The proposed APRA executive remuneration standard, CPS 511, aims to ensure that remuneration arrangements in the financial services effectively manage both financial and non-financial risks.
The key requirements of the draft standard are as follows:
- The Board of an APRA-regulated entity is responsible for the remuneration framework and its effective application.
- An entity must have a remuneration framework that captures all remuneration arrangements.
- An entity must regularly review the compliance and effectiveness of its remuneration framework.
- Remuneration outcomes must be commensurate with performance and risk outcomes.
- Certain large complex entities will be subject to more stringent standards.
Impact on remuneration design
As shown above, the draft standard does not place any restrictions on the amount of remuneration payable by financial services companies. APRA has instead proposed minimum standards for key aspects of the variable remuneration framework such as performance metrics, deferral periods and claw-back provisions.
Clearly, the impact of these minimums will depend on the specific remuneration arrangements of the company. However, it will also depend on how the company interprets the key clauses. For example, clause 38 aims to prevent over-reliance on financial performance measures; it states that:
“financial performance measures must not comprise more than 50 per cent of total measures used to allocate variable remuneration. Each individual financial performance measure must not comprise more than 25 per cent of total measures.”
But whether a company’s existing remuneration arrangements comply with this clause depends on how it interprets the term “total measures”. For example, consider the following scenario:
Company XYZ plans to issue the following variable remuneration to its CEO:
- 100,000 share rights with vesting dependent on a consumer measure, valued at $500,000
- 100,000 share rights with vesting dependent on a staff measure, valued at $500,000
- 400,000 options with vesting dependent on share price, valued at $250,000
The financial performance component 3. could be considered to represent 67 per cent of the total measures using the number of rights/options granted (400,000 out of 600,000); or 20 per cent using the economic value of the total measures ($250,000 out of $1,250,000); or even 33 per cent using the number of performance measures (1 out of 3).
Another key clause under the new standard is the requirement that CEOs of significant companies
“…defer 60 per cent of their total variable remuneration for at least seven years from the inception of the variable remuneration component. Vesting of this 60 per cent may only occur after four years from the time of inception…”.
This appears straightforward, however, in practice most companies grant rights months after the start of the performance period. Therefore, if APRA takes the time of inception as the grant date, companies that have a four-year performance period starting before the grant date will still not comply. This point is illustrated below.
Company ABC decides to grant a new round of share rights on 1 March 2019. The performance period for the share rights is the four years 1 January 2019 to 1 January 2023, which would seem to comply with this requirement. However, the period from the grant date to the end of the performance period is three years and ten months.
The cost of complying with the draft standard
Most of the focus in this area has been on the cost of compliance and the review requirements of the draft standard. However, there is also a hidden cost, that is not generally recognised or considered. This is the impact on financial statements, or the accounting cost, of switching a proportion of the variable remuneration from a market-based hurdle to a non-market hurdle.
The valuation of these benefits is governed by AASB 2 and, under this accounting standard companies can only allow for market-based measures in the fair value calculation. Therefore, rights with non-market performance measures are assumed to have a 100 per cent probability of vesting and hence have a higher initial accounting cost than those with a market-based hurdle, which typically have a probability of not vesting in the order or 25 per cent to 50 per cent. This switching cost is likely to dwarf the additional compliance cost and this needs to be considered by companies when planning their response to these new regulatory requirements.
Finally, another concern from within the sector is the standard which, if fully implemented as it is currently drafted, may affect executive recruitment in the financial services industry. It would be reasonable to expect that sought-after executives would find working in other sectors more attractive or seek larger remuneration packages to compensate for the more stringent performance measures.
Therefore, while the draft standard applies only to the financial services industry, ASIC is likely to monitor the impact of the draft standard and potentially apply it more broadly to keep a level playing field. Hence, it would be prudent for companies outside the financial services industry to be aware of the final changes and their impact on the financial services industry.
To read the draft regulation and provide input follow this link.
To find out more about how the regulation may affect you, contact Thach Huynh today.