Executive remuneration
high
definition
in
Article three – a high
definition approach
to bonus deferral
Our latest series of papers turns a high definition lens to different aspects
of executive reward. This third article examines the use of bonus deferral.
What is executive remuneration in high definition?
Sensible remuneration
strategy is often
undone by poor
execution.
©2010 Hay Group. All rights reserved
When looking at the remuneration policies
of new or potential clients, we often find
that an apparently sensible remuneration
strategy is undone by poor execution.
This usually has its roots in ‘low definition’
thinking – too many remuneration committees
are satisfied with a set of fine sounding
policy statements without realising that
these are being undermined by the reality
of how they are applied.
The good news is that these problems are not
difficult to fix. The solution is to dig a little deeper,
to ask the ‘why?’ question and to prod and poke
the policy to see if it is robust: in other words to
look at executive remuneration in high definition.
This article is the third in a series turning a high
definition lens on a particular area of executive
reward. Please email [email protected]
for a copy of the the previous editions which were
focused on relative TSR and benchmarking.
1 Executive remuneration in high definition
Bonus deferral – driven by
fashion or by logic?
Executive
remuneration should
be aligned to the
business strategy
and the talent
requirements of
the organisation.
reports where the explanation (if any) for the
deferred bonus plan is too often bland and
unconvincing.
In the mid 2000s, the deferred bonus became
the ‘must have’ accessory for the remuneration
committee chairman about town. Was this
a wonderful discovery eagerly seized on by
companies looking for a new approach that
solved their recruitment and retention needs,
a useful source of fees for down-on-their-luck
consultants, or a helpful distraction utilised to
convince credulous investors they should accept
an increase in the bonus opportunity?
In truth all of these factors played a part in
the widespread introduction of deferred bonus
plans in the FT-SE350 – over 50 per cent of
companies in the index now have such a plan.
However, for many companies the real reasons
for their bonus deferral are lost in the mists of
time. This can be seen in many remuneration
Does this matter? At Hay Group we believe it
does. We have nothing against deferred bonus
plans – in the right circumstances they can
make perfect sense. However, we are concerned
about companies that seem to have introduced
complex deferral structures without any clear
rationale – after all these arrangements have,
until very recently, been very rare in most
other European countries.
We, therefore, encourage our clients to debate
this issue from first principles. In some cases this
leads to a reaffirmation of the deferral principle,
in others it leads to the elimination or scaling
back of deferral. The key point is that executive
remuneration should be aligned to the business
strategy and the talent requirements of the
organisation.
Percentage of companies with deferred bonus scheme
70
FTSE 350
65
FTSE 100
60
55
50
45
40
35
30
2001/02
2002/03
2003/04
2004/05
2005/06
2006/07
2007/08
2008/09
2
Deferred bonus 2.0 – remuneration
and risk in financial services
n
Whilst various reasons (good and bad) were
given by organisations that introduced deferral
in the mid 2000s, risk mitigation was not a
common theme.
This has now changed dramatically. Following
the banking crisis, a new orthodoxy has emerged
– the best way to mitigate the risks inherent
in paying large bonuses earned on the basis
of one year performance is to defer a proportion
which then vests in tranches after one, two and
three years.
For example, in the UK, the FSA requires deferral
of 40 per cent or 60 per cent depending on role
and pay level.
It is difficult to argue against aligning the
pay of bankers better to shareholder interests
and to longer-term, sustainable performance.
It is, however, regrettable that a one-size-fits
all approach has been adopted that does not
take into account:
n
n
n
the design of the overall package
the nature of the institution (the same rules
apply to building societies and investment
banks alike)
the nature of a particular role (currency
traders with closed positions treated in the
same way as traders in complex derivatives).
Whilst banks and insurers will need to comply
with the current and developing requirements
of regulators, a high definition approach means
thinking about the following.
n
Is there is a need to increase the level of
deferral beyond the requirements of the
regulator in riskier parts of the organisation?
Thus far, many organisations have been
busy scrambling to comply with the
minimum regulatory requirements. As and
when the regulatory regime stabilises (which
may take 6-12 months) organisations will
need to think about their organisations again
from first principles. And they may even
be required to do so as regulators become
more sophisticated about pay – draft
guidance for EU insurers on Solvency II (EU
capital adequacy requirements for insurers)
envisages looking at how reward should vary
between different parts of the organisation.
oes the approach prescribed by the
D
regulator(s) fit with the organisation
or should a fit-for-purpose solution be
developed that still complies with the
spirit of the regulations? This assumes
that regulators are able to take a ‘comply
or explain’ position and are not pushed
into a rules-based approach by the new
government or by the EU. It also assumes
that the organisation is willing and able
to engage with the regulator about the
proposed approach, bearing in mind
that some regulators (including the FSA)
have failed to recruit people with a deep
understanding of remuneration issues.
And businesses outside the finance sector
should avoid following the banking model
unless they have a similar risk profile. ‘Best
practice’ in banking is just that – it shouldn’t
necessarily apply in retail or construction!
It is regrettable that a one-size-fits-all
approach has been adopted.
©2010 Hay Group. All rights reserved
3 Executive remuneration in high definition
Deciding whether we need a deferred bonus – in high definition
In determining whether to defer bonus, remuneration committees need to get back to
fundamentals. Too often the arguments around deferred bonus are low definition and depend
too much on:
n fashion – “everyone else in our sector has one”
n perceived ‘best practice’
n s
uperficialities – “deferring bonus will aid retention” (this can be true, but doesn’t follow automatically)
n p
lausible-sounding but ultimately meaningless statements – “to link short-term and long-term
performance”.
A high definition approach means getting to the bottom of the real arguments as set out in the
table below. This involves some careful thinking – for example there are (at least) four potential
retention-related arguments, one of which is actually against the use of deferred bonuses.
Arguments for having a deferred bonus
Remuneration
committees need
to get back to
fundamentals.
3 To target reward expenditure on individuals who choose to remain with the company
3 To signal to employees that you wish to retain them
3 To provide a financial incentive to employees not to leave
– Implies a big enough figure to be meaningful and that competitors will not buy-out the deferral
3 To focus on risk and sustainability
– In other words to avoid rewarding short-term profits with shareholders suffering
longer-term pain
– This is most useful as a principle in volatile businesses or businesses where cash does
not accurately track profit
3 To reassure regulators or investors
– For example where bonus is above typical market level or where shareholders have
concerns about the metrics used in the bonus plans
– This argument is perhaps most powerful in respect of executive directors but please note
that the ABI rejects the idea of bonus deferral as automatically being ‘best practice’ for
all companies
3 In lieu of a stand-alone LTI
– This can make sense for roles below main board level that are senior but which have
a primarily short-term or divisional focus
3 To facilitate a higher level of share ownership
3 To conserve cash
Arguments against having a deferred bonus
7 To reduce long-term costs
– £1 of deferred bonus is worth less than £1 to the individual. Therefore £800 in cash might be
preferred by most individuals to £500 in cash and £500 in shares
7 To retain talent
– Although deferred bonuses are theoretically retentive, if deferral is more onerous than in
competitors, then participants may leave
7 To simplify packages
4
Designing a bonus deferral
arrangement – in high definition
If there is a case for deferral, the next issue to
settle is the design. Whilst there are a number
of ‘boiler plate’ designs that can be adapted,
in reality the design of the plan should be
grounded in the purpose of deferral and tailored
to the business. For example, if the aim is
primarily around retention, the resulting
design may differ to that for a plan aimed at
risk mitigation. Some of the key issues to
consider (in high definition) are as follows.
Compulsory or voluntary deferral?
In our view, the default approach should be
compulsory deferral and this is the direction
in which the market is moving. Whilst voluntary
deferral (which will normally be linked to
matching) is a plausible-sounding approach,
a high-definition view reveals that:
n
n
voluntary deferral with matching delivers
a higher potential reward to individuals
who have the most spare cash and/or
are less risk-averse – a poor fit with most
reward strategies
voluntary deferral allows the individual rather
than the organisation to determine the extent
to which their pay is aligned to future share
price movements and (with performancebased matching) other long-term KPIs.
Should there be a minimum threshold
for deferral?
It is typical in the UK to defer a fixed percentage
of bonuses. The obvious and often better
alternative is to defer a higher proportion
of bonus above a threshold. The latter approach
has the twin merits of requiring proportionally
more deferral from the highest paid and
excluding individuals with low bonuses
from deferral altogether.
What is the deferral percentage?
This needs to be considered in parallel with the
minimum threshold decision described above.
If there is no minimum threshold and a fixed
percentage of the full bonus is deferred there
may be a case for a lower rate of deferral for
individuals below executive committee level,
unless the nature of the company is such that
these roles involve significant risk-taking.
Should the deferred bonus be matched?
This was once a popular approach. However,
since UK investors began to insist that deferred
bonus matching plans must have performance
conditions, the complexity involved has made
this approach less attractive. Also, once deferred
bonus matching has performance conditions,
it effectively becomes a quasi-LTI and we
have reservations about linking the value
of a (three-year, forward-looking) long-term
incentive to a (one-year, backward-looking)
bonus. At best this risks inequitable rewards;
at worst it has the potential to bring the design
and operation of the annual bonus plan
into disrepute. (Historically, there have been
companies who followed this approach in part
to achieve ‘governance arbitrage’ with less
stretching performance conditions for deferred
bonus matching than is typical for stand-alone
LTI plans; however, the increasingly sophisticated
approach taken by some investors makes this
a risky strategy today).
For which roles should deferral apply?
In deciding which roles should have part of
their bonus deferred, the tendency is to look at
market practice and/or the grading break-points
already used by the organisation. However, it is
also important to consider:
n
n
n
n
the risk-profile and time horizon of the
organisation – one would expect deferral to
extend deeper into organisations that take
greater risks and/or which have a particularly
long-term focus
w
hether differences in the risk-profiles and
time horizons between divisions are sufficient
to justify a differentiated approach
the extent to which roles below top team level
are expected to take material risks
h
ow the rest of the package is structured –
for example, whilst it may be administratively
convenient to operate bonus deferral for
every individual that participates in the LTI
plan, this makes for a big change in package
shape between individuals just above and
just below this level.
©2010 Hay Group. All rights reserved
5 Executive remuneration in high definition
Deferred bonus plans
are a useful part of
the toolkit providing
there is a clear
rationale for their use.
Pure deferral or bonus banking?
Bonus banking is a system where the bonus
earned each year is added to the ‘bonus bank’
carried forward. One-third (say) of the bank
is paid-out with the balance carried-forward.
This approach has two key advantages: firstly it
smoothes out what might otherwise be volatile
payments and secondly it can allow a negative
amount (‘malus’) to be ‘earned’ and deducted
from the bank. This is a complex approach
but can be effective for volatile businesses or
where bonus targets are based on year-on-year
improvement (which often leads to more volatile
payments than a budget-driven approach).
The downside is that payments can arise at
times when the in-year performance has been
extremely poor.
Is deferral in cash or shares?
Decisions here should depend on the reason for
deferral. Using shares makes most sense where
the aim is related to risk and sustainability or
where the desire is to promote share ownership.
Cash-based approaches, although less common
should not be dismissed as they have the
advantage of simplicity and are easier to rollout internationally; however, cash-based plans
are generally difficult to justify for executive
directors.
What is the deferral period or periods?
For top executives in businesses outside
the banking sector, three-year deferral has
become the norm, perhaps in deference to the
Governance Code (Schedule A, third paragraph).
However, it seems illogical to operate a deferred
bonus plan (one plus three years) that is longer
than a typical LTI plan (three years). Meanwhile
banking deferral is generally in equal tranches
over one, two and three years. Ultimately the
deferral period should relate to the aims of the
plan and the nature of the business.
Is there clawback of the deferred bonus
and if so how does it operate?
The balancing act here is between defending
shareholder interests and ensuring that the
employee attaches value to the deferred bonus
plan. In our view the approach taken should
depend on the nature of the enterprise. In most
organisations, the typical approach taken by UK
companies (clawback of deferred bonus where
accounts have been misstated and forfeiture of
deferred bonus on dismissal for cause) will be
sufficient. A more sophisticated approach may
be required in organisations where bonuses can
be earned based on profit figures that are related
only loosely to cash generated.
Like so many things in executive reward, deferred bonus plans are a useful
part of the toolkit providing there is a clear rationale for their use and the
design is properly thought through. With many UK businesses outside the
finance sector having operated such plans for five to six years, this may
be an appropriate time to review their operation. There is also a need to
re-benchmark the key design features. The answer to many of the questions
considered in the final section above is ‘it depends’ – in particular on the
nature and strategy of the business and the talent management agenda.
Peter Boreham | UK director | executive reward
T 020 7856 7146 | E [email protected]
In reality the design of the
plan should be grounded
in the purpose of deferral
and tailored to the business.
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