Executive remuneration is an area where we place significant importance. As active managers, it is our duty to scrutinize, and where necessary, advocate for shareholder conscious remuneration. As such, we regularly address compensation questions in the course of our ongoing engagement with Management and Boards of our portfolio companies.
ARPA is proposing to change renumeration requirements by deemphasizing the role that objective financial metrics play in determining executive compensation.
Watering down financial objectives will only diminish the focus and expectations of Boards and management
We are concerned that, while well intended, the changes will have unintended negative outcomes which impact both investors and the wider public.
As such we recently made a submission to ARPA outlining our concerns. We believe that rather than the proposed caps on financial performance metrics, Active Ownership will ultimately see better outcomes for all stakeholders.
Background to the proposed changes
On 23 July 2019, Australian Prudential Regulation Authority (APRA) released for consultation a discussion paper, “Strengthening Prudential Requirements for Remuneration”.
APRA is proposing to strengthen prudential requirements for remuneration across APRA-regulated entities in the banking, insurance and superannuation industries.
The new prudential standard on remuneration (CPS 511) will address recommendations from the Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.
The core elements of the changes to CPS 511 are to:
- strengthen governance of remuneration frameworks and outcomes, in particular through an expanded Board role, where the Board needs to be active and have direct oversight;
- set overarching remuneration objectives that inform design of all remuneration arrangements and influence remuneration outcomes;
- limit the use of financial performance metrics (share price and profit-based); and
- set minimum deferral periods (up to seven years) for senior executives to provide more 'skin-in-the-game' through better alignment to the time horizon of risk and performance outcomes.
Our concern on the changes to financial performance metrics
We welcome changes that will help improve the resilience of the financial system and alignment between the interests of financial institutions and those of stakeholders including shareholders, customers and beneficiaries, regulators and the broader community.
However, we are concerned that the proposal to limit the maximum weighting of financial performance metrics to 50%, and for this to apply to all employees, as is currently drafted under item 38, will have unintended outcomes on APRA regulated entities.
We outline our concerns in full in our submission to APRA: Martin Currie Australia submission on CPS 511.
Financial metrics are more tangible and objective than qualitative measures
Our central premise is that in relation to remuneration, we believe the majority of measures for both Short-Term Incentives (“STI”) and Long-Term Incentives (“LTI”) should be easily identifiable, measurable and relate directly to the company’s performance.
Non-financial metrics include, for example, customer outcomes such as loyalty and complaints, reputation and trust, alignment with firm values, employee engagement, team work etc.
Our concern with a prescriptive quantity of qualitative measures is that there is difficulty in ultimately devising the correct non-financial metrics for each firm, and it can create confused incentives, often leading to perverse outcomes.
By contrast, financial metrics which include relative Total Shareholder Returns (“TSR”), are very tangible and objective.
A prime example of a poor application of a non-financial metric was the CBA’s1 introduction of a ‘people & community’ metric in 2016. Absent of formal intervention by the Board in 2017, application of the ‘people & community’ metric for CEO pay would have resulted in an outcome that was outside the realm of reasonability given the AUSTRAC2 issues at the time.
By favouring all stakeholder, none benefit fully.
By definition, using non-financial metrics which treat the interests of all stakeholders as equivalent, decisions made will leave some stakeholders better off and some worse off.
Expert in corporate governance and Professor of Finance at NYU Stern School of Business, Aswath Damodaran, also predicts that “expanding decision making to take into account the interests of all stakeholders will create decision paralysis3.”
This begs the question; how Boards can truly be held accountable when there are multiple conflicting interests. Where to now for shareholder primacy?
Non-financial metrics do have merit for front line
We do see merit in using non-financial measures as key performance indicators, for specific employee groups, such as front line staff who interact with customers and suppliers. Our position recognises that there are significant differences in staff’s accountability and duty to customers compared to that of the CEO and Board accountability to their shareholders.
Qualitative measures can more easily be rorted
Financial metrics such as TSR are not easily manipulated. We see improved TSR is only achieved as a result of management efforts delivers benefits to shareholders and stakeholders. However, if a minimum number of intangible measures are mandated by APRA, we expect management will find ways to ensure they are met.
We also have concerns that this could divert management’s focus away from adhering to unbiassed accounting practices, hence reducing financial reporting quality.
We believe that this could lead to the exact opposite to what APRA was aiming for, and instead encourage excessive compensation and reduce the independence of Boards.
Our focus is on Active Ownership for better outcomes
Watering down financial objectives will only diminish the focus and expectations of Boards and management of listed companies and not be in the interests of the stakeholders to which the proposed changes are aiming to align.
Should law makers decide that components of STI and LTI become increasingly non-financial by nature, we as shareholders vow to continue to vote against such measures when nominated at company Annual General Meetings.
We believe that Active Ownership, through strong interaction with both Boards and management, will ultimately see better outcomes for all stakeholders. Furthermore, incentive structures are already highly focused on these outcomes.
1The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.
2Australian Transaction Reports and Analysis Centre
3Source: Damodaran, A 2019, From Shareholder wealth to Stakeholder interests: CEO Capitulation or Empty Doublespeak?, Musings on Markets, accessed October 2019, http://pages.stern.nyu.edu/~adamodar/
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The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.