Boardroom Best Practices

APRA improves Governance for Executive Pay

Remuneration policies are a key part of governance: There is a demand for increasing accountability from corporate boards to extend the basis of remuneration policy from only financial results to the broadest possible accounting of director and executive performance.

In Australia, while this trend has been long-standing, there is considerable dissatisfaction with the alignment between corporate performance and remuneration packages.

Much dissatisfaction stems from the reports of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. These revealed evidence of appalling behaviour by Australia’s major banks and financial planners from the past decade, including bribery, forged documents, repeated failure to verify customers’ living expenses before lending them money, and misselling insurance to people who can’t afford it, lying to regulators and charging fees to clients who had died.

And yet, remuneration packages continued to reward Australian financial services executives right through the Commission’s hearings, and even after the final reports were released. “Executive pay in large banks and other financial institutions hasn’t changed; The bits of executive pay which are described as being at risk, really aren’t,” explains Martin Lawrence of the Melbourne-based corporate governance consultancy Ownership Matters.

APRA caps financial performance component of executive pay

“Remuneration is not incentivising the right behaviours in financial services companies,” the Australian Prudential Regulation Authority (APRA) says in a press release on July 23, 2019, which specifically refers to the Royal Commission reports.

“APRA has proposed creating a new prudential standard to better align remuneration frameworks with the long-term interests of entities and their stakeholders, including customers and shareholders. Draft prudential standard CPS 511 Remuneration introduces heightened requirements on entities’ remuneration and accountability arrangements in response to evidence that existing arrangements have been a factor driving poor consumer outcomes,” the release continues.

The changes proposed include:

  • To elevate the importance of managing non-financial risks, financial performance measures must not comprise more than 50 per cent of performance criteria for variable remuneration outcomes;
  • Minimum deferral periods for variable remuneration of up to seven years will be introduced for senior executives in larger, more complex entities. Boards will also have scope to recover remuneration for up to four years after it has vested;
  • Boards must approve and actively oversee remuneration policies for all employees, and regularly confirm they are being applied in practice to ensure individual and collective accountability.

Remuneration clawed back in case of misconduct

In practice, this means that executives would see lucrative bonuses deferred for as long as seven years and company boards would have the power to claw back incentives up to four years after they were paid out in cases where poor performance or misconduct became apparent.

“Remuneration and accountability frameworks play an important role in driving employee behaviour. Where policies are poorly designed, or not followed in practice, companies may incentivise conduct that is contrary to the long-term interests of the company and its customers. In the financial sector, APRA has observed an over-emphasis on short-term financial performance and a lack of accountability when failures occur, especially among senior management. Crucially from APRA’s perspective, these incidents have damaged not only institutions’ reputations, but also their financial positions,” APRA Deputy Chair John Lonsdale pointed out.

The seven-year deferral is intended to ensure that executives have ‘skin in the game’ for a longer period, Lonsdale added. “This also allows boards to adjust remuneration downwards if problems emerge over an extended horizon.”

APRA believes that limiting the influence of financial performance metrics in determining variable remuneration will encourage executives to put greater focus on non-financial risks, such as culture and governance. “This remains a weak spot in many financial institutions,” Lonsdale comments.

Culture and remuneration are weak points at Australian boards, observes Sydney-based law firm Minter Ellison in a note. “The self-assessments were generally ‘weaker’ (less comprehensive) on these areas.  Institutions were observed to struggle to articulate their assessment of culture or provide much evidence to support their assessment.  Likewise, with respect to remuneration, self-assessments were observed to be generally less detailed and tended to focus on remuneration design rather than on the effectiveness of the framework as a whole.”

APRA states that strong governance and risk management frameworks would typically exhibit:

  • Accountability and remuneration frameworks that incentivise delivery of sound outcomes, in particular executive remuneration that is designed to better align rewards with a holistic view of performance;
  • Effective assurance and compliance mechanisms that drive proactive monitoring, early detection and escalation, and timely rectification of issues; and
  • Direct and proportionate rewards and consequences that are consistently applied to hold individuals to account for financial and non-financial outcomes.

APRA adds that to be effective, the elements identified above need to be supported by strong governance and risk oversight, and driven by a sound risk culture.

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