Aligning equity in remuneration structures with evolving investor expectations

Equity for executives

Best practice executive remuneration structures include base salary, short term incentives (STIs) as part cash and part deferred equity, as well as a long-term incentive (LTIs) with vesting periods on deferred equity in excess of three years. The deferred equity component is viewed as the preferred method to align executive decision-making with shareholder outcomes.

In Australia, shareholders have the opportunity to express their support or dissent for the executive team and the remuneration structure via the annual Remuneration Report advisory vote. The threat of two-strikes and a potential Board spill puts companies on notice to align remuneration incentives to shareholder outcomes, reinforce business priorities and performance for executives.

Pleasingly for ASX300 issuers with AGMs in the first half of 2021, there were no second strikes awarded. In fact, there were slightly higher levels of support for the remuneration report at 93.9% versus 93.6% in the prior period.

Proxy advisors have significant influence over resolution outcomes and an understanding of their approach to executive remuneration and equity holdings can be a useful tool for those setting the remuneration structures. The remuneration practices that remain contentious for proxy advisors and shareholders include:

• Excessive base pay or base pay increases not aligned to sector and workforce outcomes
• Retesting of hurdles after failing to meet performance criteria in the set period
• Excessive termination benefits
• 100% cash short-term incentive (STI) payments, with no deferred equity component
• Long-term incentive (LTI) performance periods that are too short to reflect the long-term strategy of the business³, and
• Combined incentives that do not adequately differentiate between short- and long-term performance.

Proxy advisor, CGI Glass Lewis has recognised the challenges faced by ASX-listed companies paying for performance in the context of the pandemic and, acknowledged that the pre-covid standards for bonus setting may no longer be appropriate⁴. However, the use of retention bonuses has been viewed in mixed light by proxy advisors. Though, it appears with adequate disclosures, consultation and justification, proxy advisors may apply discretion in their approval of retention schemes with adequate vesting periods.

Equity for directors

It is important for non-executive directors (NEDs) to demonstrate “skin in the game” by making a meaningful investment in company shares using their own money. After a reasonable period of service (often three years), proxy advisors expect NEDs to hold the equivalent of one year’s director fees in equity. Failure to do this can result in the proxy advisors recommending against Directors.

This can be challenging for Directors as equity gained through share option schemes or additional performance-related pay is viewed as impairing director independence. They must either purchase on-market or participate in employee share schemes which involve salary/fee sacrifice.

In reviewing and endorsing the Annual Report, Directors should also be mindful of best practice disclosures for employee remuneration practices. Recently released figures from the Workplace Gender Equality Agency (WGEA) show that the gender pay gap in Australia has risen to 14.2% (up 0.8 percentage points) over the last six months (2021). Index funds are increasingly focused on the pay distribution and parity within organisations and as a result are seeking additional disclosures concerning CEO pay ratios, gender pay equality and other pay variance. Where considerable divergence is evident, an explanation or strategy for improvement is expected.

Organisations focused on diversity, equity and inclusion (DEI) will need to pay heed to this trend within their own ranks and consider the best practice disclosures and strategies to close the gap. Meanwhile Directors will need to demonstrate oversight of these important issues and how the pandemic has impacted employee outcomes over the last 18 months.