How to strengthen remuneration governance

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry has honed in on remuneration, including the board’s role. Here our Advocacy team outline how remuneration governance can be strengthened from the board level down, and what this means for directors (including 10 questions to ask).

In his interim report, Commissioner Hayne made a number of observations regarding the causes of misconduct by entities, including the intersection of culture, governance and remuneration within entities, and observed that there can be no doubt that remuneration practices can drive, and in Australia have driven, conduct of staff and conduct of intermediaries that is not consistent with the interests of the customer.

The final round of policy hearings held by the Royal Commission further explored this theme, including the role of the board in determining remuneration outcomes. Subsequently, we have seen NAB, Westpac and ANZ receive strikes against their remuneration reports (with NAB receiving a ‘no’ vote of more than 80%).

In our submission to the Commission, the AICD commented that remuneration is not the only organisational lever to influence culture – rather, remuneration policy sits within a broader cultural ecosystem that includes other people-oriented processes, as well as ethical frameworks and risk controls.

In this article we consider how and where remuneration governance can be strengthened from the board level down, and what this means for directors (a suggested list of questions for directors to ask is included in the final section). In short, directors need to be probing management on remuneration recommendations and receiving adequate information to make well-informed, and publicly justifiable remuneration decisions.

Remuneration roles and responsibilities

As a starting point, internal frameworks for making remuneration decisions – including the role and responsibilities of the board, remuneration committees, executives and management - should be clear and documented.

To support a robust internal framework, appropriate delegations of authority should be in place. This requires key governance documents such as board and committee charters and charts of authority (that specify delegations from the Board to the CEO and from the CEO to management) to be specific, and well understood. This will assist in clarifying divisions of responsibilities and focus directors’ and executives’ minds on roles and accountability.

To support directors in effectively discharging their responsibilities, reporting processes and information flows need to have been agreed, well understood and embedded in practice. High quality board and committee papers that strike the right balance between being clear and concise, while providing the right level of detailed information in order to enable informed decision-making, are also critical.

Driving desired behaviours

Remuneration arrangements are aimed at driving and rewarding performance outcomes, but it is also important that they achieve the right behaviours. To this end, it important to be clear with executives and other employees on the purpose of variable remuneration, the rationale for particular performance metrics, and the importance of “how” performance is delivered (i.e. the expected behaviours).

The debate on this topic often understandably gravitates towards the importance of applying remuneration consequences to address conduct issues (see further below).

However, to ensure reward arrangements are effective, it is also essential to not lose sight of the need to champion and reward positive behaviours. Indeed, in the AICD submission to the Royal Commission, we agreed that companies should consider whether staff are properly rewarded for ‘doing the right thing’ (for example, identifying a breach of the law).

Exercise of board discretion in determining incentive outcomes

A key theme of the final round of policy hearings before the Royal Commission was the appropriateness (or otherwise) of certain remuneration outcomes for senior executives in circumstances where risk failures and instances of misconduct had occurred.

The use of remuneration outcomes to hold individuals accountable was also a theme of the final report of the APRA Prudential Inquiry in CBA, which emphasised that a willingness to excuse poor risk outcomes with limited consequence for executive remuneration has undermined the usefulness of variable remuneration schemes as a tool for promoting prudent risk-taking behaviours.

The AICD has previously acknowledged that, overall, it is clear that boards are expected to engage in more rigorous analysis to justify remuneration outcomes, including through the lens of conduct and risk issues. This can be particularly important at the most senior level to ‘set the tone from the top’ and demonstrate to all employees - as well as investors - that senior leaders will also suffer remuneration consequences for poor outcomes. However, there is also an expectation that appropriate adjustments to variable remuneration need to be made at all levels of an organisation where risk failures have occurred.

In the context of executive remuneration, this will involve robust challenge of management recommendations by the remuneration committee and the conducting of performance assessments through the lens of risk and conduct issues. In the context of other employees, clearer expectations may need to be communicated to managers throughout the organisation.

Interestingly, APRA’s April 2018 Information Paper on Remuneration Practices at large financial institutions noted that while the majority of institutions stated in relevant policies that risks are considered when determining bonus pools amounts, the review found that bonus pool amounts are still largely based on short-term performance measures, with little evidence of explicit consideration of longer-term risk measures. Furthermore, the majority of the sample had not developed mechanisms or processes for the adjustment of the bonus pool to respond to significant risk events.

Managing conflicts of interest

The importance of the role of the board in determining remuneration outcomes is underscored by inherent conflicts of interest at a management level. Boards should consider whether they are satisfied that the processes in place to support independent decision-making are effective.

In determining remuneration outcomes, boards may benefit from a broad internal perspective (ie, not just the CEO perspective). For example, is the Head of Human Resources comfortable that the remuneration framework in place allows the organisation to attract and retain the best people, and motivate them in an appropriate way?

Has the CFO provided input on the framework and associated remuneration outcomes having regard to affordability (including relative to business performance)? What is the view of the Chief Risk Officer on whether an organisation’s incentive plans drive the right behaviours, and how has it been reached? (Noting that for APRA regulated entities, APRA Prudential Standard CPS 220 requires the CRO to be involved in, and have the authority to provide effective challenge to, activities and decisions that may materially affect the institution’s risk profile.)

While different internal lenses will inform the board’s decision-making, boards may also wish to seek advice from independent advisers; provide market practice insight and learnings from other companies; and offer an external perspective on difficult decisions. Independent advice can also assist with countering any perception of board capture by management. In this case, it will be important that the adviser understands that they owe their duties to the board, not management.

When seeking external support it is important to keep in mind that there are Corporations Act provisions that require certain disclosures in relation to remuneration consultants. Many companies adopt remuneration consultant protocols to assist them in complying with these requirements.

Shareholder and other stakeholder engagement

Another critical component of remuneration governance for listed companies is shareholder and proxy adviser engagement.

It is important that shareholders and proxy advisers understand and are supportive of the board’s approach to remuneration, particularly given the levers available to shareholders in the Corporations Act, including the ‘two strikes’ rule.

A related consideration is the need for disclosures to be as clear and transparent as possible. In the current climate, clarity on risk alignment is especially important. For financial service entities, companies will need to clearly describe the measures taken to ensure that incentives are not risk inducing or potentially detrimental to capital adequacy, in line with APRA guidelines. Other entities should also consider how they can demonstrate the alignment between risk and remuneration.

A wider net?

The board is typically responsible for overseeing the company’s executive remuneration strategy and framework (including its alignment with business strategy), and approving remuneration outcomes for the CEO and senior executives (and a limited number of additional persons for those financial services entities that must comply with APRA Prudential Standard 510). Management is responsible for making recommendations to the board, operationalising decisions, and implementing remuneration practices throughout the organisation.

Given the misconduct highlighted at the Royal Commission hearings, and in particular the link between misconduct and remuneration, boards may wish to consider whether they require a greater level of oversight over remuneration practices – and the behaviours they drive - throughout their organisation.

The question of whole-of-organisation remuneration has been considered at a policy level.

For example, Treasury’s submission to the Royal Commission noted that one way of strengthening the Banking Executive Accountability Regime (BEAR) could be to require a senior executive to have explicit accountability to ensure that remuneration practices and policies set by the board are appropriately cascaded through an organisation.

Separately, the Productivity Commission’s report Competition in the Australian Financial System has recommended that all banks appoint a Principal Integrity Officer (PIO) (with a direct line to the board) to protect against incentive payments which conflict with customer interests.

Questions for directors to ask

1. Has the board considered whether it is satisfied with the framework it has in place to support remuneration decision-making processes?
2. Do the metrics in place support the organisation’s desired culture? Is there an overreliance on lag indicators?
3. Is the testing of metrics robust? For example, would it be appropriate for external, independent assessments to be made to supplement or test management recommendations?
4. Does the remuneration committee receive sufficient information from management to make informed decisions? Does the board?
5. How often does the board approve an amount different from the amount management has recommended?
6. Is the board provided sufficient information to apply discretion when considering executive accountability? Is the board provided with an overview of relevant issues (based on, for example, legal breaches or other regulatory issues, whistleblower reports, audit findings, HR cases and safety incidents)?
7. Is the board informed of the levers available to hold executives accountable through remuneration outcomes (including, for example, reduction of current year incentive outcomes, or reduction of deferred equity or LTI awards on-foot)? Do the incentive plan documents provide the board with the necessary discretion in this regard?
8. Does the board scan the market from time to time to benchmark incentive plans against ‘good’ or developing practice?
9. Does the board have sufficient oversight of whole-of-organisation remuneration in order to understand the impact on the company’s risk profile and culture?
10. Is the board comfortable that it can explain to shareholders and other stakeholders how and why variable remuneration has been determined?