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'Simplified' executive pay recommendations to be reflected in IA principles

Out-Law News | 28 Jul 2016 | 10:30 am | 4 min. read

The Investment Association (IA) will update its influential 'principles of remuneration' to consider the recommendations of a working group set up to "rebuild trust in executive pay structures in the UK", it has confirmed.

The Executive Remuneration Working Group (ERWG), which was set up by the IA last year, has made 10 recommendations intended to "simplify pay structures for company bosses while improving the alignment of their interests with those of the shareholders who own their businesses" (26-page / 158KB PDF). They include requiring boards to explicitly consider pay ratios when explaining why they have chosen the chief executive's pay, and encouraging companies to reconsider their use of the almost standard performance share award model of long term incentive plans (LTIP) in favour of a "more flexible" approach to the structures used to deliver incentive pay in the form of shares.

The group's report neither endorses nor opposes new prime minister Theresa May's proposed introduction of annual binding shareholder votes on executive pay, which was made about two weeks before the report was published, giving them little time to consider it. The report strongly supports the other two of Mrs May's three main remuneration reform proposals, and does discuss the idea of annual binding votes, pointing out that these could take various forms, and expressing the group's willingness to take part in policy development on the proposal. The group suggests an approach that could fit with their own recommendations might be a binding annual vote for companies that did not receive the support of at least 75% of their shareholders for the previous year's remuneration report.

"The recent intervention from our new prime minister shows that investors and companies need to work together and address the concerns with executive pay," said Andrew Ninian, director of corporate governance and engagement at the IA, which provided secretariat services to the working group. "Our industry is clear that it expects UK listed companies to work with us to tackle the lack of trust that has resulted from the UK's complex and ineffectual pay regimes."

"We will now look to amend our Principles of Remuneration so the asset managers who look after the financial interests of millions of savers and investors can play their part in delivering the change that is sorely needed," he said.

The IA represents the interests of the UK's asset management industry, worth an estimated £5.5 trillion. Its principles of remuneration are updated annually to provide its members with a set of best practice recommendations that they can rely on when voting on the remuneration packages of the companies that they invest in.

The current rules give shareholders a legally binding vote on future pay policy once every three years, backed by an annual shareholder vote which is not directly binding on the company, although a majority against will trigger a binding vote on pay policy the following year. However, in a speech given just two days before she became prime minister earlier this month, Theresa May said that there should also be an annual binding vote. She has also backed further corporate governance reforms to include consumer and employee representatives on company boards, broaden the UK's 'pool' of non-executive directors and require companies to publish bonus targets and pay ratios.

The working group, which was chaired by Legal and General chief executive Nigel Wilson and made up of five industry experts, said previously that the current approach of UK listed companies to executive pay is "not fit for purpose". In its final report, the group proposed a shift from the current reliance on performance share LTIPs, which pay out in shares typically after three or five years based on the satisfaction of performance conditions set at the time of grant, and instead giving companies more discretion to explore bespoke equity pay structures capable of gaining "market trust".

The report proposes stronger and more accountable company remuneration committees, better shareholder engagement and more transparent bonus target setting. This should include the retrospective disclosure of performance ranges, and providing explanations where discretion has been used. Boards should better explain why maximum pay has been set at the level that it has been, perhaps with reference to the pay ratios between chief executives and different employees, while non-executive directors should have at least one year's experience on a remuneration committee before they can be appointed as its chair.

Share plans and incentives expert Suzannah Crookes of Pinsent Masons, the law firm behind Out-Law.com, said that the group's recommendations were based on "engagement, accountability and rebuilding trust".

"The core recommendation is to move towards a more flexible remuneration structure, recognising that the current regime is widely regarded as 'not fit for purpose'," she said.

"A flexible approach will bring its own challenges. Companies, executives and investors would need to assess all potential alternatives, with the need for education on all sides to understand fully the implications of different structures, and sufficient trust between investors and companies to allow alternative models to be adopted," she said.

Both the IA principles of remuneration and the EWRG's recommendations specifically apply to UK quoted companies, meaning those with shares listed on the London Stock Exchange main market or on any other UK exchange subject to the Listing Rules. They do not directly apply to AIM companies. However, Crookes said that to the extent that the recommendations and any resulting changes to the IA's principles altered UK quoted company pay practice, AIM company pay "will probably also change to some extent, and perhaps over a longer period".

Remuneration expert Graeme Standen of Pinsent Masons attended the launch event for the group's report. He said that the group's main conclusion was that the standard LTIP approach, "although well intentioned, lies at the heart of current dissatisfactions with executive pay, which are felt by the public, politicians, investors and indeed by executives themselves".

"The LTIP gains that executives realise from year to year are volatile and unpredictable, partly because of the difficulty in setting the 'right' performance conditions three to five years in advance," he said. "This often makes these LTIPs ineffective as incentives, and has helped to drive up total pay.

"The ERWG understands that innovation in equity incentive structures can only take place if shareholders will actually support the adoption of alternative models by specific companies, which has not happened in the past. They made it clear that some large investors are committed to making these recommendations work, which will require more effective engagement on pay, and increased mutual trust, between quoted companies and their major investors. The aim is to alleviate the long-running controversies over executive pay and its relationship with company performance. The EWRG's rationale is that this should help restore public trust in big business, and also allow investors and companies to engage better on more important strategic issues, with a shared goal of making UK capital markets and large companies deliver more for all of society, and do so more efficiently," he said.