2008 has been a dramatic year for bonuses, which has shifted the limelight from severance payments and long-term incentives which had been the main focus of investor and media attention for some time.
To those involved in executive compensation, Government interventions on both sides of the Atlantic on executive pay in banks and related remuneration waivers at senior levels have been as dramatic and unprecedented as the financial and stock market news. While decisive action in 2008 may mean that 2009 onwards will see a return to normal trends of self-regulation and lack of scrutiny, this seems unlikely given that share price movements, earnings shifts and political and regulatory influence in this area look permanent. It also seems probable that reactions to what has happened in the financial sector may start to influence bonus thinking generally and cause investors to start looking at remuneration arrangements below board level.
The enclosed law-now sets out some thoughts on this subject. While the Financial Services Authority (“FSA”) pointers on remuneration are formally limited to the financial services industry, we think that some of their ideas are of general application for all industry sectors.
So far, the UK has not seen any legislative changes in this area, although European Commission proposals may result in this happening. The FSA has published some very informal but highly influential guidance, but, although it is still looking at the issues and further conclusions on the subject are to emerge in 2009, there seems little doubt that it already has firm views that remuneration arrangements have certainly contributed to general instability where they have rewarded excessive short-term risk-taking without regard for longer-term stability. The most recent FSA letter on the subject can be accessed at http://www.fsa.gov.uk/pubs/ceo/ceo_letter_13oct08.pdf. Although there is a significant amount of detail in this subject, there are 4 key inter-linked points which all companies should probably bear in mind when framing any bonus scheme:
- Bonuses should be driven by profits not short-term revenues
Investors have for years been keen to see financial rewards driven off measures that see shareholders properly rewarded. Dashes to increase turnover or transaction bonuses to reward an increase in a group's size have not been favourably received without some kind of underpinning. Banks have been able to resist these ideas when framing schemes for many of their front-line staff, and have seen simple increases in trading volume or product sales as adequate on their own, but this may have to change if such measures are seen to exacerbate behaviour which is too risky.
- Bonuses should not be too short-term
Bonuses should not just be paid on the basis of the outturn in the year. Some kind of deferral is warranted for at least some of the bonus to ensure that the impact of decisions taken earlier on are felt. This can at its simplest just be a question of delaying payment, with payment only made if the executive is still in place at the time of delayed payment, but it can also include gearing the payment so that the size of a bonus is reduced (or increased) according to subsequent performance.
- Bonuses should be partly payable in shares
Most executive Board directors have for some time been expected to receive their long-term (3 year plus) remuneration only in shares, and this has now also become common throughout many UK quoted companies. Higher-paid executives in the banking sector were perhaps the exception and it will be interesting to see how they are brought into line. Linking bonuses to shares has an upside though - if the shares rise in value, the bonus received may turn out to be much larger than the bonus originally awarded. Traditionally, banks have not been able to force many employees to take shares - but maybe this will have to change.
This may lead to a new kind of bonus scheme. Companies are familiar with long-term incentives plans or "LTIPs". However, will there soon be medium-term bonus plans? In quoted companies a new form of share scheme has silently emerged over the last few years in the form of a Deferred Annual Bonus Scheme (or "DABS") which has many of the same attributes.
- Bonuses should not cause excessive risks to be taken
This is particularly important for financial services firms because it is currently only where the FSA believes that excessive risk is taken that it has grounds to challenge actual remuneration. However, this principle is of general application. Companies need a weighted/balanced approach, focusing behaviour and activity but not leading to perverse incentives to delay capex or valuable maintenance, for example.
Aside from general bonus design issues, various practical points arise:
What about 2008?
In some cases, although 2008 targets may not have been met, companies will still want to award bonuses for 2008. The tensions that they face are retention and motivation difficulties from executives who have come to rely on large bonuses and are performing well, yet on the other hand falling share prices and profits for investors. This is a difficult decision for remuneration committees and it is one where careful shareholder relations skills will be needed, particularly as investor bodies may well start asking questions about below board level remuneration in more detail from now on.
In certain cases, 2008 performance may be leading to a higher bonus level than the remuneration committee thinks justified. Scaling back awards which have been earned on their own terms is dangerous. Aside from the obvious dissatisfaction from executives, it can lead to employment claims. Quite how confident executives will be to mount these challenges in current times remains to be seen. In addition, to avoid unforeseen UK tax charges, salary and bonus waivers need to be carefully documented by both the company and the employee before an actual right to payment arises, so any decision on this should not be delayed.
What about 2009?
For many companies, the 2009 bonus targets are now being set. Given that the environment this time next year is not known, at the very least companies should give themselves flexibility in payment arrangements for next year and should reserve the right to make adjustments if needed.
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