5 minutes on the release of the Prudential Practice Guide CPG 511

6 May 2021

In brief

APRA recently released their draft Prudential Practice Guide CPG 511 on 30 April, 2021 which sets out principles and examples of better practice to assist regulated entities to comply with the Prudential Standard on Remuneration (CPS 511) which is expected to be finalised later this year. This guidance has been much anticipated given the principles-based, rather than prescriptive, nature of CPS 511. In particular, the consultation process to date revealed some common topics that entities appear to be seeking further clarification on such as: 

• expectations regarding the nature of a ‘risk modifier’; 
• metrics that would be accepted as contributing to the non-financial metric weighting; how to justify a weighting on non-financial metrics as being ‘material’;
• the nature of board accountability for third party remuneration arrangements; and
• implications for global companies with locally regulated entities. 

Below we have outlined the major areas for which the practice guide has helped provide clarification, and areas in relation to which the industry may wish to seek further guidance.

In detail

CPS 511 is a new prudential standard (replacing CPS and SPS 510) that sets out the requirements for regulated entities to design and maintain prudent remuneration arrangements that promote effective risk management, sustainable performance, and long term soundness. The supporting draft practice guide - CPG 511 - has provided clarification on a number of important aspects.

Firstly, in relation to the Role of the Board, and collaboration between Risk and Remuneration Committees (RemCos) on relevant matters, the use of joint committee meetings is expected, rather than solely relying on cross-membership of those committees. From a reporting perspective, expectations have been outlined that risk and internal audit executives present a formal assessment, including key risks and audit metrics, on at least an annual basis, and that RemCos be provided formal documented risk and performance assessments for specified individuals, and aggregate reporting for relevant cohorts (e.g. Material Risk Takers (MRTs)). The nature of RemCo responsibility and governance expectations in relation to third party remuneration arrangements has been further clarified (e.g. taking ‘reasonable steps’ to identify and address conflicts of interests in part by defining a materiality threshold and a process to manage risks of remuneration practices of third party service providers). 

In terms of Remuneration design, it has been made clear that there is no requirement to have variable remuneration as part of your framework and that entities have the flexibility to use various models, although there are some models that have been highlighted as “challenging” to align with the requirements, such as discretionary profit share arrangements, and service-based awards. A more comprehensive list of forms of remuneration that would be considered variable remuneration has been provided. In terms of deferrals, it has been clarified that the amount to be deferred for SFIs should be based on the total amount of variable awarded in a given financial year, which suggests the STI paid in any given financial year (earned from the prior performance year), and the LTI granted in that same financial year.

In relation to expectations regarding specific cohorts, for MRTs, entities are expected to establish and disclose a threshold definition for MRTs including quantitative indicators and qualitative criteria. Expectations are also clearer regarding incentive arrangements for Risk and Financial Control Personnel (RFCP), including that there be a higher proportion of fixed pay, and individual performance measures within bonus arrangements to be principally based on non-financial metrics. Furthermore, the determination of performance and reward outcomes should not to be determined by managers of the business areas they monitor.

Further guidance regarding non-financial metrics was much needed, and a more comprehensive list of examples has been provided in terms of what would be considered a non-financial metric, broken down by entity type. ‘Categories’ of non-financial metrics have been described with specific guidance that ‘broader indicators’/strategic goals should not be used exclusively to satisfy the material weighting on non-financial measures (i.e. strategic goals, employee engagement, customer satisfaction, ESG criteria), with the implication being that risk metrics (financial, non-financial, and conduct risk) must feature in all incentive arrangements. Some additional guidance was provided to support the determination of a “material weight” on non-financial metrics for SFIs, including criteria that should be considered, and that the weight could vary across roles within the same entity, and that each entity will be expected to define a minimum level (or range), and review annually.

Clearer expectations regarding the tools and criteria for adjustments was also being sought by entities. Helpfully, the guidance does appear to confirm that adjustment tools can be used in sequence/in order of ease of application (in period adjustment, followed by malus, followed by clawback) rather than the adjustment tool being determined by the nature of the event. Expectations are clear that remuneration adjustment guidance should ideally include a ‘severity scale’ to guide decision-making on the level of severity and indicative remuneration impacts that would be expected to result.

Finally, in terms of framework reviews, expectations regarding the Annual Compliance review are clearer, including that it should examine both policy/design AND outcomes relative to CPS 511 requirements. And the Triennial Effectiveness review expectations appear to imply a focus on an external view of effectiveness (market trends, domestic and international examples of poor risk and conduct consequences) as much as internal (e.g. where an entity’s strategy / objectives have changed, whether outcomes are consistent with the objectives of the remuneration framework).

However, there are still some notable aspects of the requirements that would benefit from additional guidance:

• Whilst the PPG has provided criteria to inform a position on what would be considered a ‘material weight’ on non-financial metrics, in some cases the criteria may create more confusion than clarity e.g. how to apply “is robust and cannot be overshadowed or diminished by performance or outperformance on financial measures” is unclear given in common balanced scorecard mechanics, performance or outperformance on one financial measure could well diminish the outcome for underperformance on a non-financial measure, given the reward would naturally be larger. 
• Whether a standalone ‘modifier’ (as referenced in the revised CPS 511) is required and if so, what form the modifier would need to take such that it did meet a distinct and separate expectation from those outlined by APRA regarding the risk and conduct downward adjustment process.
• With regards to calculating the deferral value, more explanation is required regarding the meaning or intent behind 'use the number of shares rather than dollar value for the vesting schedule' for equity related remuneration, particularly given that either approach, should yield the same amount of deferral (since the requirements are based on proportions).
• How one might go about making a “pre-emptive” adjustment in relation to risk, particularly in scenarios that result in less than 100% downward adjustment (i.e where a matter does not result in complete cancellation of an award), and therefore, the actual reward outcome won’t be known until year end. In this situation, it may be challenging to pre-emptively apply a proportionate downward adjustment for a risk event without knowing the value of the eventual award being adjusted.
• For those organisations that do not have variable reward arrangements, no further clarity has been provided as to how organisations without variable pay can meet some of the requirements of CPS 511, particularly in relation to risk and conduct adjustments. This is particularly sought after for less serious matters (that may not result in termination). 
• For more complex variable reward arrangements e.g. for leveraged incentives (loan-based plans, equity options), APRA expects these to be avoided or “tightly controlled”. However, greater guidance is required as to how these are to be “tightly controlled” or more controlled than other arrangements.       
• For foreign ADIs, Category C Insurers and EFLICs, the “relevant oversight function” is responsible for the entity’s remuneration framework i.e. the senior officer outside Australia. For foreign companies that may for example have an Australian Board, more explicit guidance could be provided on whether it would be the Australian Board or the relevant oversight function who is accountable for compliance with CPS 511. 

The takeaway

Clarification has been provided on a number of key aspects of the CPS 511 prudential standard and so entities should be in a position to now conduct - or refresh - a more thorough gap analysis relative to current arrangements and refine any programs of work in relation to complying with CPS 511. The industry would still benefit from further guidance in relation to some key matters to ensure we see real change to current practice where it is needed, and that we don’t create an unlevel playing field in terms of attracting and retaining key talent between financial services and other industries, or between different sized financial services organisations. As such, we encourage entities to actively participate in the consultation process on the CPG 511 which will be open until 23 July, 2021.