Latest Market Insights into Incentive/Variable Remuneration Trends

Each year GRG analyses the senior executive incentives practices of the ASX300 and publishes the results in the Variable Remuneration Guide to help clients determine whether a deeper strategic review may be needed. We highlight some of the key findings from the latest edition.

GRG Remuneration Insight 144

by Denis Godfrey, James Bourchier & Peter Godfrey
8 November 2022

One of the most complex areas in the field of executive remuneration is incentives, or as it is increasingly referred to in the modern governance environment, variable remuneration. The full range of stakeholders from shareholders through to executives through to Remuneration Committees often struggle to get a sense of how executive incentives compare to peers, not least of all because it often takes an expert team to make sense of the disclosures in remuneration reports. Each year Godfrey Remuneration Group Pty Limited (GRG) analyses the variable remuneration practices of the ASX 300 (281 companies in the sample due to certain non-disclosing entities being among the 300) in relation to their senior executives, to provide comprehensive information to support sense checking and to help determine whether a deeper, strategic review may be needed. The results of that analysis are published in the GRG KMP Variable Remuneration Guides (previously referred to as the Incentive Guide). This GRG Remuneration Insight highlights some of the key findings from the latest edition of the Guide.

Variable Remuneration Plans Overview

The two main types of variable remuneration plans are:

• short term incentives (STIs) or short term variable remuneration (STVR), and
• long term incentives (LTIs) or long term variable remuneration (LTVR).

A small number of companies have attempted to maintain the poorly regarded Single Incentive Plan (SIP), but its use has declined to a minimal percentage of companies which have ignored criticism from the majority of stakeholders.  It should be noted that Simple SIPs are STIs (no LTI) with payment partly in cash and partly in equity instruments that are either vested at grant or vest with future service.  Complex SIPs are similar to Simple SIPs except that they are partly paid out in equity instruments with additional performance vesting conditions, comparable to those used in LTI plans.  Complex SIPs fail to meet their primary objective, which was to achieve greater simplicity – instead, short and long term reward systems become inextricably conflated, with no fewer instruments, rules or variables.  Both types of SIPs excessively focus on short term results and undermine long term alignment.

The foregoing table has been extracted from the FY23 GRG KMP Variable Remuneration Guide and shows that SIP usage is minor compared to STVR plans used in conjunction with LTVR plans. SIPs will not be discussed in further detail in this Insight.

Long Term Variable Remuneration Plans

Common Features

LTVR plans are the most powerful tool in supporting long-term behaviours and strategic thinking, and aligning the experience of various stakeholders.  Accordingly, they should have at least an equal weighting to STVR as part of executive remuneration packages.  Unfortunately, most such plans suffer from antiquated terms that have poor links to executive contributions, making them unlikely to produce value, e.g. service testing that matches long term outcomes testing.  Certain aspects of the design of LTVR plans have remained relatively stable over recent years including:

1. annual grants of equity instruments are offered, as part of an annual package,
2. equity instruments are mainly rights, but options (or increasingly Share Appreciation Rights/SARs which produce identical outcomes at lower dilution) are used when more appropriate to a company’s circumstances including growth prospects,
3. performance-based vesting conditions are attached to the equity instruments,
4. measurement periods are typically at least 3 years,
5. two performance metrics are commonly used, to balance performance views,
6.  retesting of performance is now exceptionally rare.

Evolving Features

Other aspects have been evolving such as:

1. the following tables, extracted from the FY23 GRG KMP Variable Remuneration Guide, indicate the usage of various categories of performance metrics:
   
2. the forms of the TSR metric being used continue to migrate away from ranked relative TSR (rTSR) – often criticised as producing lottery-like outcomes, particularly in volatility, and producing vesting when shareholders have lost value. Indexed TSR (iTSR) which overcomes the problem of identifying a peer group set, and reduces tracking costs, has held its ground, but absolute TSR (ATSR) appears to be making a surprising comeback,
3. earnings per share growth (EPSG), which was the vastly dominant form of financial metric in the past, is being displaced by return metrics such as return on equity (ROE) and return on invested capital (ROIC), which can be more directly linked to shareholder return,
4. operational and strategic measures are starting to emerge but have not been welcomed by some stakeholder groups, particularly when metrics are opaque or discretionary,
5. using AASB2 values of equity instruments has generally been abandoned in favour of:
   1. face value (share price) for rights – this approach is favoured by Proxy Advisors, or
   2. instrument value that ignores vesting conditions for rights, options and SARs – the technically correct approach (e.g. undiscounted Black-Scholes value),
6. many companies are using stretch LTVR award opportunities to calculate the number of equity instruments to be granted, which can be correct in some circumstances but can give an erroneous result if the target vesting percentages are not taken into account to determine the stretch values for different tranches of equity instruments, – see GRG Remuneration Insight 139 for more information on this aspect,
7. malus and clawback provisions are starting to emerge in LTVR plans, not only by reference to such policies, but also by including a minimum approach built into rules,
8. exercise and disposal restrictions are increasingly being used to ensure longer-term holdings of vested equity interests, thereby ensuring that executives have more skin-in-the-game and satisfy minimum equity holding guidelines (provided that vested rights are counted towards equity holdings), as well as to enable malus and clawback policies,
9. automatic exercise of rights on vesting is being replaced by manual exercise between the latter of vesting or cessation of exercise restrictions and the end of the term of the rights, to improve financial and tax outcomes for participants,
10. gates such as TSR needing to be positive, or Environmental/Social/Governance (ESG) outcomes, are being introduced to override vesting scales and deliver nil vesting when appropriate to the performance outcome, and
11. forfeiture of unvested equity units on termination of employment is being replaced with them being allowed to be retained for possible future vesting subject to performance and the company’s malus and clawback policy. This is aligned with the removal of tax at termination, under a change to the Tax Act in FY23.

Aspects to Watch Out For

Although not yet evident or minimally evident in market practice research, several aspects need to be monitored. These include:

1. responses to changes to the way that the Corporation Act and Class Orders regulate equity issues, noting that ASIC is currently consulting on how to provide equivalent relief for on-sale of newly issued Shares, under the 1 October 2022 amendments to the Corporations Act, noting that international participants may be particularly impacted. It appears the Class Orders can now continue to be relied upon until 1 January 2023,
2. dividend equivalents in respect of vested equity (Rights) are becoming increasingly popular as a means of enabling executives to retain vested rights without the disadvantage of forgoing dividends by delaying exercise – this also supports holding policies,
3. many sets of LTVR plan rules will need to be amended to address the new requirements of the Corporations Act, and changes to the Tax Act. Such new plan rules will require shareholder approval if issues under the plan are not to count towards the ASX Listing Rules annual 15% limit on new issues that may be made without shareholder approval.
4. Due to the new employee share scheme provisions in the Corporation Act that come into effect in October 2022, it is highly likely that SARs will replace options as the equity instrument of choice in companies with high share price growth potential such as explorers, technology innovators and health care treatment developers. Traditional Options will be considered a “contribution plan” from 1 October.

Short Term Variable Remuneration

Common Features

Certain aspects of the design of STVR plans have remained relatively stable over recent years including:

1. the type of STVR plans being used are in the majority target-based plans with discrete performance metrics,
2. measurement periods being the company’s financial year,
3. performance metrics tending to be weighted to reflect their relative importance,
4. performance metrics tending to have scaled outcome ranges and scaled award opportunities, and
5. financial metrics having the highest weighting for top executives.

Evolving Features

Other aspects have been evolving such as:

1. STVR awards being partly paid in cash and partly deferred by delivery in the form of restricted equity is growing in use,
2. use of environmental/social/governance (ESG) metrics as award modifiers or gates is emerging, and
3. replacing service vesting rights with restricted rights (fully vested at grant) for STVR deferred awards since a risk of forfeiture is no longer required to defer tax.

Conclusion: Top 4 Aspects to Watch Out For

Although not yet evident or minimally evident in market practice research, several aspects need to be monitored. These include:

1. companies switching from options to SARs, which are favoured under new regulations,
2. the Government via the Australian Prudential Regulatory Authority (APRA) has, at least for the finance sector, exerted influence to increase the use of ESG performance metrics but shareholders and likeminded stakeholders have resisted this initiative in favour of outcome metrics, predominantly of a financial nature, which is pushing non-financial risk to modifier or gate arrangements. Tensions between stakeholders where non-financial risk and ESG metrics are used will be a key area to monitor,
3. deferral of a proportion of variable remuneration (STVR &/or LTVR) in the finance sector has become compulsory for senior executives and for periods of 4 or more years (including the Measurement Period) – deferral for shorter periods has become common practice in large ASX listed companies but whether the new finance sector requirements will extend to “best practice” in other sectors remain to be seen, and
4. the possibility of the ASX starting to police ASX Listing Rule 10.17B which prohibits an executive director’s remuneration from including a commission on, or a percentage of, operating revenue, noting that some ASX 300 companies are using revenue as a metric.

For more information on market practice in relation to variable remuneration plans please order your copy of the 2022 GRG KMP Variable Remuneration Guide.