PFS Consulting is pleased to provide this submission in relation to the draft Prudential Standard CPS 511 – Remuneration (“CPS 511”).
PFS Consulting is an independent consultancy established in 2001. We provide remuneration, governance, and risk consulting services to a wide range of clients. These include APRA regulated entities including superannuation funds, life and general insurers, and banks.
As part of our executive remuneration services PFS Consulting has provided valuations of Long-Term Incentive (“LTI”) plans for over ten years. One of our Principals Thach Huynh was on the Actuaries Institute’s Executive Remuneration committee and was involved in the development of the guidelines for practitioners undertaking valuations of Long-Term Incentive (“LTI”) plans.
In addition to LTI valuations PFS Consulting also provides ongoing performance monitoring of incentive plans, and advice on remuneration design. We also undertake independent reviews of governance, risk management, and other frameworks required under APRA Prudential Standards.
Our multifaceted practice means that we bring perspectives from consultants who would be undertaking annual and three yearly remuneration framework reviews, as well as providing valuation and remuneration design advice.
Section 6.3 of the Discussion Paper dated 23 July 2019 requests information from stakeholders regarding the compliance impact and other substantive costs of introducing the standard.
We suggest the one-off accounting cost of changing the design of part of a company’s Long-Term Incentive from a market to a non-market performance measure is likely to be much more significant than the compliance impact.
The valuation of share-based payments for the purposes of financial reporting is governed by Australian Accounting Standard AASB 2. In assessing the fair value of share-based incentives with a market-based performance measure, this standard permits a company to allow for the probability of the incentive not vesting (which is typically 25% to 50% for current LTI designs). However, in respect of incentives based on non-market performance measures the standard requires that there be no discounting for the probability of the incentive not vesting.
Hence incentives based on non-market performance measures have a significantly higher cost, as reported in financial statements when granted, than incentives with market-based performance measures.
Our submission on this issue is set out under Q3 below, in relation to variable remuneration that depends on both a non-financial performance measure and a financial performance measure.
Draft Prudential Standard
In respect of the draft Prudential Standard, we suggest clarification is required in the following key areas:
Clause 9: This Prudential Standard commences on 1 July 2021.
Q1 – In respect of remuneration design, does this mean that the Prudential Standard will only apply to remuneration granted on or after 1 July 2021? Can APRA confirm that variable remuneration arrangements granted prior to this date but that could result in payments after 1 July 2021 – e.g. LTI granted in earlier years with a four-year performance period that runs beyond 2021 – are not affected?
We submit that this should be the case.
Clause 38: For any variable remuneration arrangement of an APRA-regulated entity, 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. Financial performance measures include but are not limited to:
- revenue, profit and volume based measures;
- share-based measures that reflect changes in the value of shares and dividends paid or the return on the number of shares issued; and excludes risk-adjusted measures and an RSE licensee’s investment return measures.
Q2 – What metric will be used to assess the 50% cap on financial performance measures? For example consider a Company that grants its CEO the following variable remuneration, measured over an appropriate performance period:
- 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 total economic value of these grants is $1,250,000. The options represent 20% of this ($250,000 out of $1,250,000) using economic value as the criterion, but 67% (400,000 out of 600,000) using the number of rights/options granted.
In our view it would be appropriate to use the economic value, as assessed in accordance with the relevant accounting standard, and we submit that this should be clarified.
Q3 – Would an LTI grant where vesting is dependent on a non-financial condition such as customer satisfaction score, but subject also to a financial performance condition, be considered as subject to a non-financial or financial performance measure?
We submit that if vesting of variable remuneration depends on both a non-financial performance measure and a financial performance measure, that remuneration should be considered by APRA to be subject to a non-financial measure. This will allow companies to add non-financial hurdles to their existing arrangements without the accounting cost impact discussed above. This will achieve APRA’s objective of limiting the weight given to financial performance measures, while being more likely to be acceptable to shareholders.
Q4 – Would deferred share acquisition rights which vest subject only to service criteria and are not subject to any performance measures at all be treated as variable remuneration with no financial performance measures?
Q5 – Would options be treated as a financial or non-financial measure? Options have an implied financial hurdle, but this is different to performance measure(s) which determine vesting, which could be either financial or non-financial. We consider it appropriate for the performance measures that determine vesting to be the criteria applied. If there are no performance measures the question is in effect identical to Q4 above.
Deferral and clawback for significant financial institutions
Clause 53: A significant financial institution must, for a Chief Executive Officer (CEO), 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 and no faster than on a pro-rata basis.
We submit that the seven year deferral period should be reduced to no more than 5 years, and that the pro rata rules be removed for simplicity (see comments in response to consultation questions below).
Q6 – Long Term Incentives are generally granted on dates that differ from the start of the performance period. For example, a new CEO who joins a company on 1 January may be granted an LTI that has a performance condition based on performance over the 7 years starting on the previous 1 July. Would this comply, given the performance period is 7 years, even though the actual period of service to vesting is 6.5 years?
We submit that vesting should be allowed at the end of the performance period provided the grant is made within the first say 12 months of the performance period.
Is triennially an appropriate frequency for conducting independent reviews of the remuneration framework? Yes
What areas of the proposed requirements most require further guidance? No Comments
Are the proposed duties of the Board appropriate? Yes
Are the proposed duties of the Board Remuneration Committee appropriate? Yes
APRA is proposing that financial performance measures make up at least 50 per cent of variable remuneration measurement and individual financial performance measures are limited to 25 per cent. Is this an appropriate limit, if not what other options should APRA consider to ensure non-financial outcomes are reflected in remuneration?
No comments on an appropriate limit.
As alluded to in our questions above, we believe that APRA needs to clarify what will be included as a financial performance measure. We believe that if a grant has both a financial and non-financial performance measure it should count as a non-financial measure. This will allow companies to add non-financial hurdles to their existing arrangements without significant financial statement impact relative to prior arrangements.
What would be the impacts of the proposed deferral and vesting requirements for SFIs? For ADIs, what would be the impact of implementing these requirements in addition to the BEAR requirements?
We submit that the seven year deferral period for the CEO of an SFI is too long, and may make such a role less attractive to many senior executives, and result in pressure for more fixed and less variable remuneration, neither of which is a desirable outcome. We submit this period should be reduced to no more than 5 years and that the pro-rata rules be removed for simplicity.
Would the proposals impact the industry’s capacity to attract skilled executives and staff?
We believe the proposed standards are likely to result in:
- Talented executives choosing to work in other industries or other countries and/or
- Executives seeking larger remuneration packages to cater for the longer deferment periods etc and/or
- Executives seeking a greater proportion of their remuneration as fixed salary.
What practical hurdles are there to the effective use of clawback provisions and how could these be overcome? Would requirements for longer vesting where clawback is not preferred address these hurdles?
What transitional provisions may be necessary for particular components of the new standard or for particular types of regulated entities?
Remuneration arrangements granted prior to the introduction of the standard should be excluded.
ARPA should establish a mechanism for companies to seek clarifications on aspects of the changes introduced.
What disclosures would encourage a market discipline in relation to remuneration practices? No Comments
Thach Huynh, Principal
John Newman, Managing Director