The conversation examined key responses from the market and external stakeholders plus a summary of possible actions for remuneration committees to consider for the current performance year (FY20) as well as the upcoming performance year (FY21). Further details are outlined in an article “10 minutes on Reward and Performance in a COVID-19 environment” available here.
This is an edited transcript of a discussion led by Emma Grogan and Andrew Curcio, Partners in PwC’s People and Organisation Business on how companies are managing reward & performance in a COVID-19 environment.
A number of companies announcing a deferral or reduction in CapEX to preserve cash, these are translating into executive reward adjustments at some organisations
The situation is changing rapidly with more companies making announcements each week
In the current environment, boards are still looking at very targeted reward needs, particularly global executives in local markets to ensure competitiveness, but there is no real appetite for a broad organisation-wide remuneration review that you would typically see at this time
It would be wise to continue to monitor the appropriateness of adjustments to salary and STI outcomes given the COVID-19 business impacts, particularly given the guidance offered by external stakeholders.
It will be important to do the right thing for your organisation with an eye to the market and any investor and regulator expectations. So ensure you have as much data and evidence as possible for your specific business context to inform your considerations. Develop a clear rationale for any resulting decisions, regardless of whether you decide to make salary and bonus adjustments or not.
As we're well aware, business performance has been quite adversely impacted by COVID 19, particularly with the associated government restrictions. Already a number of companies have announced a deferral or reduction in CapEx to preserve cash, including 27 in ASX100.
These changes are now translating into executive reward decisions. A number of organisations in Australia and other territories have announced executive salary and bonus adjustments well in advance of the financial year end. Around 15% of ASX100 companies have made announcements, particularly those in industries most severely impacted in terms of financial performance or workforce changes, such as airlines, travel, casinos and some major retailers. But this figure is changing almost daily. A number of companies in the construction and logistics industry, and even the first big bank have also now announced adjustments to executive pay outcomes for this year.
In terms of the quantums, there is quite a range, but most commonly we're seeing a 20% cut in executive pay for the remainder of the financial year, with a similar reduction to NED fees, although not always. The largest reduction we've observed is Qantas which essentially announced a 100% reduction, while other travel related companies such as Flight Centre, have announced significant reductions at 50%.
Approximately half of those companies have also announced STI outcome adjustments (typically a nil bonus outcome), while to our knowledge, just one organisation so far has announced an LTI grant adjustment for the upcoming performance year. Companies are holding off on decisions around LTI vesting outcomes for the current performance year because of the longer performance timeframe and the proportion of the performance period that has been affected by COVID-19 is smaller over a long-term performance.
While the majority of the market hasn’t made any adjustments yet, the situation is changing rapidly with a handful of additional ASX100 companies making announcements in the past week.
A number of external stakeholders have also now made public announcements on how they believe executive reward should be managed given the impact of COVID-19.
The Australian Institute of Company Directors (AICD) has shared a set of principles to guide reward decisions. The Australian Council of Superannuation Investors (ACSI) has encouraged boards to use discretion and “read the room” appropriately when making decisions about year end outcomes, which they stress was not done well during the GFC.
We've seen proxy advisors, including ISS and CGI, encouraging a proportional approach. That entails considering the specific circumstances of the organisation, both performance and workforce impacts, and if a response is required, ensuring it is proportionate to the shareholder and employee impact. Proxy advisors are also emphasising the need for disclosure of a clear rationale for any decisions. We believe that rationale will be expected to be disclosed whether you decide to make an adjustment or not. Aside from that, they have made no official change to their existing guidelines, so they still stand and are relevant.
In financial services we’ve seen the most prescriptive position of all with APRA encouraging organisations to expressly limit executive bonuses. While in the UK, APRA’s counterpart, the PRA has taken an even more extreme position, asking banks not to make any bonus payments in 2020.
It would be wise to continue to monitor the appropriateness of adjustments to salary and STI outcomes, particularly given the guidance offered by external stakeholders.
Some key areas for boards to consider are
The appropriateness of any payments made at the end of this year in light of a broad set of stakeholder impacts, not just shareholders but also employees, customers and community.
An expectation that executives will share the pain with the workforce. This was referenced by the AICD and requires boards to be cognisant of how pay decisions at the executive level will cascade through the organisation.
For those organisations still performing well, and in some cases very well if they are directly benefiting from the current conditions, who are not planning to make an adjustment, give some thought to how that will be seen across the rest of the market. As a number of companies will not be paying incentives, the median STI payment for FY20 will be down on prior years so any on target or above target payments, even for performing companies, may appear elevated.
In the current environment, boards are looking at very targeted reward issues, for example competitiveness of global executives in local markets, but there is no real appetite for a broad spectrum remuneration review that you would typically see at this time.
One of the interesting topics of discussion is the value of adjustments to targets before the year end versus the application of discretion at year end in relation to bonus payouts. For companies that are still tracking in terms of making a payment, there is a pressure to limit or minimise those amounts. But to what extent do they normalise those bonuses for the impact of COVID-19 or not and how do they do that?
A number of companies will typically apply some adjustments to performance outcomes, to take into account one-off costs or things outside of management control. That would typically be the mechanism by which you would adjust the outcomes to better align to an executive’s contribution or to apply pure discretion to an executive’s bonus payout for example from 75% to 60%. The latter is very rarely used and only typically used downwards rather than upwards. Adjustments, however, can be both directions.
There will be a lot of pressure in relation to adjustments and organisations will need to be very clear on when the impact or COVID-19 actually hit. For example, if it only impacted one quarter of the performance year, where were they tracking for the rest of the year. If a company was tracking strongly for most of the year, should there be some bonus or recognition of that performance, notwithstanding that the share price has fallen?
The other topic being discussed by regulators and proxies in relation to bonuses is whether they are paid in equity rather than cash. On the face of it, delivering equity instead of cash for the full bonus, does make sense in a cash constrained environment. However, if you have a lower share price, you're actually leveraging up the pay mix and that’s counter to some of the debate on what to do with LTI at present.
The other interesting point is whether that equity should immediately vest. Does it put the individual in the same economic position as a bonus or should they be filtered in through a deferral mechanism? Companies would need to use newly issued shares rather than onmarket purchase as that would be the same as spending cash. Consideration also needs to be given to the fairness of any forfeiture element - quite a nuanced and complex issue for the remuneration committee to deal with.
Whether we reward effort or outcome tends to flip depending on the cycle. There will be many debates between boards and executives who have worked very hard throughout the year but not necessarily achieved an outcome. Should they be rewarded and recognised for that contribution? That's the very environment that we’re in at the moment and heightens the importance of disclosure and rationale.
A number of organisations are already starting work on their remuneration report and including dummy wording around the discretion policy, clawback, malus and the board’s approach in considering these issues, the robustness of decision-making and the extent they’ve looked at different data sources. We think there'll be more pressure to disclose more which will probably make REM reports even longer this year.
As we think about the next financial year, there are a number of particularly big issues that we’re talking to clients about.
The first is target setting and budgeting. Most management teams would be struggling to put together a budget for next year, let alone the next three years. How will they calibrate their LTI performance targets and budgeting for the STI, which aligns to incentive targets?
We would suggest that wider performance ranges are something to consider. There are discussions around potentially moving to a rolling quarterly approach for the incentive plan, but not necessarily for the budget. There’s certainly the pressure to think of things differently but setting targets is going to be very challenging. For example, if you’ve got relative TSR as your performance measure and you've got a one-month averaging period for the TSR start date, should you be thinking about a longer averaging period? What we're seeing out of the UK is minimal changes with the intention of using discretion at the backend rather than adjusting too much at the front end.
Articulating the adjustment and discretion policy in the annual report will also help set the scene for how and why the committee will apply its adjustments in two or three years time. A number of decisions made in the next few months will actually be on foot for the term of the LTIP award if you decide to grant an LTIP, so be very careful in terms of what is performance or COVID related or the bounce back in the market. What we're trying to avoid is the perception of a free kick at the time at which you allocate the LTI at a low price point and vest in three years time when the market has more than recovered.
The last point around the allocation of LTIP and the award is that with just a basic example of a drop in share price and staying as a percentage of salary, that the numbers of instruments will increase.
Certainly in overseas markets there’s typically an expectation if the share price drops 25%, that there would be some sort of consideration and reduction in the number of instruments to remove the leverage at the backend. We haven't seen that in Australia, but there will be pressure to do that, particularly if you've got an executive pay mix that is highly leveraged or geared towards the LTI. What we’re trying to avoid is that leverage impact of allocating equity at a low point and investing at a high point, and the perception that management won’t be seen to be doing much to affect that but rather just benefiting from the whole market falling and then rising.
We suggest looking at different data points for your LTIP awards such as looking at different VWAP periods. If you've got five to ten day VWAPs, explore three, six, twelve months to test the impact on vesting outcomes. That doesn't mean it's a change in policy but you may in fact have to apply some ultimate discretion on the award sizes for this particular year.
It comes down to what is fair and equitable. What will investors and employees think around this particular issue? And some of these decisions will be judged at the backend when the outcomes are disclosed rather than now.
The counter-argument is that we’ll be in a turnaround scenario for most organisations where you tend to see quite specific remuneration structures where you might shift, for example, from relative TSR to absolute TSR or consider a more highly geared incentive arrangement. Like most things that we do on a day-to-day basis in this field, we would always encourage you to do what's right for your organisation. Keep an eye on the market, make sure your disclosure is absolutely spot on and have robust discussions because you will be challenged on the decisions you’ve made.
Another issue coming out of the UK is if there were to be significant government support, a bailout for example, there’s a particular heightened scrutiny on the impact on executive pay - both targets and levels.
When you're doing your shareholder map, depending on where your shareholders sit they will either follow one of the proxies or engage in conversations themselves around the points of view. If you are doing your annual shareholder or investor consultation then it may be a good opportunity as a listening tour, to really understand the views of your investors on these particular issues because it will be quite sensitive. And as we know with that mechanism of the strike, it doesn't take much in terms of a no vote and using that as a lightning rod for other reasons.
In conclusion we would say do the right thing for your organisation with an eye to the market and the regulators and get as much data and evidence as possible for your considerations. We believe the conversations that you will be having over the coming months are an opportunity to think more creatively and innovatively on the way we set targets and align reward and performance. Boards are way ahead of regulators and proxies in relation to having these debates, so we are hopeful that the weight of all of you and us as advisors can actually make some positive change after all this is said and done.
There will certainly be less pressure on organisations that haven’t suffered major adverse impacts on the workforce. If you haven’t reduced headcount but cash flow earnings are still down materially, there will still be an expectation because of the alignment between the executive level with the employee, shareholder, customer and community experience.
There’s likely still an expectation that you would make an adjustment if earnings are down, particularly if it's COVID related. If there are other things contributing to that outcome that are within management’s control or outside, then that may require a different, more nuanced consideration.
It's important to note that investors have long memories. There will be an expectation to consider issues that underlie business performance separate to that of the impact of COVID, which will be important, particularly with to explain in disclosures. The consideration of why earnings have dropped and the reason for that is always really important, and so in the current environment separating as best you can what is COVID related and what isn’t will be key.
The prevalence of adjustments is still the minority of the market. We don't think there’s necessarily a blanket expectation that all salaries will be cut. We are getting external stakeholder guidance that companies should be very sensitive to the bonus payments they are making and whether they align to the full set of stakeholders and their experience. In terms of the quantum of adjustments, that is ranging but most commonly we're seeing a 20% cut, in place up to the end of this performance year. Some companies are announcing they will be reevaluated at that point in time.
From what we've seen it's across the board. The Workplace Gender Equality Agency (WGEA) has extended its deadline dates, so all of the typical analysis that we would be seeing on gender pay coming up in the remuneration committee around this time has been shuffled back. We still expect to see that happen but it hasn't factored in who gets a reduction or not.
One of the reasons we’re not seeing organisations utilise this opportunity to reapportion pay spend is because it has been positioned as a temporary decision. We have seen a couple of organisations make decisions about pay reductions targeted to particular employee segments, for example, ALDI and Tesco in the UK awarded a 10% bonus to store stuff for hours worked. We hope that organisations who are making decisions based on employee segments are also looking at whether there is a disproportionate gender representation in those particular employee segments and at least considering the impact of those decisions.
We would be hesitant to advise any organisation to make any significant changes this year. Any changes to executive pay frameworks will require a strong rationale, but there would still be a certain amount of nervousness with any once-off arrangements. And we still don't really know how long the impact will last.
Boards would also need to consider the level of engagement required with proxy advisors in the current environment to introduce a unique reward arrangement. The level of scrutiny would be very high.
Although a number of committees that we're talking to are looking at the performance period differently. For example, rather than a three-year performance period, looking at shorter performance periods, three one year periods or some cumulative approach.
There are also some examples coming out of the UK after the financial crisis, where organisations put their plans on hold and put turnaround plans in place, but it was quite limited.
If 2020 is the final testing year and the COVID-19 impact has hit only in the last two or three months, we're not seeing any major adverse impact on vesting conditions yet.
One way to exercise discretion is adjusting the performance measures to remove the impact of a particular event or scenario to try and normalise that amount. While that is less transparent to investors and shareholders, a number of organisations will be doing that to come up with a fair assessment of performance for what would be the final year of a three-year period that might otherwise have vested.
The application of pure discretion for investors will always be assumed to be downward but management may well expect an upward application in the current environment. While there are some examples it rarely goes upwards, which is why the adjustment approach (i.e. the adjustment of performance outcomes rather than pure discretion) is much more effective. I think re-testing is also something that just gets a big cross in the proxy guidelines. You could justify it by planning to test again when the market is less volatile. However, it might actually make things worse because you’re only going to include a greater proportion of the overall performance period that will be impacted by the COVID 19.
The testing period might refer to the period over which the instrument is valued for allocation purposes. For example, if you have a relative TSR measure, over what period do you value it so that the VWAP is less affected by volatility in the share price? Investors might be more receptive because typically we might value the share over a five-day VWAP but due to volatility that VWAP could be misrepresentative of the overall performance period. In this context, we will increase that period to 3 or even 6 months as we have seen in the UK, for extremely volatile industries.
We've always been sensitive to changing averaging periods without a commitment to use the averaging period for both the start and the end period and not changing it for the next three or four LTI cycles. TSR is already often seen to be a lottery and depending on whether the recovery commences before or after the grant of that LTIP award, using a longer averaging period may be a disadvantage.
Certainly we may see more discretion applied at the year end. That's not to say people will throw out the existing framework and introduce a purely discretionary framework. In relation to setting performance targets, there are a number of approaches that boards are actively discussing. At this stage we haven't got too much guidance or direct commentary from proxy advisors about methodologies that they would be more comfortable with.
One thing you could do is delay the target setting. Another is to commit to periodic recalibration of the targets. And thirdly, consider introducing much broader performance ranges. For example, assume you currently pay your threshold STI payment at 90% of profit target and pay your max at a 110% of profit target. The rationale might be we expect those profit results to fit within a much broader range now because they are harder to predict and the market is more volatile. So we will move to pay our threshold payment at a lower level, say 80%, and we will push out our maximum payment to a higher level, for example 120%. I think we will see these approaches creep in, but still with the expectation that the metrics and targets will be transparent and disclosed, along with resulting performance outcomes.
In a wider performance range, we might also think about reducing the amount paid for threshold performance, so if you pay 50% of maximum for 90% of target performance and you’re widening the range you might reduce that payout to say 20% or 30%, so they would go hand in hand.
One board that we have been working with has been thinking about increasing the weighting of non-financial measures for FY21 year to give a little bit more control in terms of the measures. Last season we saw quite a bit of activity around this including APRA’s proposal around 50% of non-financial measures. We would caution any change or increase in non-financial measures on the basis that it will be seen to be making the bonus easier to achieve. That perception is very hard to overcome versus a financial component. One could observe that these non-financial measures sound like a normal day-to-day job of a CEO and executive team in just keeping people safe. The counter to that is that this environment is not normal and that they're applying what is otherwise normal activities within a heightened and unprecedented market environment.
I recently completed some research for an organisation that explored whether you had a differentiated remuneration model for overseas jurisdictions, particularly North America to Australia. We found that Australian organisations typically have one framework that fits all executives so I suspect that if you've got overseas executives they will be treated in the same way as Australian executives.
While we’re not expecting an increased receptivity for changes in models, we are hoping that a greater use and acceptance of discretion, over and above the formulaic outcome of the performance reward framework, will emerge. Increasing expectations around that practice have existed for some time, particularly coming out of the Royal Commission. But we’d expect to see the use of discretion will be enhanced this year and that will flow on to other years as well.
A bigger concern is more regulation. As we know, regulation is typically written on the basis of heightened issues or a minority of issues that arise. If any organisation is seen to be doing the wrong thing we'll get more regulation than less, so we all need to try and avoid this scenario happening again.
Partner, People and Organisation, PwC Australia
Tel: +61 (2) 8266 2420
Partner, People and Organisation, PwC Australia
Tel: +61 (3) 8603 1685