The Investment Association (IA) recently wrote to the chairmen of remuneration committees of all FTSE 350 companies with key changes to its Principles of Remuneration (the Principles). The changes follow on from the Executive Remuneration Working Group Final Report that was published in July 2016 and sets out a significant shift in a number of important areas. The Principles are mainly targeted at companies with a main market listing but are also relevant to companies on other public markets (including AIM).
For a copy of the updated Principles, click here. To view a copy of the letter to remuneration committee chairmen, click here.
The 2017 reporting/AGM season will see a large proportion of listed companies putting their remuneration policies back to shareholders for renewal. The updated Principles will therefore need to be thought through carefully and consideration given to what extent they should influence the design of executive remuneration.
The key changes are as follows:
- Greater flexibility
Whilst continuing to promote simplicity and transparency, the Principles no longer recommend a single preferred structure for variable remuneration - i.e. an annual bonus plan and a long term incentive plan (LTIP). Rather they acknowledge there should be increased choice for companies when it comes to choosing a remuneration structure that is best suited to them. The Principles positively encourage remuneration committees to adopt remuneration structures that are appropriate for their particular business and ongoing strategy, provided that they are designed to deliver value to shareholders in the long term.
A shift in approach from a "one-size fits all" is welcomed but this will need to be coupled with greater engagement with a company's institutional shareholders to ensure they fully understand and are supportive of the proposals being made.
- Post termination shareholding requirements
There is now an expectation for remuneration committees to consider implementing post-employment shareholding requirements. Executives would be required to retain part of their shareholding for a specified period of time after they have left employment. Although no guidance is given on how long that period should be, consistent with the overall theme of the amended Principles, companies will want to consider how best to tailor any post-employment shareholding requirements to appropriately reflect the role of the executive.
- Pay ratio
To give context to the remuneration that is paid to executives, a pay ratio between the executive team and groups of employees in the company's workforce (including the median employee) should be used as a reference point.
Whilst not specifically addressed in the Principles, the covering letter to remuneration committees goes further by suggesting pay ratios should be disclosed, including the pay ratio between the CEO and the median employee.
A pay ratio in this context is addressed for the first time, reflecting the recent BIS Select Committee inquiry on corporate governance which raised the question of introducing pay ratios. Exactly how pay is defined and deciding which groups of employees should be included for the purposes of determining the pay ratio will need to be considered, but it is likely that companies will want to be consistent with the way this will be calculated for gender pay reporting requirements which come into force in April 2017.
- Consulting with shareholders
A 'Shareholder Consultation' section has been added into the Principles, shifting the focus from consultation with shareholders from the details of pay, to the major strategic remuneration issues. It also clarifies the role of consultation with shareholders and confirms that companies should listen and respond to shareholder feedback.
In cases where there is a significant vote against a remuneration report (20% or more of the votes cast), companies should try to find out the reasons why. In addition, companies should publish an explanation of the reasons for the vote against the policy and say what is being done to address the concerns raised.
- Annual bonuses
The Principles raise the expectation around how much information should be given in relation to annual bonuses. In particular, there should be full retrospective disclosure of bonus targets, the level of performance achieved against these targets and the resulting bonus amounts paid. Disclosure of the bonus targets should be made no later than two years following payment, but preferably within one year.
If companies fail to disclose targets and/or target ranges, they are likely to be 'red-topped' because there will be insufficient information for shareholders to make informed voting decisions.
In addition, a thorough explanation as to why bonus payments have been made, not just a description of non-financial performance indicators, will be required. If companies provide insufficient information on non-financial targets, companies are likely to be 'amber-topped'.
If companies consider amending their remuneration policy towards annual performance periods instead of long term performance, shareholders would expect a reduction in maximum potential to reflect the increased certainty of measuring performance.
- Long term incentive awards
(a) Performance targets
Where adjustments are made to the metrics for performance targets, these adjustments and their impact should be clearly explained. The impact of any share buy backs, and other capital management decisions, should be taken into account when determining whether or not a performance measure has been met.
(b) Grant size
In relation to grant size for executives, where a fixed number of shares is used (as opposed to a multiple of salary) the number of shares that have been awarded should be reviewed to ensure that windfall gains do not arise where a share price has increased. In any event, remuneration committees should review each year whether or not the grant level is appropriate in light of company performance and/or share price performance
(c) Change of control
The IA has confirmed there is a shareholder preference that in the event of a change of control, any outstanding awards owing to directors be rolled over and exchanged for equivalent awards in the new entity, rather than immediately vesting and/or becoming exercisable. Obviously, achieving this will depend on whether rollover is offered by a buyer and whether the buyer's view is that executives should be incentivised under a new arrangement that is more suitable to reflect the nature of the business at that time - and its objectives under a new ownership structure.
(d) Restricted share awards
There has been some recent discussion in the industry around whether using a restricted share scheme may be a suitable alternative to the traditional performance based LTIP. For the first time, the possibility of awarding restricted shares to executives is addressed in the Principles.
Some shareholders are resistant to the use of restricted shares but others have indicated that they would support the use of restricted shares if it works for a particular company structure and can be justified by the relevant remuneration committee. If a company has a sensible historic approach to remuneration and a level of trust with its investors and shareholders then it is more likely to be supported.
However, the trade-off is that grant sizes should be reduced by 50%. In addition, awards should not vest earlier than the third anniversary of the date of grant at which point they should then vest in equal tranches over time. A significant shareholding requirement should also couple any restricted share arrangement.
There is still a concern regarding the disparity between executive director pension provision and that of the general workforce. In instances where contribution rates for executives and the general workforce differ, the differences should be clearly justified. If there is no clear justification then the company must clearly explain how it intends to reduce the disparity.
Comment: The Principles reflect a shift in approach as to how institutional investors are prepared to engage in discussion around executive remuneration. Companies have often been frustrated with the inability to design remuneration structures that best suit their individual needs and which are tailored to reflect their specific financial model and strategy. Whilst additional flexibility is tempered with additional disclosure, it is hoped that ongoing and positive dialogue will build up a level of trust that demonstrates a company's commitment to strengthen the link between pay and performance.
For further information on this topic or to discuss any other aspect of your company's employee share plans and executive remuneration, please contact us.