Design of remuneration packages
This guide is based on UK law.
This article considers some of the approaches companies take to
the design of base salary, benefits, annual bonuses and
pensions.
“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 Combined Code and the ABI guidelines.
Principle B.1 of the Combined 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 stretching,
verifiable and relevant.”
The government seems to concur with these views. Under the
Regulations, a quoted company must disclose the relative importance
of performance-linked and non-performance-linked elements of
remuneration. Many companies fulfil this disclosure 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). An interesting
development in relation to companies’ disclosures of the balance of
packages is that investors have begun to ask for pensions to be
included in this analysis – this reflects the growing awareness
among investors of the value (and cost) of pension
arrangements.
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 Combined Code, where the supporting
principle to B1 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.”
When looking at salary data, remuneration committees should
ask:
- how appropriate are the comparator companies? Should a broader
crosssectoral 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?
Since the introduction of the annual vote on remuneration
reports, institutional shareholders have been more inclined to
comment on base salary rises for executive directors if they view
them as out of line with “market norms”. This should be remembered
in informal discussions about remuneration policy proposals.
Agreement on changes to annual bonus schemes and share incentives
can count for little if shareholders rebel when details of a base
salary rise emerge in the annual report and accounts.
Benefits
With the exception of permanent health insurance 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. Some
will offer cash alternatives to company cars.
Annual bonus
The Combined 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. 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 made 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 be weighted 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.)
Directors will be more ready to accept a deferral if:
- it is linked to an increase in the overall maximum payment
(cash and shares combined);
- there is an option to accept a lower “cash only” bonus if they
need the money.
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.
Since the 1995 Greenbury report there has been a best-practice
requirement to describe in remuneration reports the types of
performance conditions that companies apply to annual bonuses (for
example, profits before tax), but not the threshold targets.
Companies need also to be aware of continuing and growing
investor interest in bonus-plan design. Institutional shareholders
are increasingly asking for additional disclosure for annual bonus
performance conditions. The NAPF and ABI have both requested that
when bonuses are paid companies disclose in the following year’s
remuneration report the extent to which target thresholds were
achieved.
Annual bonus rises remain an issue of particular concern – since
2003, IVIS has been drawing increases in companies’ maximum annual
bonus levels to subscribers’ attention by giving relevant company
reports an “amber top”. The 2006 ABI guidelines say that increases
in maximum bonus levels should be “explicitly justified” and that
shareholders expect increases to be matched by more stretching
performance targets.
Pensions
The nature and potential cost of executive directors’ pensions
has, over recent years, been keeping finance directors awake at
night. This is not just because of the much publicised and
continuing “pensions crisis”.
There was concern that the increased disclosure requirements for
pensions under the Regulations (including disclosure of the total
transfer value of an individual director’s pension) would be “a
story a day” for financial journalists, with large figures
providing an easy target. 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
long-standing contractual promises (particularly in respect of
older final salary plans).
Many companies have, nonetheless, been reviewing their pensions
arrangements for directors. The principal trigger has been “A day”
(April 6, 2006), when the tax regime for pensions was reformed. The
focus is, in particular, on those directors who have already
accrued tax approved savings above the new tax threshold (or
lifetime allowance), set at £1.6m for 2007/8. Companies have tended
to address A day in one of two ways:
- offering directors the opportunity to continue to accrue
pension entitlements, on the understanding that accruals above the
lifetime limit will be taxed;
- offering directors the opportunity to forego further pension
accruals and instead accept a “salary supplement” (a fully taxable
cash payment) that they can choose to invest in whatever way they
want.
Where companies with money-purchase pension plans have offered
salary supplements, these 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 cost to the director by scaling down
the salary supplement so that its overall cost (supplement plus
NICs) is not greater than the previous pension contribution
cost.
Investor reaction to the post A day environment is, to date, one
of “watch this space”. The ABI has said that it expects it to take
at least two full reporting years for clear post A day market
practice to emerge. Accordingly, the ABI’s guidelines on what
constitutes acceptable practice on executive pensions should be
expected to change significantly in coming years.
The ABI’s December 2006 guidelines did, however, repeat certain
themes that investors have been putting forward for a number of
years:
- disclosures should be full and informative;
- companies should not compensate individuals for changes in
their personal tax position because of A day;
- companies should consider whether other forms of remuneration
could be more “costeffective than a pension fund and more aligned
with shareholder value creation”.
