Chapter 16 - Test yourself Q&A's - Remuneration of directors and senior executives

Question 1

What are the typical components of an executive director’s remuneration package?

Answer 1

The remuneration package for a director or senior executive is likely to consist of a combination of:
* a basic salary;
* payments into a pension scheme for the individual (or payments in lieu);
* an annual bonus, usually linked to the annual financial performance of the company;
* long-term incentives, usually in the form of share options or share awards (sometimes called ‘restricted stock
awards’);
* other benefits and perks, such as free medical insurance, a company car or accommodation.

Question 2

What company performance targets might be used as a basis for fixing annual bonus payments to a CEO?

Answer 2

Bonus payments may depend on the achievement of both individual targets and the performance of the company over the previous financial year.

Question 3

What are the problems with linking rewards to performance for senior executives?

Answer 3

It is difficult to design performance-related remuneration for the following reasons:
* selecting the right performance measures;
* setting the thresholds at which rewards are paid;
* setting a cap on any rewards under the incentive scheme;
* ensuring that the targets used promote the long-term success of the company;
* ensuring that the targets used do not promote bad behaviour;
* ensuring that executives who perform well are rewarded and preventing those that don’t from piggy-backing on the
success of their colleagues;
* executives may develop an expectation that they should receive annual rewards regardless of the actual
performance of the company; and
* designing a scheme that will be satisfactory to shareholders.

Question 4

What company performance targets might be used as a basis for deciding how many shares should be granted to a senior executive as a long-term incentive arrangement?

Answer 4

Most companies use total shareholder returns (TSR) or earnings per share (EPS) against a comparator group of companies.

Question 5

What are the drawbacks to using share options for long-term incentive schemes?

Answer 5

The drawbacks of using share options as a long-term incentive are:
* Share prices are volatile. Option holders may be unjustly enriched in a bull market where prices are rising and inadequately rewarded in a bear market when prices are falling.
* If the market price of a company’s shares falls below the exercise price for the share options, those options may no longer provide any incentive for the directors.
* It is more difficult to apply a holding period for shares acquired under a share option scheme as directors and senior executives may need to sell at least part of their holding in order to finance the exercise.
* International Financial Reporting Standard 2 (IFRS2) Share-based Payment requires companies to recognise the award of share options as an expense, chargeable against the company’s profits, from the time that the share options are granted.

Question 6

What does the UK Corporate Governance Code say about the general level of executive remuneration?

Answer 6

Principle P of the 2018 Code now provides:
‘Remuneration policies and practices should be designed to support strategy and promote long-term sustainable success. Executive remuneration should be aligned to company purpose and values, and be clearly linked to the successful delivery of the company’s long-term strategy.’
Principle R of the 2018 Code states that:
‘Directors should exercise independent judgement and discretion when authorising remuneration outcomes, taking account of company and individual performance, and wider circumstances.’

Question 7

What is the main guidance in the UK Corporate Governance Code on the design of performance-related pay?

Answer 7

Code Provision 40 recommends that:
* remuneration arrangements should be transparent and promote effective engagement with shareholders and the
workforce;
* remuneration structures should avoid complexity and their rationale and operation should be easy to understand;
* remuneration arrangements should ensure reputational and other risks from excessive rewards, and behavioural risks that can arise from target-based incentive plans, are identified and mitigated;
* the range of possible values of rewards to individual directors and any other limits or discretions should be identified and explained at the time of approving the policy;
* the link between individual awards, the delivery of strategy and the long-term performance of the company should be clear. Outcomes should not reward poor performance; and
* incentive schemes should drive behaviours consistent with company purpose, values and strategy.

Question 8

What are the principal duties of the remuneration committee under the UK Code?

Answer 8

Code Provision 33 provides that the remuneration committee should have delegated responsibility for:
* determining the policy for executive director remuneration; and
* setting remuneration for the chair, executive directors and senior management.
It also states that the committee should ‘review workforce remuneration and related policies and the alignment of incentives and rewards with culture, taking these into account when setting the policy for executive director
remuneration’.

Question 9

Describe the recommendations of the Code regarding the composition of the remuneration committee.

Answer 9

Code Provision 32 states that the remuneration committee should consist exclusively of independent non-executive directors and should comprise at least three or, in the case of smaller companies, two such directors. The company chair is permitted to serve on the remuneration committee if they were considered independent on appointment as chair (although they are not allowed to chair the committee). The chair of the remuneration committee must have served on a remuneration committee for at least 12 months before their appointment.

Question 10

What provisions are included in the Code on remuneration consultants and why?

Answer 10

Code Provision 35 provides that:
* Where remuneration consultants are appointed, this should be the responsibility of the remuneration committee.
* The consultant should be identified in the annual report alongside a statement about any other connection it has with the company or individual directors.
* Independent judgement should be exercised when evaluating the advice of external third parties and when receiving views from executive directors and senior management.

These provisions reflect concern about potential conflicts of interest remuneration consultants may have which may compromise their objectivity.

Question 11

What are the two main component parts of the directors’ remuneration report?

Answer 11

The two main components of the directors’ remuneration report are:
* the directors’ remuneration policy; and
* the annual remuneration report.

Question 12

What is the purpose of the annual remuneration report?

Answer 12

The purpose of the annual remuneration report is to disclose to shareholders how the board has implemented the directors’ remuneration policy during the financial year.

Question 13

What are the principles and provisions of the UK Code with regard to severance payments for senior executives?

Answer 13

The UK Corporate Governance provides in Code Provision 39 that:
* Notice or contract periods should be one year or less.
* If it is necessary to offer longer periods to new directors recruited from outside the company, such periods should reduce to one year or less after the initial period.
* The remuneration committee should ensure compensation commitments in directors’ terms of appointment do not reward poor performance.
* They should be robust in reducing compensation to reflect departing directors’ obligations to mitigate loss.

Question 14

What are the principles and provisions of the UK Code with regard to severance payments for senior executives?

Answer 14

The UK Corporate Governance provides in Code Provision 39 that:
* Notice or contract periods should be one year or less.
* If it is necessary to offer longer periods to new directors recruited from outside the company, such periods should reduce to one year or less after the initial period.
* The remuneration committee should ensure compensation commitments in directors’ terms of appointment do not reward poor performance.
* They should be robust in reducing compensation to reflect departing directors’ obligations to mitigate loss.

Question 15

Who should set the fees of NEDs?

Answer 15

Code provision 34 provides that the remuneration of non-executive directors should be determined in accordance with the articles of association or, alternatively, by the board. In practice the chair and the executive directors will take the lead on making a proposal to the board regarding the fees that should be paid to non-executives, probably after taking advice from the company’s remuneration consultants. Remember that, under the Code, the remuneration of the chair (even if non-executive) must be determined by the remuneration committee.

Question 16

Why is it inappropriate for NEDs to participate in performance-related schemes?

Answer 16

Non-executive directors are expected to play a role in setting the risk appetite of the company. Anyone whose remuneration is based on short- to medium-term performance has an incentive to take more risk in order to chase profits.
Shareholders expect non-executive directors to act as a moderating influence in this regard. If they were allowed to participate in performance-related schemes, their interests would be more closely aligned with those of the executive team, rather than the interests of shareholders.

Question 17

Why might it be appropriate for some or all of NED fees to be paid in shares? What are the practical difficulties with this proposal?

Answer 17

Some people argue that paying NEDs fees in shares would more closely align their interests with those of the shareholders, as it would force them to become shareholders themselves. However, if you want them to remain as
shareholders, you would have to impose a minimum holding period. They could, for example, be required to hold the shares until they ceased to hold office. This would potentially mean that they did not receive any remuneration for their services until the end of their tenure. This would be likely to give rise to recruitment and retention problems. Accordingly, non-executives would probably have to be allowed to sell at least some of their shares. However, share sales by directors always send a negative message to the market. Setting up a system where these become a regular occurrence is not an attractive prospect for companies. A possible compromise might be for a minimum percentage of their fees to be paid in shares (say 20%), in which case a minimum holding period could also be applied. The minimum holding period
could allow them to sell those shares after, say, three to five years. The average tenure of NEDs is around four years.

Question 18

Why are the IA Principles of Remuneration and the PLSA Policy so influential?

Answer 18

The IA Principles of Remuneration and the PLSA Policy represent the views of institutional shareholders (e.g. investment managers and pension funds) who hold a significant stake in most listed companies. Most companies realise that shareholders will not support remuneration policies and structures that breach the guidelines issued by the two bodies. In addition, both bodies have a significant influence on government and regulatory policy in the field of corporate governance. Even if the majority of companies comply with the guidance, policy makers often give those
recommendations more force by adopting them as legislative or code requirements.

Question 19

Give two broad examples of things covered in the IA Principles and two broad examples of things covered by the PLSA Policy.

Answer 19

The IA Principles cover levels of pay, bonuses, pensions, long-term incentive schemes, contract terms and severance payments. A particular focus in recent years has been on ‘malus’ and ‘clawback’ arrangements.
The PLSA Policy covers a wide range of corporate governance issues of which remuneration is only one. It focuses more on matters that will be voted on by shareholders at the AGM. Accordingly, it focuses on the directors’ remuneration policy
and the annual remuneration report and explains the circumstances in which shareholders are most likely to vote against any resolution on those matters.