure.
Under the Guidance for Share Schemes, a redrafted section 3 on grant policy might therefore have been appropriate. At present the ABI addresses only the phasing of awards and grants although the section on cost and basis of participation suggests companies should express individual participation as a function of base salary (the key problem). The request for expected value disclosures on new share plans continues to be ignored by remuneration advisers and companies alike.
On individual participation, the IFSA Executive Share Plan Guidelines in Australia take an interesting approach, focusing not on a function of base salary but on the specific circumstances:
Entitlements under an equity plan should be reasonable, taking into account the total remuneration package of an executive and reflect that executive’s position and level of responsibility. Although equity plan design will vary, the level of reward that an executive may be entitled to if they achieve their performance benchmarks should generally be consistent with equity plans for companies of similar size, industry and complexity.
An equity plan should also take into account the circumstances of the company, including the market place in which it competes, and the executive at the time of the grant.
On performance measures, the ABI guidelines over-emphasise TSR, including a reference to it in the first sentence under the section on performance criteria at the expense of encouraging performance measures that are appropriate to the company’s circumstances. TSR measures the value of a company rather than its performance. TSR as a performance measure therefore measures the effect on the market of the performance of the company, rather than the performance of the company itself. Irrational market exuberance may thus reward executives. The prime example of the folly of utilising only TSR in incentive plans was the record cash payout to Mick Davis at Xstrata in 2008, only for the share price to collapse shortly afterwards.
Total Shareholder Return (TSR) relative to a relevant index or peer group is one of a number of generally acceptable performance criteria. However, Remuneration Committees should satisfy themselves prior to vesting that the recorded TSR or other criterion is a genuine reflection of the company’s underlying financial performance, and explain their reasoning.
The IFSA Executive Share Plan Guidelines take an altogether different tack on this issue:
Executive equity plans should be designed to reward superior performance. Companies should develop executive equity plans that provide incentives and rewards based on materially improved company performance in terms of growth in the value of the company and resulting increases in shareholder value. The selection of suitable performance benchmarks are critical to securing this objective and are expected to vary depending on each company’s circumstances.
In this context, it is disappointing that a more thorough overhaul of the guidelines has not been considered. In proxy season 2010, do not be surprised to hear companies bemoaning that shareholders are unhappy with pay policies, despite the company’s policies being “broadly consistent with the ABI Guidelines”.
ABI Executive Remuneration Guidelines, Dec 2009