Investment Association updates principles of remuneration for 2017

The Investment Association (IA) and its predecessor organisations have for many years published guidelines setting out the issues that will influence its members in deciding whether or not to support a company’s remuneration policy or approve the adoption or amendment of a particular share plan or incentive structure.

On 31 October 2016, the IA wrote to chairmen of remuneration committees of FTSE 350 companies setting out significant changes in its principles of remuneration. Most of these changes are made in response to the report published in July 2016 by the Executive Remuneration Working Group. For more information, see Legal update, Executive remuneration: Working Group's final report.

For more information on investor shareholder guidelines on executive pay and share schemes, see Practice note, Institutional investor guidelines on share schemes and incentives.

Parts of the principles of remuneration have been significantly rewritten, and some new guidance has been added. The main changes include:

Previously, the principles recommended that a company should use a simple structure for variable remuneration consisting of one annual bonus plan and one long term incentive scheme.

This has been replaced by an encouragement to remuneration committees to adopt the structure which is most appropriate for the implementation of their business strategy. The IA still considers that simplicity and transparency are important but it recognises that the standard model of one annual bonus plan and one long term incentive scheme may not be appropriate in all cases.

Many companies have shareholding guidelines whereby executives are expected to hold a minimum number or value of shares. The amended principles state that executives should be expected to continue to hold these shares after termination of employment. This is presumably so that the executives can continue to enjoy (or suffer) the consequences of decisions they made while still employed.

The covering letter to remuneration committee chairmen refers to encouraging "post-retirement" shareholding guidelines, but the principles themselves do not limit the requirement to continue to hold shares to situations where the executive retires.

In judging the appropriateness of the amount of remuneration paid to senior executives, the remuneration committee should use as a reference point the ratio of the remuneration of the median employee to members of the executive committee. The covering letter says this ratio should be disclosed, although this requirement is not included in the principles.

The revised principles note that there should be a more useful dialogue between companies and shareholders. This should address the strategic issues facing the company rather than the detail of particular proposals. Companies should take account of the views of shareholders to enhance their proposals.

Remuneration committees should be concerned if more than 20% of votes are cast against their proposals. They should seek to understand why shareholders are opposed and should take an early opportunity to explain how they will respond to shareholders' concerns.

A company which pays pension contributions at different rates for executives compared to employees as a whole must be prepared to justify the difference. If it cannot justify it, it should set out its intentions for reducing the disparity.

Companies should provide more details to shareholders about how performance is measured for annual bonuses. This should include the specific target ranges for financial measures, and a detailed rationale for personal or strategic objectives. Bonus targets should be disclosed within no more than two years, and preferably one year, following payment. Companies that do not commit to disclosing their financial targets are likely to be "red-topped", while companies that do not give sufficient detail around non-financial targets should expect to be "amber-topped".

Shareholders expect that executives should defer part of their bonuses into shares.

If companies respond to the new flexibility in incentive design by reducing long term incentives and increasing annual bonuses, shareholders will expect a substantial reduction in the maximum potential pay-out. This reflects the increased likelihood of pay-out from an annual arrangement.

Companies should take account of capital management decisions and share buybacks in determining whether financial performance targets have been achieved. This reflects concern that some companies have used earnings per share as a measure of performance. A share buyback can enhance earnings per share even where there is no improvement in underlying business performance.

Some companies have been awarding a fixed number of shares to executives through incentive plans, rather than a multiple of salary. The IA notes that this can result in windfall benefits if the share price increases. Remuneration committees should carefully monitor grant levels.

The revised principles include new guidance on corporate transactions: where there is a change of control, directors should roll over their awards into equivalent awards in the acquiring company, if this is offered.

A performance on grant scheme is one where the executive is rewarded for performance that has already been achieved. The award is subject to continued employment but not to the future achievement of performance conditions. This type of plan has not been common in the UK, but may become more so.

Since these schemes are more likely to pay out, the size of awards should be significantly reduced.

The revised principles include a section on restricted share awards for the first time. Not all investors are willing to support this type of scheme as they consider it weakens the link to long-term performance. However, some shareholders will support schemes if they are proposed by companies that they trust.

Companies that adopt restricted share schemes should reduce award sizes by at least 50% to allow for the greater likelihood of the awards vesting. The awards should vest over a period of at least three years, followed by annual vesting over a period of time. Companies should impose substantial shareholding requirements on executives who receive restricted shares.

Companies will welcome this new openness from the IA to consider alternatives to the "one size fits all" LTIP structure that has been prevalent for many years. However, it seems clear that some members of the IA will require considerable persuasion before they will support an arrangement which in their view is not linked to long-term performance conditions.

Companies will also welcome a more open and positive dialogue with shareholders although it remains to be seen how much time shareholders will be able to commit to during the runup to the AGM season.

If the overall result is to strengthen the link between pay and performance, and give greater transparency to the process of setting executive reward, this will be welcomed by shareholders and government.

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