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Where we’re going wrong on REM

In Australia today almost every company follows a somewhat similar formula for executive remuneration. Rather than creating remuneration schemes that incentivise their executives to perform, organisations follow a model that the market has come to expect.

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In Australia today almost every company follows a somewhat similar formula for executive remuneration. Rather than creating remuneration schemes that incentivise their executives to perform, organisations follow a model that the market has come to expect. Many boards are considering how best to break the mould and create remuneration models that reflect their business objectives.

Remuneration models have become too complex

Corporate Australia has developed a pretty complex model for executive remuneration with long-term incentives, short-term incentives and fixed remuneration. While the mix differs between companies and depends on how targets are set and weighted, the broad formula is the same across many large companies.

The problem with having complex models is that you spend so much time getting stuck in the detail rather than looking at the big picture. The basic proposition of remuneration should start with the board and management’s long-term goals. From this starting point it ought to be possible to create incentives totally aligned with the achievement, in measured steps, of those goals. This approach should enable the board to articulate clearly how the remuneration structure supports the attainment of the strategic goals not only to satisfy itself that the structure makes sense but in turn to enable the board to explain this to important stakeholders like shareholders and proxy advisors.

The fixed component of remuneration needs to be set by reference to market relativities and the company’s need to attract and retain executives with the required qualities and experience. Not much more can be said about the fixed component. The long-term incentive should be tied to wealth creation for the shareholders. The biggest problem area is the short-term incentive.

It’s not always clear what short-term incentives are for

 Many years ago, short-term incentives were called bonuses and paid on a discretionary basis for exceptional performance. Current practice, on the contrary, is to define targets for the achievement of which the executive receives a defined amount. The manner in which targets are set and achievement is measured has led to short-term incentives often being seen as part of fixed remuneration. If a company is paying 100% of their short-term incentives year after year it becomes harder to argue that the so-called “incentive” is not really part of fixed pay.

Where, for example, targets are set by reference to achievement of the numbers derived from the corporate budget, which has been set to be realistically achievable rather at “stretch”, the short-term incentives can look like a reward for business as usual, i.e. for running the business well in line with the board’s (and shareholders’) legitimate expectations.

The other issue with short-term incentives is that it’s not always clear how the incentives for short-term performance and long-term performance fit together. It’s important to marry the short-term goals with the long-term interests of the company.

A step towards overcoming some of these issues is to set short-term objectives that dovetail into the long-term objectives. Once you have set long-term targets, then set milestones for them that need to be achieved each year. These can be a major element of the short-term incentive targets that executives are rewarded for achieving.

Of itself, however, this will not overcome the “business as usual” criticism. For that to occur, the board needs to articulate its reward philosophy – is it paying 100% of STI at budget or for outperformance? There is no right answer, but boards create problems for themselves when they say they are paying “bonuses” (suggesting outperformance) when in fact they are rewarding performance in line with budget.

Incentives sometimes reward behaviour that diminishes long-term value creation

A business risk is that executives become excessively influenced by remuneration design. That’s not what you want in a chief executive.

When you’re leading a company you've got to have your wits about you, looking for small variations and market occurrences that signal you need to adapt and change direction. You can’t be driven solely by a target that was set at the beginning of the year if the continued pursuit of that target will detract from long-term performance.

Good chief executives want to be paid fairly for the work that they do and place the success of the company above their own personal gain. A good test of management’s mettle is when pre-set targets become counter-productive. A good management team will stop doing something that’s no longer in the shareholders’ interests. If your management continues down their target-driven path when circumstances change such that the best interests of the company would be served by taking a different path, then you’ve got the wrong management team.

In the short term it’s sometimes not easy to evaluate executive performance. Making sure that your objectives and incentives are intimately tied together not only makes it easier to apply an incentive scheme but also assists in performance evaluation.

Getting alignment right

Many have shown a desire to align executive pay with shareholder interests. The hurdles set for the variable elements of executive pay should reflect the company’s strategic goals which increase the value of the company’s shares.

This alignment needs emphasis right now, when some are advocating less tangible concepts such as stakeholder interests and social responsibility.

A positive way to demonstrate greater alignment is for a substantial part of an executive’s remuneration to be “paid” in the form of equity shares. Equity shares are a proven concept– remuneration in the form of shares and options has formed a part of executive remuneration for decades and is ubiquitous in the private equity world.

Remuneration from shares help foster an “ownership” culture, where the director feels a greater sense of responsibility in their role.

Directors reviewing executive pay design should, I believe, be looking to increase the equity (share) component as a means to reward directors for a job well done.

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