ASX300 Incentive Practices

This Insight summarises and comments on the incentive practices of companies in the ASX300. The data was extracted from FY16 annual reports. As change in the incentive area tends not to be rapid, companies can be confident that this data is reflective of current practices.

GRG Remuneration Insight 97

by Denis Godfrey, Nida Khoury & James Bourchier
24 August 2017

What is an ASX300 Company?

The group of companies that constitute the ASX300 regularly changes as companies move into or out of the ASX300 due to changes in market capitalisation, listing or delisting or other factors that affect qualification for inclusion in the ASX300. Typically, the ASX300 covers market capitalisations down to below $100 million. Thus, there are many ASX listed companies that fall within the ASX300 market capitalisation range but are not included in the ASX300. Hence, the ASX300 is not a comprehensive group of companies of similar size. Nevertheless, it remains a solid group by which to assess the market practices of leading Australian companies, from a qualitative if not a quantitative perspective. Tailored benchmarking can provide appropriate references regarding quantum.

Incentive Mixes

The vast majority of ASX300 companies use both a short term incentive (STI) with or without deferral and a long term incentive (LTI). A small minority use a single incentive plan (SIP). The SIP typically involves a large STI award of which part or all is deferred into equity with disposal restrictions or service vesting conditions covering several years.

The market has not been able to identify meaningful and measurable STI key performance indicators (KPIs) that evidence good long term decision making or otherwise reflect long term growth in shareholder value. Thus, SIPs tend to use commonly applied KPIs that focus on annual performance and produce excessive short-termism, which is a major concern to serious long term investors including many institutions and super funds. BlackRock has written extensively on this.

Despite being promoted by well-meaning but ill-informed stakeholders it remains unlikely that the SIP approach will gain traction while its inherent deficiencies remain unaddressed, and GRG has observed a number of companies rolling back this practice, re-introducing LTI, since variation in SIP does not correlate well with long term performance from a shareholder perspective.

Long Term Incentives

Key points to emerge from the analysis of LTI plan practices among the ASX300.

1. Rights are overwhelmingly used in preference to options, other equity instruments or cash. Often it is unclear whether the rights are share rights or indeterminate rights, although indeterminate rights are growing in use due to their flexibility and improved tax and termination outcomes.
2. Annual granting of LTI as part of an annual package earned each year, is the dominant approach.
3. Due to pressure from proxy advisors the formula for calculating the number of equity units to grants that is increasingly being adopted is:
   Stretch LTI Award Value ÷ Share Price.
   While it appears to be simple it does necessitate adjustment to the Stretch LTI Award Value to recognise both the nature of the vesting scale that will apply to the grant and that the value of the equity unit being granted is generally less than the Share Price – rights and options have values that are lower than the Share Price. The main point of confusion in this area tends to be poor interpretation or application of the Threshold, Target and Stretch concepts.
4. Measurement periods used to assess long term performance remain overwhelmingly at 3 years.
5. Retesting remains a minority practice even though it can be acceptable to various stakeholders, if appropriately structured to ensure that it does not make vesting easier, and no “second bite of the cherry”.
6. Performance vesting conditions are slowly undergoing transformation with: a. Ranked TSR (rTSR) being replaced by other TSR metrics , financial metrics and other metrics, b. EPS growth is being replaced by other financial metrics with return metrics dominating e.g. ROIC, ROE, RONA. These tend to link better to TSR over the long term, when the cost of capital is a consideration in setting the goals and capital is not diminishing. However, rTSR and EPS growth remain the two most commonly used performance metrics, despite their obvious deficiencies.
7. Most LTI plans use at least two performance metrics, with one internal and one external measure emerging as a popular approach.
8. For EPS growth and other financial metrics it is understood that some proxy advisors are assessing their degree of difficulty by reference to consensus forecasts of stock analysts and expecting significant outperformance for stretch targets. To address this development companies are making reference to analysts’ forecast and explaining, when relevant, why their targets differ from the analysts’ forecasts.
9. Retention of shares acquired under LTI plans is an emerging concern for governance advisors and stakeholder groups. Such retention is becoming expected for a period ending up to 3 years following termination of employment, noting that a number of executives have landed in hot water for selling equity to pay down tax while still employed. Such issues are entirely surmountable.
10. The accounting treatment of LTI grants with service conditions and financial and other non-market related performance vesting conditions seems to have been a factor in the change away from rTSR to return metrics. Actual vesting does not affect the accounting charge for equity instruments with market related vesting conditions whereas it directly affects the accounting charge for those with non-market related vesting conditions.
11. Some companies are starting to consider the use of performance vesting conditions that do not require service for the complete measurement period. This restores the value of LTI as a remuneration component, and changes the accounting for the grant from being amortised over the measurement period to being expensed in the year of grant and allows greater discounting of the value of the grant to recognise a wide range of conditions attached to the grant (regardless of the vesting condition class).

Short Term Incentives

STIs remain the least well disclosed aspect of executive remuneration. However, several important features of current market practice emerged from our analysis.

1. Measurement periods remain stable at one year being the company’s financial year.
2. Key performance indicators (KPIs) continue to be selected from business plans and budgets.
3. Performance targets tend to be derived from budgets.
4. Actual performance targets for future incentives are rarely, if ever, disclosed in Remuneration Reports on the basis of commercial sensitivity and not wishing to inadvertently provide market guidance on future expected financial performance. Sometimes prior year targets are disclosed, and this appears to be a response to pressure from stakeholder groups to provide transparency regarding the link between performance and reward outcomes.
5. Deferral of part of STI awards into equity is common practice. The need for deferral arose from excessive weighting of incentives towards the short term. While deferral helps address this problem it does not address the fundamental problem of inadequate weighting on the LTI, as deferred STI varies less than LTI.
6. To delay the taxing point on deferred amounts of STI it has been common practice for deferred STI to be subject to risk of forfeiture if a period of service was not completed. This practice arose because to defer the taxing point there needed to be a real risk of forfeiture in the past. Changes to the taxation laws mean that there is no need for a real risk of forfeiture to defer the taxing point. Conditions attached to STI deferred into equity are starting to reflect the changes to the taxations laws.

Holding Policies

An alternative to applying disposal restrictions to shares acquired under LTI plans and deferral of STI awards is for companies to adopt minimum shareholding policies applicable to senior executives (and to non-executive directors). While not as tax effective as disposal restrictions they can help to achieve a similar outcomes, although the lack of tax efficiency makes it more difficult for executives to build up the required levels of shareholding. Introducing salary sacrifice plans can address both the tax efficiency, and holding of equity issues. Holding policies are now common among ASX300 companies.

Target Incentive Award Opportunities

GRG has for some time been collecting two sets of information on incentive award opportunities being:

1. Actual reported amounts of STI and LTI, and
2. Policy targets for STI and LTI.

The policy targets for STI and LTI that are collected are those where GRG is confident that the disclosures are consistent with GRG’s definition of Target or GRG has been able to confidently determine a target. The “target” award opportunity level is seen as the award applying when a challenging but achievable performance level is achieved, and not a maximum or stretch outcome. GRG has adopted the foregoing approach because companies do not apply consistent approaches to setting targets. For example, it is not uncommon for companies to refer to the stretch levels of LTI as being the target even though only 50% vests at the level of commendable/expected performance and the maximum/“target” outcome being considered highly unlikely (i.e. aspirational target). Disclosure of “target” award opportunity levels is reasonable among the ASX300 companies but poor for others, particularly smaller companies.

The data in the tables below shows that policy data on targets levels of award opportunity is generally higher than actual reported data. In relation to LTI this arises for several reasons including:

1. Amortisation over measurement periods (typically 3 years) and annual grants give rise to several effects:
   1. No LTI being reported until an LTI grant has been made,
   2. The LTI values reported will be less than the target LTI value whenever the executive has received less LTI grants than the number of years in the measurement period,
   3. The effect of a rise in the value of LTI opportunities is spread over the measurement period.
2. If the performance vesting conditions are non-market related and vesting is not being achieved then LTI reported values will be nil or even negative in some circumstances.

For STI the median actual reported values also tend to be lower than the policy target award opportunities, despite significant variation between the STI awards earned by individuals. Analysis of actual STI awards compared to target policy levels suggests that around 38% of participants received awards in the range of 80% to 120% of the target policy, 38% received awards below the target policy and 24% received awards higher than the target policy. On the following page is a summary of the policy targets and actual payouts for STI and LTI combined for roles that are direct reports to the CEO.

For more detailed information on STI and LTI market practices among ASX300 companies or companies of any size, please feel free to contact us.