Non-financial targets are not ‘soft’ – they have a place in determining executive remuneration
Ahead of the AGM season, debate is growing regarding executive remuneration – specifically the metrics used within annual variable reward plans.
Some investors and proxy firms (who vote on behalf of investors at AGMs) have reportedly challenged top companies’ use of non-financial metrics – including customer focused measures – as providing executives with the ability to receive significant payments even if financial returns may have diminished.
Some key questions immediately arise: what is the purpose of the variable reward?
Is it intended to provide a reward on achieving a budgeted level of performance or only where outperformance is achieved? Is it meant to incentivise behaviour or be a vehicle to share the rewards of specific outcomes? Should it be provided as a cash payment, or provided in equity to create further alignment with shareholders? Is it a combination of the above?
In our experience, it is essential that the purpose of the variable reward is understood and appropriately communicated to mitigate any expectation gap between participants and investors. This is also a critical element for the Board when determining the quantum of any payment that may be made at different levels of performance.
What are appropriate metrics for the Short-Term Incentive (STI)?
The STI metrics for executives should align with the business strategy and in our view, a mix of financial and non-financial measures will generally be most appropriate.
We consider the use of ‘underlying’ earnings are appropriate for the purposes of determining outcomes under annual variable reward plans. But this is on the proviso that adjustments from statutory profit figures are transparent, consistent and work both ways – so that they could result in either an increase or decrease from statutory profit.
The onus is on the Board to provide a compelling rationale for any adjustments, with clear communication and a reconciliation to statutory profit. It is important that adjustments should not be made for ‘business as usual’ items and that management remain accountable for any decisions they have influenced.
KPMG does not agree with some of the recent criticism that well-structured non-financial measures are somehow ‘soft’ and not to be taken as seriously as financial metrics: in fact it seems at odds with calls for companies to give greater consideration to their social impact.
We consider non-financial metrics play a key role in STI plans. The pursuit of financial goals, with no regard for behaviours or other non-financial considerations may undermine long-term value creation. For example, the pursuit of short-term profit at the expense of customer relationships, will ultimately lead to value erosion. A business that is focussed on financial metrics with no regard for behaviour may undermine culture which can lead to risk, safety and other negative issues arising. It is also clear that the impact of decisions made in one year may not be understood until future years.
The challenge regarding non-financial metrics most commonly arises where there is limited explanation for why the non-financial measures were chosen, how they align with the creation of shareholder value and how performance was assessed against them. In our experience, the lack of transparency around the setting, and assessment, of non-financial measures is an issue that is often raised by investors. This is compounded where the financial performance may have declined in the year and the STI continues to pay out based on the achievement of the non-financial metrics.
The quantum of STI is also a key issue. Factors impacting quantum should include the complexity of the role, the impact that executives may have on the creation of value, the volatility of results and the level of payout that will be made to executives as a percentage of overall profit.
Aligning the executive with shareholders through minimum shareholding policies, or the payment of part of the bonus in restricted equity can also address the impact of any short-termism by executives. This is further enhanced by the inclusion of clawback policies that go beyond the current fraud and material misstatement limitations and hold executives accountable for situations where large bonuses may be paid in one year and significant adverse events tied to management decisions subsequently occur and diminish value in a subsequent year.
Depending on the industry, and business model, the removal of STI, or the merging of the STI and long-term incentive (LTI) may also be more appropriate than the traditional remuneration model. This type of framework is likely to emerge in future years particularly given the issues that can arise in setting a suitable LTI structure.
In conclusion, we consider a combination of financial and non-financial metrics that are directly linked to the business strategy is most appropriate. The problems that typically arise in STI plans are due to the level at which the targets are set (e.g. not enough stretch), or the lack of communication regarding why the specific metrics were chosen, how they align with the achievement of shareholder value, and lack of clarity and consistency in applying adjustments to statutory results.