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Design of directors' remuneration packages

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on Remuneration of directors . This guide considers some of the approaches companies take to t...

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on Remuneration of directors.

This guide considers some of the approaches companies take to the design of base salary, benefits, annual bonuses and pensions. A separete guide addresses the Design of share incentive plans.

'Total remuneration' and the 'balance' of the package

Many companies look at packages on a ‘total remuneration’ basis – that is, they consider all the elements of an executive’s package together, rather than each one (base salary, benefits, pension entitlements, annual bonus and share incentives) in isolation.

In theory, this allows them to compare the ‘total value’ of remuneration packages in their sector or market. But, while useful, a total remuneration analysis can only be an approximate guide. The differences between the separate elements of remuneration packages can make like-for-like comparisons difficult. One company may, for example, offer an expensive final salary pension plan; another, a money purchase plan.

An alternative approach is to focus on the ‘balance’ within a package between the fixed elements (base salary, benefits, pensions) and the variable or performance-linked elements (annual bonus, share incentives). The balance of a package is given emphasis in both the Corporate Governance Code and the ABI guidelines. Principle D.1 of the Code states:

"Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully, but a company should avoid paying more than is necessary for this purpose. A significant proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance."

The ABI’s guidelines for the structure of remuneration say:

"Remuneration committees are responsible for ensuring that the mix of incentives reflects the company’s needs, establishes an appropriate balance between fixed and variable remuneration, and is based on targets that are appropriately stretching, verifiable and relevant and which take account of risk."

Whatever the balance, the government wants the details to be disclosed. Regulations under the Companies Act require a listed company to disclose the relative importance of performance-linked and non-performance- linked elements of remuneration.

Many companies fulfil this requirement by including in the policy section of their remuneration report a form of ‘boilerplate’ that tracks the wording of the Code closely – for example: ‘a significant proportion of directors’ remuneration is performance-linked through participation in the annual bonus plan and share incentive plans’.

Others go further, using graphs to illustrate the relative importance of the elements of a director’s remuneration. An example would be a bar chart showing a split between salary (40 per cent), target annual bonus (30 per cent) and expected long-term share incentives (30 per cent).

Base salary

Base salary remains the foundation stone of remuneration packages, often determining the levels of other elements such as pensions and bonuses.

When setting base salaries for executive directors, companies typically bear in mind:

  • the director’s performance, individual responsibilities and experience;
  • comparisons with salary levels in other companies.

The former is the more important criterion. While external comparisons can be a useful ‘benchmark’, they should never be used as the sole justification for salary levels. Indeed, the ‘bandwagon’ argument will always be difficult to sell to investors. This is evident from the Corporate Governance Code, where the supporting principle to D1 says:

"The remuneration committee should judge where to position their company relative to other companies. But they should use such comparisons with caution, in view of the risk of an upward ratchet of remuneration levels with no corresponding improvement in performance."

This statement has been followed in the ABI’s ‘Key Principles’. (See: Deciding directors' remuneration packages (and the influence of institutional investors), an OUT-LAW guide.)

When looking at salary data, remuneration committees should ask:

  • How appropriate are the comparator companies? Should a broader cross-sectoral group of companies with similar market capitalisation and turnover be considered as a ‘health-check’?
  • How large is the salary comparator group? Could removing or adding, say, one or two companies significantly alter a quartile analysis?
  • How up-to-date is the data? Could there have been intervening salary reviews? Has the data been ‘aged’ to reflect possible earnings inflation? Is the ageing factor appropriate?

In 2009, virtually any significant rise in base pay was criticised by institutional investors, and many companies were reported as freezing directors’ salary levels.

Benefits

With the exception of permanent health insurance (which is addressed in our guide to Directors' remuneration packages), benefits are typically non-contentious. They will usually comprise a mix of insurance benefits and fringe elements or perquisites such as cars and other extras.

Changes to the tax system have led companies to review their approach to benefits. Some now offer a flexible programme whereby employees can choose the things they want from a benefits ‘menu’ – provided, of course, they stick to a budget.

Annual bonus

The UK Corporate Governance Code’s guidance on the design of annual bonus plans is set out in Schedule A, paragraph 1:

The remuneration committee should consider whether the directors should be eligible for annual bonuses. If so, performance conditions should be relevant, stretching and designed to enhance shareholder value and to promote the long-term success of the company. Upper limits should be set and disclosed. There may be a case for part payment in shares to be held for a significant period.

Typical features of annual bonus plans include:

  • performance targets based on internal financial measures (for example, budgeted profits before tax, sales or economic value added), company development measures (for example, product development goals) or personal performance measures (for example, employee safety records);
  • payments linked to performance targets – with the maximum paid for achievement that exceeds budgeted or predicted levels to a degree specified by the remuneration committee.

Where executives have group-wide responsibilities, the performance targets are likely to focus on group performance. Where executives have distinct divisional responsibilities, the targets will usually include some weighting towards divisional performance.

The amount of bonus payable for achieving budgeted or target levels of performance can vary significantly from company to company; it will depend on how stretching the remuneration committee thinks the initial budgeted targets are. For example, some annual bonus plans are structured so that payments are heavily weighted towards achieving the budgeted targets or better. Around half of the maximum may be payable for achieving the budgeted target and only a low level (for example, 10 per cent of the maximum) for near achievement (say, 90 per cent or 95 per cent) of budgeted targets.

Deferral of part or all of a bonus into shares is becoming increasingly common. It is seen by shareholders as a way of aligning directors’ interests with theirs; if part of the bonus is delivered in shares after, say, two or three years, the director has a good reason to stay with the company and to improve shareholder returns. (The shares will usually be forfeited if the director leaves during the deferral period.)

This trend is likely to develop further, particularly among larger companies. The Walker guidelines endorse deferral of annual bonus, calling it ‘the primary risk-adjustment mechanism’ for annual bonus. Additionally, they recommend a deferral of two-thirds of annual bonus into shares for a three-year period.

Unlike long-term share incentive schemes, deferred bonus plans for directors do not need shareholder approval under the Listing Rules, provided they do not involve the issue of new shares.

Companies also get off fairly lightly when it comes to the disclosure rules for bonuses. They must disclose in their annual report and accounts:

  • any bonuses paid in respect of the financial year;
  • the bonus maximum for the current financial year.

Other than that, there are no formal requirements – largely because disclosures of performance conditions based on internal budgets could involve the release of commercially sensitive information.

However, institutional investors have made a concerted push for more disclosure in relation to annual bonuses in recent years. Investors would prefer to see:

  • for the most recent year’s bonus, full retrospective disclosure of any financial targets and the company’s performance against them, leading to the calculation of bonus earned;
  • for the most recent year’s bonus, details of any personal performance metrics;
  • for a current year’s bonus, a description of the performance metrics to be applied – without the disclosure of commercially sensitive numbers.

Investors are keen to see that personal performance measures are real and quantifiable and not a way of making a purely discretionary award.

Pensions

The nature and potential cost of executive directors’ pensions has long been keeping finance directors awake at night. This is not just because of the much publicised and continuing ‘pensions crisis’.

Company law requirements for the disclosure of the total transfer value of an individual director’s pension raised the prospect of a media frenzy, with large numbers providing an easy target for journalists. Companies’ fears, though, have not been realised. This is probably for two reasons:

  • pensions disclosures are difficult to understand and to value, particularly on a comparative basis;
  • there is greater understanding that pensions often represent longstanding contractual promises (particularly in respect of older final salary plans).

Restrictions on income-tax relief for pension contributions mean the practice of paying executives a fully-taxable ‘pension replacement’ cash sum, in lieu of an actual pension contribution, is likely to continue.

Such supplements are often lower than the pension contributions they replace. This is due to the additional employers’ National Insurance cost on the cash payments: the company indirectly passes this to the director by scaling down the salary supplement.

More detailed information on pensions and the current tax regime is given in our series of guides on Pensions.

Rewarding non-executive directors

The Walker Report and the UK Corporate Governance Code emphasise the need for non-executives to have sufficient time to devote to their increased responsibilities (see: Corporate governance, an OUT-LAW guide); and investor and media focus on the role of non-executives in protecting shareholders’ interests further increases the burdens.

So how should companies decide NEDs’ fees?

The key determinants

Levels of remuneration for non-executive directors should reflect the time commitment and responsibilities of the role – provision D.1.3 of the Corporate Governance Code.

Many companies accordingly break NEDs’ fees down into:

  • a basic fee;
  • additional fees for committee membership (eg remuneration or nomination committee);
  • further fees for the responsibility of chairing a committee.

In line with the Smith guidance (annexed to the Code), companies should consider paying a premium for membership and chairmanship of the audit committee.

If companies benchmark their NEDs’ fees against those paid by other companies, they will typically look at companies where non-executives have comparable time commitments. Survey data on NEDs’ fees is differentiated on this basis.

Other considerations

Articles of association

As noted in our guide to Directors' renumeration packages, a company’s articles may limit the amount the company can pay in directors’ fees. NEDs’ fees will count towards this limit, and the articles should therefore be checked when additional non-executives are appointed or when fees are reviewed.

Shares, share options and performance-related pay

The Corporate Governance Code and the ABI and RiskMetrics guidelines are all strongly against participation by non-executives in share options or other performance-related pay. The rationale for this is that such remuneration will compromise a non-executive director’s independence.

However, some companies will pay all or part of the fees in shares. The ABI guidelines encourage non-executives to use their fees to acquire shares in the company as this is seen as promoting alignment with shareholders.