Should boards incentivise better culture with pay?

The banking Royal Commission raises big questions on pay and performance. We discuss how boards should modify pay structures to encourage better culture and performance.

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry has starkly exposed the risks that poor governance of remuneration can pose to the health of an enterprise. In the final report, Commissioner Kenneth Hayne AC QC states, “Too little attention has been given to the evident connections between compensation, incentive and remuneration practices and regulatory, compliance and conduct risks. The very large reputational consequences that are now seen in the Australian financial services industry, especially in the banking industry, stand as the clearest demonstration of the pressing urgency for dealing with these issues.”

That the Commission focused not just on narrow pay design concerns, but on the intersection of culture, governance and reward systems, and the disaster that can follow when they are not set properly, has important lessons for the way in which boards steward the risk, compliance and human resources functions under their remit. While the materiality of related problems may be greater in the financial sector, the same lessons, as they pertain to conduct and value destruction, hold true across all sectors.

In the spirit of not wasting a good crisis, Australian boards should use the opportunity provided by the Commission’s recommendations to drive change that will protect the value of the enterprises they oversee. Meeting their obligations in this new environment requires going beyond tinkering with discrete technicalities of executive pay plans. A comprehensive understanding of the whole ecosystem of culture, governance and rewards, and the tools for shaping and monitoring that system, will be critical. This requires a rethink of governance, stakeholder management and whole-of-enterprise reward architecture.

In light of the Commission’s findings, some boards and remuneration committees are revising their charters to explicitly include a protocol for monitoring governance and cultural indicators. These charters need to be alive to the potential for conflict of interest at every level, and explicitly allow for effective scrutiny of organisational silos and power battles that can develop, which are often at the root of governance failures. Management should be challenged to explain how conflicts of interest are avoided or managed where they exist.

The governance requirements for reward plan design for the whole organisation should be explicit, including allowance made for their review through different prisms. For example, requiring sign-off by the chief risk officer and the head of human resources confirming that the plans have been stress tested to ensure they do not encourage undesirable behaviours. AGL and Wesfarmers director Diane Smith-Gander FAICD suggests directors will need to go the extra mile to supplement messages from management to better understand cultural issues, reward-related or not. She advocates boards obtain and analyse data such as customer complaints, time taken to resolve complaints and the method by which they are resolved. She also believes directors can learn a lot about culture from exit interviews — preferably conducted by an independent third party soon after departure.

Clarity of objectives is important, according to Kathleen Conlon FAICD, chair of the remuneration committees of Lynas Corporate, REA Group, Aristocrat Leisure and the Benevolent Society. “You must ensure your remuneration systems are doing what you want them to do and are being operated in the context of systems, processes, controls and risk management,” she says.

Reward plan design

The “trust” crisis engendered by the Commission’s findings provides boards with the opportunity to design whole-of-enterprise approaches to reward, which support viable strategies for sustainable value creation.

The structure of many executive pay plans may need to be reviewed in today’s context, where it is now accepted that acting in the best interests of the company will involve considering the interests of various stakeholders, over the longer term.

This is more pronounced in Australia, with the compulsory superannuation regime meaning the investment landscape has shifted profoundly. As contributions grow, greater financial power resides in the superannuation behemoths — many of which are industry funds — on environmental, social and governance (ESG) issues that are seen as critical to the long-term sustainability of the company.

While executive pay plans based almost exclusively on shareholder alignment received significant investor support (because they did well), current community expectations, coupled with the rapid rise of the sustainable investment movement, has material implications for remuneration philosophy, strategy, structure and the processes by which remuneration practices are socialised and implemented.

“All around the world in many industries we have seen remuneration structures that have resulted in perverse outcomes, even where on the surface they seem aligned with the objectives of the company,” says Pablo Berrutti GAICD, head of responsible investment for Colonial First State.

“Remuneration committees and boards have a duty to act in the interests of the company as whole, which can survive in perpetuity. By definition, this means creating value for multiple stakeholders over multiple time periods. Long-term shareholders understand this and engagement with these shareholders is an important part of developing balanced remuneration structures.”

Frontline alignment

The design of reward plans, which may well include benefits and perquisites in addition to remuneration, should be reviewed to ensure they are fit for purpose within this new and evolving context. Going beyond arrangements for C-Suite executives, overall remuneration plans should be consistent or aligned throughout the organisation. Linking variable pay to behaviours at higher levels without a similar emphasis throughout the organisation has the potential to put the rank and file employees at odds with senior management (and vice versa).

Conlon agrees, saying that in the wake of the interim Royal Commission report, the remuneration committees she chairs now do deep dives into all frontline remuneration, not just executive arrangements. “We now look at all the remuneration structures and have a conversation about what we are trying to achieve with those structures and how to measure their effectiveness and manage for unintended consequences,” says Conlon.

Stephen Walmsley, a Melbourne-based partner in leadership, performance and reward with KPMG, supports redesigning reward plans to better reflect the community within which companies operate. Walmsley, who works with many ASX-listed company boards, says boards have become “defensive about remuneration”. This has led them to focus less on broader strategic issues such as talent management and corporate culture.

“One of the traps boards have fallen into over recent years is to remain wedded to signed-off performance scorecards, and not looking outwards to the external environment,” he says.

Walmsley notes the surprise expressed by some directors about the extent of the investor backlash, as manifested by the large annual general meeting strikes against the remuneration reports of the big banks. This shows that while boards have been diligent in applying the predetermined rules in executive pay plans, they have failed to properly understand the textural backdrop within which pay decisions are judged.

“Boards have been reluctant to use discretion in winding payments back, and in the case of financial services, have not understood that the findings from the Royal Commission have led many stakeholders to believe no bonuses should have been paid at all,” says Walmsley. While acknowledging boards can be in a bind — executive contracts are in place, after all — Walmsley says there has been a reluctance to properly engage with stakeholders about the “elephant in the room” — the overall quantum of executive pay, an issue that has attracted strong public response over the seriousness of exposed misconduct and concerns about deepening societal inequality.

Stakeholder consultation

Avoiding unpleasant surprises at annual general meetings is critical, but the solution to the challenge of attracting, retaining and rewarding the right talent for sustainable value creation will not be a neat, one-size-fits-all for organisations.

The new, post-Commission world is likely to require an increased, sustained emphasis on genuine ongoing consultation with stakeholders to deliver holistic strategies that address the myriad issues surrounding conduct, risk and corporate culture. They will need to be open to new ways of doing things, remunerating accordingly, and developing an ongoing, genuinely open dialogue with stakeholders to include them on a jointly beneficial journey. This is particularly important given the levers available to shareholders in the Corporations Act 2001 (Cth), including the “two-strikes” rule on voting on remuneration reports.

Consultation is essential and doesn’t ever “end”, says Smith-Gander, who is assisting Graeme Samuel on the review of Australian Prudential Regulatory Authority capability. She also notes stakeholder management is challenging and that the issue of investors possessing widely different perspectives on remuneration is perennial.

“When we do our consultation rounds, we will hear from one institutional investor that they are highly critical of any form of total shareholder return (TSR) measure in long-term incentive plans (LTIs). Then we go around the corner and meet with their proxy advisors who insist on some form of relative TSR. It’s impossible to satisfy these conflicting perspectives,” she says.

At the same time, she emphasises that “agreements have been made with our executive teams and we need to maintain a constructive relationship with them”. Smith-Gander believes that boards have work to do in reminding executives that “variable pay should be just that — variable”.

The 2018 Australian Council of Superannuation Investors (ACSI) report on executive pay, revealed a median STI (short-term incentive) payout of 70.5 per cent of maximum for ASX 100 CEOs.

Smith-Gander says that an entitlement mentality has become entrenched with executives, who have come to expect a significant percentage of their target incentives to be paid out year on year. While investors and their advisors remain adamant that “at risk” pay should only be awarded for exceptional performance, many executives believe there are situations where the exercise of their talents that may not lead to a net increase in value for shareholders — for example, steering a company through a crisis — may indeed warrant rewards beyond fixed remuneration. Investors approve remuneration reports for listed entities and their engagement on such measures as incentives for non-financial metrics and risk is critical.

Management guru Peter Drucker’s famous quote: “Culture eats strategy for breakfast” remains as pertinent today as it was decades ago.

As Commissioner Hayne notes, “Culture, governance and remuneration march together. Improvements in one area will reinforce improvements in others; inaction in one area will undermine progress in others.”

Directors now have an opportunity to put their stamp on this period in history — to preside over a new era of sustainable value creation that may well come to be seen as a seminal point in Australia’s corporate history.