Remuneration – reducing misconduct and repairing trust
The Royal Commission has provided a blueprint for raising the bar on the design, implementation and oversight of remuneration that will have impact beyond just financial services firms.
While the recommendations regarding remuneration arising from the Royal Commission may be a case of ‘no surprises’, the challenge for financial services firms is to act now and ‘set the table’ while regulation follows. There is enough clarity in the Final Report to start raising the bar on remuneration policies, practices and governance. Taking action now will enable firms to start repairing reputations sooner by attending to the remuneration issues that can cause misconduct. It will also enable listed companies to get a head start on engagement with external stakeholders, given the recommendations’ push back on financial results being the sole driver of reward outcomes.
The recommendations in Chapter 6 (‘Culture, governance and remuneration’) of the Final Report of the Royal Commission set a clear path for stronger regulation on pay in financial services firms. This position is enhanced by the proposed extension of a Banking Executive Accountability Regime (BEAR)-like regime across APRA-regulated financial services institutions, to be jointly administered by APRA and ASIC.
The supervision of remuneration by APRA takes its lead from the Financial Stability Board’s guidance on sound compensation principles and practices. In practice this means that there will be a much clearer focus on ensuring remuneration programs are designed to encourage the sound management of non-financial risks and reduce the risk of misconduct. This will require boards to assess the effectiveness of their remuneration systems against this new standard.
While not prescriptive (for example, there are no recommendations specifying the ratio of fixed versus variable pay nor proposed caps on incentive pay) the recommended regulatory settings will require a lot of boards and management to ensure they are improving how pay is set, managed and reviewed. It will require consideration of how culture and risk are incorporated into the framework including remuneration outcomes. It goes deeper than just executive pay in that it recommends financial services firms review the design and implementation of their remuneration systems for front line staff annually to ensure they focus on both the ‘what’ as well as the ‘how’. For banks there is the further requirement to implement the recommendations of the 2017 Sedgwick Review in full.
For executive remuneration in particular, the recommendation to limit the use of financial metrics in the design of long term incentives will create both internal and external challenges for financial services firms. There are long held beliefs and practices in place that see Total Shareholder Return and other financial indicators such as Earnings per Share or Return on Equity as the only way to align executive pay to long term shareholder outcomes. Many firms will have been concerned to adopt other appropriate metrics, like customer or employee engagement, based on anticipated negative votes on their remuneration report (like CBA in 2016). This recommendation, and the emphasis on non-financial risk, sets up an interesting debate with investors and proxy advisers on the primacy of financial metrics as the basis for variable reward. This will mean that engagement with these stakeholders becomes even more critical as firms take a serious look at whether their remuneration structures are fit for purpose.
Boards will need to take a deep dives into how remuneration operates across the whole firm, not just at the executive level. They will need to understand whether the various incentive systems and pay programs are effective. That is, are the plans working as intended, e.g. if they are supposed to support better customer outcomes, where is the evidence? These recommendations will necessarily add to the breadth of the board’s responsibilities and add to the pressure on management to ensure that the information, systems and reporting that are required to support this expanded remit are in place and operating effectively. The board will need this support to understand remuneration decisions below the executive level and to ‘see through’ to risk or conduct adjustments that are made or need to be made. Consequence management will take on a greater importance, including the requirement to establish policies to ensure that vested remuneration can be clawed back in relevant circumstances.
Arguably Hayne avoided the need for detailed prescription on remuneration arrangements by proposing the extension of the BEAR to all APRA-regulated financial services institutions. The non-bank financial services firms will need to prepare for both the accountability aspects of this regime and the remuneration requirements. This will mean closely reviewing their remuneration policies and practices to establish if they will meet the deferral obligations and the need to adjust remuneration in the event of accountability breaches.
While the remuneration recommendations may not be surprising, there is definitely a strength in their scope. It is clear that this will change how remuneration is designed, implemented and monitored. And while the focus is on financial services, it is apparent that the new standards that emerge will likely become norms across much of the Australian remuneration landscape. This is particularly the case for any company that uses incentives to reward customer facing employees or where a lack of focus on non-financial risks can impact the overall health of the business. Non-Executive Directors sitting on financial services boards will bring the new expectations to their roles in other industries.
Finally Hayne also makes the clear case that remuneration, culture and governance are linked – they cannot be treated in isolation. Firms will need to take an integrated approach to addressing each area or risk failures like those exposed within the Royal Commission. Taking action now to set clearer expectations for staff, will enable early engagement with external stakeholders and start the repair of public trust.
Top five facts on this topic
- APRA’s regulatory focus on remuneration will be to ensure remuneration systems encourage sound management of non-financial risks
- Boards will be required to take a broader remit to ensure their remuneration systems operate effectively, including pay programs for front line staff
- Limits will be placed on the use of financial metrics for long term incentives
- Banks will need to fully implement the Sedgwick recommendations
- The BEAR regime will extend the remuneration deferral and reduction policies to non-ADI financial institutions
Top seven implications for clients in this sector
- There is no need to wait for APRA regulation on remuneration – the design of remuneration systems supporting sound management of non-financial risks can start now
- Boards will need better quality information to understand how pay decisions below the executive level are made and how and why risk adjustments are being made
- Management will need to ensure that the systems, information and reporting are in place to enable this increased board governance role
- Engagement with external stakeholders around the use on non-financial metrics for long term incentives will be critical to gaining the required support for the remuneration policies for listed companies
- Non-bank financial services firms shouldn’t underestimate the time required to implement the BEAR requirements – now is the time to start reviewing remuneration policies and practices
- The outcomes of these recommendations will resonate beyond financial services and become a standard for remuneration across a range of industries
- Remuneration policies and practices are inextricably linked to improving culture and better governance – and that improvement in all these areas are critical to re-establishing trust
Read more about the Royal Commission on the KPMG NewsRoom.