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

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

Answer 2

2. What company performance targets might be used as a basis for fixing annual bonus payments to a CEO?
   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 ‘malus’ and ‘clawback’ provisions and where might you find them?

Answer 14

‘Malus’ provisions allow the company, in specified circumstances, to forfeit all or part of a bonus or long-term incentive award before it has vested and been paid (also known as ‘performance adjustment’). ‘Clawback’ provisions allow the company to recover sums already paid.

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

2. 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.

Question 20

Chapter summary

Answer 20

Chapter summary
* The corporate governance framework in the UK on directors’ remuneration for listed companies includes a mixture
of statutory provisions, listing rule requirements and code recommendations.
* A directors’ remuneration package is likely to consist of a combination of fixed and variable pay elements. The
fixed elements, which are not dependent on performance, include basic salary, pension payments (or payments in lieu) and other benefits and perks. The variable elements depend on performance and usually include short-term
incentives, such as an annual bonus, and long-term incentives, usually in the form of share options or share awards
which pay out for performance over a longer period.
* One of the fundamental principles of the Code is that no director should be involved in deciding their own
remuneration outcome. In practice, the Code requires companies to establish a remuneration committee of
independent NEDs to determine the company’s remuneration policy for executive directors and to set the
remuneration of the chair, executive directors and senior management. The committee is also expected to ‘review
workforce remuneration and related policies and the alignment of incentives and rewards with culture’ and take
these into account when setting the policy for executive remuneration.
* The Code provides that ‘remuneration policies and practices should be designed to support strategy and promote
long-term sustainable successes and that ‘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’.
* The Wates Corporate Governance Principles for Large Private Companies state that boards should ‘promote
executive remuneration structures aligned to the long-term sustainable success of a company, taking into account
pay and conditions elsewhere in the company’.
* The CA2006 requires quoted companies to put their directors’ remuneration policy to a vote by shareholders at least
once every three years and prohibits them from making any payment to a director unless it is consistent with that
policy or has been approved by shareholders in some other way.
* Quoted companies are also required under the CA2006 to publish detailed information on directors’ remuneration
in a separate section of their annual reports and accounts, known as the directors’ remuneration report. The
information in this report is designed to enable shareholders to understand how the company has applied the
approved policy during the financial year. The directors’ remuneration report must be put to an annual vote by
shareholders. Payments to directors are not contingent on the resolution being passed. However, if it is defeated,
the company must put its existing remuneration policy (or a new policy) to a shareholder vote in the following year.
* The above regime gives shareholders in quoted companies far more say over directors’ pay than they have ever
had before. Most companies now consult their major shareholders (or bodies that represent them) before putting
their directors’ remuneration policy to the vote, and representative bodies (such as the Investment Association and
the PLSA) publish detailed guidance on their expectations regarding remuneration policies and structures.
* The Code includes a number of measures designed to tackle the perception that directors are rewarded for failure.
It provides that notice or contract periods for executive directors should be one year or less. It requires companies
to be robust in reducing compensation to reflect departing directors’ obligations to mitigate loss and requires them
to adopt malus and clawback provisions that enable the company to recover and/or withhold sums or share awards
in certain circumstances. In addition, the remuneration committee is expected to have general discretion to make
adjustments to performance-related pay where there is an unjustified outcome.
* Subject to certain limited exceptions, the Listing Rules require all share option and long-term incentive schemes for
directors and senior executives to be approved by shareholders.
* The remuneration of non-executive directors will be fixed by the board or under some other procedures determined
by the articles. The articles of association of listed companies used to place an overall cap on the fees that could be
paid to NEDs. This is now exceedingly rare. The current norm is for the board to have power to fix the remuneration
of NEDs.
* The Code provides that the fees paid to the chair and NEDs should reflect the time commitment and responsibilities
of the role they undertake. For example, those who serve on or chair committees will be paid a higher fee.