Tension can exist between shareholders, managers and employees – what should Remuneration Committees be focusing on?
As we head into 2023, we still live in the reality of a pandemic that not only fundamentally changed us but has also introduced new strategies in the workplace. But even in the context of these challenges, we can still move forward with hope.
Remuneration Committees have an onerous task of navigating one of the most contentious issues in almost any company – that of setting remuneration for executives, and more recently, overseeing the remuneration of the workers.
The tension between shareholders, managers, and employees is a delicate balance to deal with in the framework of best practice, remuneration theory, and competitive outcomes. This tension is further exacerbated by the wider stakeholder of customers, suppliers, communities, the environment, and the legislative landscape in which they operate.
So where should Remuneration Committees focus their attention and why would they do that? Obviously, the definition of victory would be to achieve fair and transparent remuneration (King IV) whilst getting a “YES” vote for the remuneration policy, report, and implementation at their AGMs.
Here are the issues we think are important for the Remuneration Committees to consider and address. Given the continuing impacts of COVID-19 and geopolitical instability on the performance of these companies, proxy advisers and institutional investors, and the business media, will be paying close attention to how remuneration committees respond and the ways in which discretion is exercised:
- Remuneration Committees need to be proactive on policy changes to adapt for the changing economic environment by recognising and addressing economic headwinds. Cognisance needs to be taken of the changed political environment, continuing impacts of COVID-19, rising domestic inflation, labour shortages and wages pressure. Remuneration and incentive frameworks need to be stress tested to determine whether they remain fit-for-purpose. The main agenda items that need to be considered are as follows:
- The recent world changes have brought a focus on Environment, Societal and Governance (ESG) issues in a move from shareholderism (delivering value to the shareholder) to stakeholderism (creating value for the wider stakeholder) thereby achieving a balance among the interests of executives, shareholders, employees, communities, the environment, customers, suppliers, and government. The rise in the stakeholder vote is here to stay and, companies need to include ESG in their company purpose and link it to the executive pay to ensure sustainability and long-term value creation.
- Whilst many employees have been laid off or required to work a 4-day week for less pay, there is now a labour shortage in developed countries accompanied by the “Great Resignation”. Remuneration committees need to adapt their Employee Value Propositions (EVPs) to cater for flexible working conditions, hybrid working models and remuneration strategies that address more than the pay element for employees. Non-executive directors and executives should share the pain of pay cuts and changes in working conditions.
- Discretion has become more important in establish a framework for assessing performance and applying variable pay. The uncertainty about the severity and duration of COVID-19’s impact, has meant that many companies now use discretion at the end of the year on annual incentive pay-outs, but it is important to establish a framework for how discretion is, and is not, applied to ensure decisions at year end are fair and consistent with expectations for both employees and shareholders. As companies improve performance with the easing of Covid impacts, it is important that discretion is applied both up and down (positively and negatively) so that windfall gains are not paid out where companies are coming off a low base.
- Non-financial key performance indicators (KPIs) may have been achieved, including key ESG KPIs such as safety and societal measures. For companies with no financial or total shareholder return (TSR) hurdles, a discretionary proportion of annual incentive for these important outcomes may be paid. This needs to be balanced with shareholder investors considering their own losses in value. To minimise negative the reaction to these discretionary payments, companies may consider Deferring payment until the cash position improves or paying all the incentive in equity.
- Annual incentive target setting will be crucial and difficult given the complex uncertainty in which companies find themselves. Companies could consider and review and confirmation of targets halfway through the year. While highly unusual, this would also provide a basis for agile responses to a rapidly changing external environment. Companies could consider setting a wider span between the threshold performance requirement and the maximum to consider the uncertain conditions. Focus on sustainability metrics like cash flow, cost containment and operational efficiencies could ensure the survival of the company. Converting the annual cash pay-outs to deferred payments or equity could also conserve cash in difficult times.
- Long term incentives (LTIs) have become particularly challenging because the outlook is so uncertain with rising inflation, supply chain shortages, energy constraints and a potential recession. Remuneration committee could choose relative measures only; extending the term of the LTI to greater than 3 years when some form of normality returns (most bear markets last up to 3 years; putting predominantly sustainable value creation measures in place; and putting some (less than 50%) of the LTI award into time restricted equity to cater for retention. Equity allocations should be done on an annual basis to avoid cliff vesting on large tranches granted at post covid depressed share prices. Remuneration Committees need to explain transparently the basis for determining the number of shares to be granted has been consistent through cycles and may consider making grants using a longer VWAP period, explain how cyclical swings and roundabouts impact pay both negatively and positively, reduce the grant number to account for lower share prices, and communicate that discretion will be exercised on consideration of vesting outcomes to ensure no realisable pay windfall gains. Imposing minimum shareholding requirements and revising the levels upwards could be seen as skin in the game whilst uncertainty plays itself out.
- Retention has become a real challenge with the “Great Resignation” in executive and scarce skill jobs. The remuneration committee might consider whether the company is within a vulnerable industry where executive demand is high or scarce skills are prolific. If this is the case, the Remuneration Committee may consider a bespoke LTI to cater for the threat within the industry but needs to be cognisant of the optics of the scheme regarding shareholders and the wider stakeholder.
These challenges are unprecedented in the remuneration landscape and Remuneration Committees need to be seen as being more “human” in finding innovative ways of meeting both shareholder and stakeholder demands.
B.Sc. Chem. Eng., MBA – Leadership & Sustainability,
CEO of 21st Century