AICD responds to APRA’s proposed standard on remuneration

The AICD has lodged a submission with APRA on its proposed new standard on executive remuneration – CPS 511. The standard is far-reaching and will affect all APRA-regulated entities.

The standard is informed by the findings and recommendations of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, as well as through insights gained by APRA through its prudential inquiry into the Commonwealth Bank of Australia and other regulatory reviews. It represents a departure from the previous principles-based approach that APRA has taken to remuneration, and instead sets out extensive and prescriptive requirements for firms’ remuneration frameworks.

The AICD acknowledges the need to review and strengthen the regulatory settings that apply to pay in the financial services sector. We support a stand-alone prudential standard on remuneration, recognising the significant impact that remuneration structures can have on firm culture, conduct and performance, and the need to strengthen current remuneration practices.

We also support several key aspects of the standard, including requiring board approval of the remuneration policy and active oversight of an entity’s overall remuneration framework, adjustments to remuneration outcomes to reflect performance and risk outcomes, and regular compliance and effectiveness reviews.

However, we are concerned that the more prescriptive elements of the standard may ultimately work against APRA’s objectives. In some instances, they go well beyond financial services’ pay regulation in other highly regulated jurisdictions.

Overview of proposals

The standard touches on almost all aspects of remuneration, from overall Board oversight and approval of remuneration frameworks, down to design, including deferral and clawback of variable remuneration.

In particular, APRA has proposed that the board must approve the remuneration policy, actively oversee the remuneration framework, approve the specific remuneration of senior executives and other key roles and ensure that risk and reward outcomes are aligned. This will result in a much more direct oversight role for boards, particularly when it comes to approving the individual remuneration arrangements for senior executives.

Another key feature of APRA’s new standard is to increase the use of non-financial performance measures for variable remuneration. The standard proposes mandatory consideration of factors such as how the remuneration framework promotes effective management of financial and non-financial risks, as well as a proposed ‘cap’ on financial measures, which would limit financial measures to 50% of performance measures across variable rewards.

For significant financial institutions, APRA also proposes much longer deferral periods than current industry practice and the requirements under the Banking Executive Accountability Regime. For the CEO, APRA is proposing a 7-year deferral period with pro-rata vesting after 4 years, and a 6-year deferral period for senior managers and highly-paid material risk takers.

Finally, again for significant financial institutions, APRA is proposing mandatory malus and clawback requirements, including a clawback period for at least 2 years after variable remuneration vests, and up to another 2 years where an individual is under investigation.

Key challenges

As currently drafted, the standard presents particular challenges for boards of listed entities given the “two-strikes rule” on the remuneration report, which could lead to an unworkable tension between regulator demands and investor expectations given investors’ strong views on how executive remuneration should be structured (including a strong preference for financial rather than non-financial targets).

Further, while we agree that it is important to have mechanisms such as deferral to ensure alignment between risk and reward, we are concerned that some of the proposals could significantly diminish the motivational effect of long-term incentives.

In our submission, we have urged APRA to reconsider the following proposals:

• the requirement that the board approve the remuneration arrangements and outcomes for an expanded number of people, which, as currently drafted, is impractical and risks blurring the role and accountability of the board and management;
• the imposition of a 50% cap on financial metrics across all variable remuneration, which is a blunt instrument that undermines the board’s role in setting remuneration structures that are tailored to the needs of their organisations. Further, it does not accommodate the range of remuneration models used in the market, many of which may be more responsive to risk and performance outcomes; and
• the lengthy deferral period (with clawback on top) that applies across sectors, which is at odds with our understanding of international practice and is not sufficiently sensitive to differences in entity risk profile and strategy.

Overall, we consider it to be critical that boards retain responsibility and accountability for structuring executive remuneration and setting remuneration frameworks that are tailored to their organisation’s strategy and risk profile.

The AICD’s full submission can be found here.