The Executive Remuneration Working Group has published its Final Report on its review of executive remuneration in UK listed companies. In our update in May we summarised the Group's findings in its Interim Report.
The Final Report makes ten recommendations on how to address problems with pay structures in the UK. It confirms that there is a need for a more flexible, company-specific approach to designing pay structures. The current "one-size-fits-all" LTIP approach is often not best suited to a company's specific business strategy.
The Final Report's recommendations, which the Group considers are cornerstones of rebuilding trust, focus on five specific areas:
Increasing flexibility – the "core recommendation" is that remuneration structures must be suitable for the business in question. The Group's view is that current use of "inappropriate remuneration structures" has led to the growing complexity of performance targets and rising quantum. Two possible alternative structures to the current LTIP model suggested are the deferral of bonuses into shares and the use of restricted share awards - which could be more appropriate for companies with shorter business cycles, or that are unable to set meaningful long-term performance targets due to the nature of their business.
Strengthening remuneration committees and their accountability – the whole board and, in particular, the chairman, should be appropriately engaged in the remuneration setting process, while recognising that the ultimate decision-making is the responsibility of the remuneration committee. Non-executive directors should have at least one year's experience on the remuneration committee before taking on the role of its chairman – it will be interesting to see if the UK Corporate Governance Code is updated to reflect this principle, as suggested.
Improving shareholder engagement – a constructive two-way dialogue between shareholders and the company is critical to enabling companies to adopt appropriate remuneration structures. The Final Report contains recommendations for both parties: shareholders need to focus on the strategic rationale for remuneration structures, acknowledging both the governance and the investment perspective, while companies should concentrate their consultation on major strategic remuneration issues and aim to understand their investors' views.
Increasing transparency in the target setting process – rebuilding shareholders' trust in the remuneration setting process is a recurring theme, and the Final Report recommends that this can be achieved by disclosing:
- The process for setting bonus targets;
- The performance range (retrospectively); and
- The use of discretion, along with clear justification of how it was used.
Addressing the level of executive pay – this is perhaps the one area that is most visible to the general public and shareholders, with many companies during this year's AGM season receiving significant and well-publicised votes against their remuneration reports due to rising levels of remuneration. To counter this, the Final Report suggests that the board should use external and internal ratios (including a publically disclosed ratio between remuneration of the CEO and median employee pay) to justify remuneration levels, and that remunerations committees should guard against the potential inflationary impact of market data on remuneration decisions.
What happens next?
The UK's new Prime Minister, Theresa May has been vocal in her criticism of excessive executive pay, promising a crackdown on the "irrational, unhealthy and growing gap between what these companies pay their workers and what they pay their bosses". Many of her proposals strike a chord with those contained in the Final Report.
One proposal from Mrs May is that the shareholder vote on remuneration reports should be binding rather than merely advisory. Her comments came too late for full analysis in the Final Report, which simply notes that a similar proposal was considered by the Coalition Government and rejected due to legal and operational issues. We will need to wait and see how this debate develops over the coming months.
Finally, the Investment Association has said that it will look to amend its guidelines to reflect the Final Report's findings. Given the recent publicity that executive pay has attracted and the Government's renewed commitment to taking action, the Investment Association will be under pressure to make these amendments sooner rather than later.
The Final Report can be found here and the Interim Report can be found here.