Blog Home

 
Blog

Earlier this month the Financial Research Council (FRC) issued a revised version of its Corporate Governance Code.  The Code sets out the principles and modus operandi that company boards must adopt in their corporate governance arrangements, including leadership, effectiveness and accountability, how boards should engage with shareholders, and how they should go about setting pay for company directors.  All Premium-listed companies in the UK must either comply with the Code, or explain why they are unable to do so.  The FRC reviews the Code every two years to reflect the way that thinking in corporate governance has moved in the intervening period.

This time round a number of the FRC’s revisions relate to executive pay.  The changes are subtle, but nevertheless provide a useful barometer reading of how thinking in this area has shifted following the sustained media and regulatory attention of the last few years.

The most significant revision is the replacement of the Code’s long-held principle theme, that pay should be sufficient to ‘attract, retain and motivate’ directors of the right calibre to ensure the success of the business.  Now boards must focus much more on ensuring that executive pay design promotes the firm’s long-term success in a sustainable manner.

So does that mean that market rates are a thing of the past, at least as far as executive pay is concerned?  This would mark a significant shift in approach if true, as the need to pay what it takes to lock in a high-performing executive has long been used to rationalise the sort of pay levels that have journalists reaching for their pens in outrage.

Of course the answer is that it is not as simple as that.  Even the Code makes it clear that it expects boards to continue to review pay levels in other organisations, albeit with a clear warning about the potential ratchet effect of using market data, and a clear message to boards not to pay ‘more than is necessary’.   However it is clear that, when making decisions about executive pay, remuneration committees are expected to take as much account of the nature of the business and its performance as they do of what the competition are paying.

For example, the Code requires remuneration committees to establish an appropriate balance between fixed and variable pay, and to decide how much of that pay should be immediate, and how much deferred.  Where business outcomes are highly uncertain, perhaps because the industry as a whole is evolving, a higher level of variable pay might well be appropriate.  And for businesses in which income booked in one year but where the true profitability of that income may not be known for several years to come, as is the case in much of the financial services industry, a greater proportion of reward is likely to be deferred.  This provides some cushion against the impact of profits booked in one year turning out to be illusory in subsequent years.

It follows then that remuneration committees must be up to speed with the business approach to risk, and the systems it has for measuring and mitigating risk.  The Code requires them to factor this into their own policies on pay for senior staff.  The revised Code is also much more prescriptive on the use of clawback and malus in performance-related pay arrangements, which must now include provisions enabling the company to recover sums paid or withhold payment of deferred awards.

The new wording on clawback doesn’t go as far as the Financial Conduct Authority’s new requirement, that clawback arrangements should enable firms to recover variable pay awards for up to seven years after they have been made, but is nevertheless a marked stiffening of the Code’s approach.  This is coupled with a stronger steer that remuneration committees should require executives to hold on to a minimum number of shares after any equity awards have vested, strengthening the link between incentives and the long-term value of the business.  The new Code makes it clear that this can include a period after the executive has left the company.

Pay and employment conditions of other employees must also be taken into account, especially when determining annual salary increases.  So there are plenty of moving parts that remuneration committees must think about before reaching their final decisions.

So does all this mean that market rates of pay will soon be a thing of the past for executives?  Despite the direction of travel embodied by the revised Code, this seems unlikely.  Companies will still look to market data to understand typical salary, and use this information as a key element in setting salaries for their own executives.  They will also consider external practice in levels of target and top-end variable pay, and the overall structure of reward.

But the new Code should lead remuneration committees to delve much more deeply into the market data available to them – how appropriate are the comparators used, how accurate are projected forward pay movements, what is the quality of matching against benchmark roles – if they are to use market data in the considered and informed way that the new Code requires them to. And the Code is much clearer than before that this can only be part of the picture, that companies must think carefully about how their approach to executive pay fits in with the business strategy and structure.  No brave new world perhaps, but certainly plenty for remuneration committees to think about.


« Back