The executive pay debate: risky remuneration’s link to poor culture & conduct

There are a number of important questions and compliance issues to consider when it comes to executive pay

There are a number of important questions and compliance issues to consider when it comes to executive pay, which will help HR in supporting Boards while having effective discussions with risk and reward teams, according to Gordon Williams and Paul Baillie

It has been a tumultuous year for the financial sector which is undergoing its greatest period of scrutiny and change in living memory and executive remuneration is a key focus. Interestingly, that focus is not just on quantum (which is what usually grabs the headlines) but also about whether executive pay design is contributing to inappropriate and unacceptable risk-taking and conduct. As a result, we are seeing employers across a range of industries, not just the financial sector, reviewing both their remuneration arrangements and organisational culture.

Following a number of scandals involving financial services companies often centered around an allegedly aggressive, sales-driven culture, the Government announced a package of reforms in the 2017/2018 Budget. This included a new Banking Executive Accountability Regime (BEAR), which applies to APRA regulated Authorised Deposit-Taking Institutions (ADIs), including Australian and some international banks.

Meanwhile, APRA was conducting its own review into the remuneration practices and policies of large APRA-regulated entities. The primary finding from this review, is that remuneration frameworks and practices across the sample did not consistently and effectively meet APRA’s objectives of encouraging behaviour that supports risk management frameworks and long-term financial soundness.

And of course, there is the Banking Royal Commission. For the last few months, we have been inundated with stories of poor employee behaviour, often in the context of a culture of excessive risk-taking leading to adverse customer outcomes.

“We are seeing employers across a range of industries, not just the financial sector, reviewing both their remuneration arrangements and organisational culture”

So what is the risk in remuneration?
Performance-based pay has become an integral component of corporate culture as a means to motivate and reward staff (especially executives) to achieve particular corporate and financial objectives. However, the psychological impact of reward opportunity on those employees accountable for financial results has often been ignored in executive pay design. Put simply, people will do what they are paid to do – and this can often lead to unintended and undesirable outcomes.

When incentives are misaligned or the ‘carrot’ is too big, this can crowd out balanced and sensible decision making to the detriment of the company, its customers and other stakeholders, over the medium to longer term.

The global financial crisis (GFC) in 2008 raised widespread awareness of this risk. It highlighted the strong link between remuneration and misconduct – especially that variable pay can encourage excessive risk-taking and ineffective accountability.

What was the reaction to these risks factors?
In Australia, APRA responded by releasing a series of Prudential Standards and Practice Guides to address culture, risk management, governance and remuneration for APRA regulated entities (other sectors remain largely unregulated).

For example, these standards recommend that a majority of performance-based pay be deferred and at risk for an extended period. This is due to the time it takes to adequately measure the outcome of business activities after the pay has been awarded.

Not surprisingly, companies began to defer a proportion of short-term incentives and this is now commonplace across all industries.

“The psychological impact of reward opportunity on those employees accountable for financial results has often been ignored in pay design”

The use of malus and clawback in policies and/or executive incentive was also a natural extension. These arrangements are designed to take back incentives before or even after they are earned and paid and would typically arise in situations of executive misconduct or financial misstatements. While initially restricted to financial services companies, increased pressure from stakeholders has seen these arrangements become mainstream across all industries as part of prudent remuneration design.

With increasing frequency, we are also seeing formal gateways or Board discretions applying the award of performance-based pay, often focusing on executive behaviour or conduct or other non-financial objectives.

BEAR goes one step further. The objective of the BEAR is to provide a heightened responsibility and accountability framework for the most senior and influential decisions makers – called accountable persons – within ADIs. The main changes impacting remuneration under the BEAR include the mandatory deferral of a significant portion of an accountable person’s variable remuneration for at least four years, obligations to reduce variable remuneration where breaches occur and broad powers for APRA to adjust and review ADI remuneration policies.

Looking forward, we expect something very similar to the BEAR will be extended to other financial services organisations. 

Executive pay takeaways for HR
Boards will be under increasing pressure to review their company’s remuneration framework and executive pay outcomes in order to be able to manage, monitor and mitigate the risk associated with performance-based pay. This is not limited to Boards of financial services companies who are currently grappling with the BEAR or APRA’s prudential findings. A key lesson from post-GFC developments is that changes in Australian remuneration practices in the financial sector have ultimately found their way (or fed) into remuneration design across the broader market. It is therefore important that your company understands the risks associated with its particular remuneration arrangements.

“Companies must ensure proper oversight of employee behaviour and conduct and apply appropriate pay related sanctions”

Regardless of the industry you are in, a good way to enhance this knowledge starts with reading Prudential Standard CPS 510 Governance (CPS 510) and Prudential Practice Guide PPG 511 Remuneration (PPG 511). The former sets out APRA’s requirements in relation to remuneration (for regulated entities) and the latter provides useful guidance on considering and prudently managing the risks that may arise from remuneration arrangements.

Some questions to consider while you explore these insights include:

  • What is your company incentivising your executives to do (through variable pay) and is this consistent with the values and strategic direction of the company?
  • Does your remuneration policy sufficiently explain the objectives and structure of your company’s remuneration arrangements – and how often is it reviewed/updated to take account of relevant changes?
  • Have the remuneration outcomes of key staff been regularly reviewed for consistency with the intention of the remuneration policy and the risk management framework?
  • Do your risk and financial control people receive variable pay that supports their independence?
  • Are individuals in your company with poor risk management or conduct scores still receiving a significant portion of their annual bonus or other variable pay?

Contemplating and addressing these types of questions, in accordance with the prudential standards and guidelines, will ultimately help you be better informed, supportive of the needs and pressures facing your Board and enable you to have more effective discussions on this topic with your risk and reward teams.

3 key points: lessons in executive pay

  • The financial sector is being scrutinised more than ever before and executive remuneration, and the role it plays in risk and culture, is a key focus
  • Managing the risk requires a suitable balance between the fixed and variable pay with appropriate performance measures
  • Companies must ensure proper oversight of employee behaviour and conduct and apply appropriate executive pay-related sanctions

Paul Baillie is a remuneration governance principal consultant with Minter Ellison.