Evolving executive compensation

With strengthened corporate governance regimes post the global financial crisis, executives getting massive pay cheques with minimal oversight is now a thing of the past. Public and regulatory pressure has driven boards and remuneration committees (RC) to devote more attention on executive compensation.

The Code of Corporate Governance (the Code) in Singapore encourages listed companies to disclose the level and mix of executive remuneration, as well as the policies and processes for remuneration setting. Written terms of reference, as required under the Code, have to clearly set out the RC’s authority and duties in reviewing and recommending to the board a general framework of remuneration for the executives. This allows for a structured approach in determining executive compensation so that it is fair, equitable, and commensurates with performance.

When reviewing the remuneration framework for executives, the RC typically covers these aspects: corporate governance to ensure proper due diligence of executive compensation has been carried out; overall remuneration strategy to ensure the pay philosophy of the company allows it to continue to attract, retain and motivate key executives; and setting and assessing the performance measures of both short-term incentive (STI) and long-term incentive (LTI) of executive compensation.

The ways to compensate executives is evolving as boards and RCs challenge themselves to ensure rigor in their oversight duties. How much should executives be rewarded for overachieving, achieving or underachieving the targets set? Over what period of time horizon should executives be receiving the pay-out to ensure long-term sustainability of performance and retention of high-performers rather than promote short-termism and risk-taking?

What to pay for?

If you consider that there are other aspects of a business, apart from financial measures that stakeholders consider in determining a company’s long-term sustainability, then paying for performance must similarly take both financial and non-financial measurements into account. 

From a holistic perspective, the Board and RC will have to find the right balance in ensuring executives are being assessed appropriately across the four aspects of financial, operational, customer and people, in order to be answerable to activist investors who are likely to watch short-term financial goals, as well as institutional investors, who are usually more concerned about the long-term sustainability and growth of the business.

How much to pay?

The traditional way of determining pay packages based on prior year’s compensation is no longer acceptable without benchmarking. Executive benchmarking against similar-sized industry players should be undertaken to ensure market competitiveness.

How to pay?

Determining the quantum is only the first step. Following that, it would be necessary to set a target pay mechanism to determine the proportion of guaranteed pay to at-risk pay. Optimizing the split is key to preventing excessive risk-taking by executives.

Beyond paying for achieving annual company goals in the short-term, some companies also have in place a Medium-Term Incentive (MTI) in the form of an Economic Value Added (EVA) based incentive.

Instead of paying for performance based on accounting profit, the measure of economic profit introduces additional scrutiny over executive decision on opportunity cost that can only be observed over a longer period of time. This form of incentive has a banking mechanism whereby an annual declaration of award, positive or negative, will be placed in a “bank”. Only a portion of the bank balance will be paid out, staggering the incentive payment over a period of time to prevent excess risk-taking.

LTI is also gaining popularity as a means of aligning executives’ interest with the shareholders’ in the form of equity or bonus deferrals, with the objective of retaining key executives in mind. Relative total shareholder return (TSR), which accounts for capital gains and dividends declared, is a popular form of LTI to measure an executive’s performance in bringing shareholder value in the context of the broader financial market.

When to pay?

STI is accrued and paid on an annual basis while MTI is declared annually with staggered payment. On the other hand, LTIs typically span beyond a year, with the duration dependent on the company’s rationale for implementation, be it for retention or motivation to prepare for an initial public offering (IPO) launch. The duration should also take into account potential returns for executives at the end of the vesting period.

Executives generally prefer an immediate reward over waiting out for a larger payoff. A likely reason would be uncertainty over the goals that should be achieved for the pay-out. Clarity over the key performance indicators allows executives to better manage their long-term resources to commit to achieving those goals.

The way forward

In the US, transparency and accountability on executive compensation are enforced through mandatory disclosure of top executives’ compensation and also via a non-binding vote on executive compensation by the shareholders on a periodic basis.

As mandated by the Code, Singapore-listed companies are required to disclose their top executives’ compensation. However, companies can avoid this by justifying the non-disclosure, usually citing compensation confidentiality and the competitive nature of talent attraction and retention as reasons.

The say-on-pay vote also has its critics as it places undue regulatory burden on companies, even if it is non-binding. There is also the concern of shareholders’ ability to understand the mechanics of executive compensation and the extensive education required to bring about this awareness.

Notwithstanding the above, the increase in fiduciary responsibilities of boards and RCs to ensure that executive compensation is justifiable and answerable to shareholders and the public has reduced the ambiguity on what fair compensation entails.

Corporate governance on executive compensation is here to stay. Ultimately, the board and RC have to balance the company’s talent strategy with its executive compensation rationale such that both will stand up to stakeholder scrutiny.

The views in this article are those of the author(s) and do not necessarily reflect the views of the global EY organization or its member firms.

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