How you structure a remuneration system that actually makes sense

Too many Australian companies use a one size fits all executive remuneration model – that doesn’t reflect the needs or the industry of the organisation.

Far too many Australian companies have adopted what is now a standard executive remuneration scheme. It’s one-third fixed remuneration, one-third short term incentive (STI) and one-third long-term incentive (LTI). The LTI is usually deferred for three years and measured against relative total shareholder return (Relative TSR). While this structure might be suitable for some organisations, executive remuneration should never be a one-size-fits-all solution.

Remuneration must start with company strategy

A remuneration structure must match the strategy and operations of the organisation, otherwise it sends the wrong signals and incentivises the wrong behaviour from executives. The remuneration scheme must take into consideration the way the company operates and the industry that it operates in. For example, a company in the technology sector needs a remuneration scheme that’s flexible enough to respond to the fast-moving changes in the market dynamic. That’s very different to an asset-heavy company investing in projects that run over 10-20 years.

If there are certain parts of your strategy that are critical to achieving your business’ goals then they also need to be reflected in your remuneration scheme.

For example when we introduced customer service metrics at the Commonwealth Bank we included these metrics in both the LTI and STI components of the remuneration scheme. This was a very clear indication, not only to senior executives but to the whole company, that we took customer service very seriously indeed. It then provided the impetus that enabled the organisation to turn around customer experience.

Remuneration should reward the long-term

The default approach to executive remuneration structures favours short-term wins over long-term achievements. In my opinion, STIs are inappropriate for senior executives – if you need an incentive at that level you’re probably the wrong person for the job. With that said, STIs are useful in giving management clear guidance about what the board thinks are the important short-term priorities, but STIs should never be the main incentive.

While it’s important to consider how LTI is weighted relative to STI, the timeframe for the LTI must also be appropriate for the business. An LTI that runs over three years is not always sufficient to guide management to think about the longer term. This is particularly the case for businesses that have a long-term investment horizon. Companies in the mining,and oil and gas sectors are making investments that will literally last for 30, 40 or 50 years and their executive remuneration structure should reflect this.

Shareholder expectations need to be managed

Many executive remuneration schemes are linked to Relative TSR. This is based on the theory that investors choose between your company and everything else in the ASX100, but this isn’t necessarily the case in practice.

Relative TSR works in a large market where there are lots of comparable organisations and the “noise” is smoothed to a certain extent. In a small market, like Australia, there is less choice and the noise can have a bigger impact on performance – effectively Relative TSR becomes a reward for volatility rather than consistent performance.

There are alternatives, return on equity (ROE) and return on invested capital (ROIC) are also important, for example. But using ROE isn’t very common in Australia, with the exception of resource-heavy industries.

The real issue is that fund managers prefer Relative TSR because it’s how they are measured and compensated. As shareholders, fund managers want a company they’re investing in to be rewarded or punished the same way they are, but short-term RTSR is rarely the most relevant measure of a company’s long-term success.

This requires an often nuanced negotiation to ensure that your remuneration scheme reflects the strategy of the company and is also palatable to your key shareholders. Spend time with shareholders and explain your rationale – why it’s better for the company and will drive results. This can be a process in itself, involving not just shareholders but also proxy advisors, but it’s a necessary one to successfully implement a sustainable remuneration scheme.

Keep it simple

The best executive remuneration schemes that I’ve seen recently are those companies that have simplified their model – Wesfarmers, SEEK and Telstra are good examples.

At Telstra, the new remuneration scheme has five or six metrics that are measured before the stock is locked up for a period of time. Some companies have scorecards with 50 things that each account for 2% of the STI – most executives in such situations just throw the scorecard in the drawer and forget about it.

With just 5 or 6 clear priorities, it’s easier for executives to direct their energies and attention. Typically, this will include some financial metrics that reflect what’s important to shareholders. Consumer-focused organisations should also have some metrics around customer satisfaction and experience. A business in a heavy industry will include health and safety. Whatever you include, it needs to be relevant to your business and should be limited to a small number of clear items.

It’s also helpful to ensure that each priority isn’t defined too prescriptively. A good remuneration structure allows executives some flexibility over how they achieve their goals.

Every business is different and this should be reflected in their approach to executive remuneration. The most important differentiator for each business is their strategy, and this must always be the starting point when designing an appropriate remuneration scheme.

Get an unfair advantage, subscribe to the free monthly update

The best of The Resolution, delivered to your inbox every month