Pay Decision-Making in 2023

Introduction

The decision-making on board pay outcomes is underway if not already largely done. Companies that are also seeking approval for a revised Directors’ Remuneration Policy already have a good idea of what the changes will be. Except where corporate strategy has been overhauled, many companies are taking a ‘steady-as-she-goes’ approach and making few if any changes to policy.

The Investor Forum has this to say in its December 2022 paper “Thinking Aloud”:

“Given the challenges that society faces with the cost-of-living crisis, and the large number of remuneration policies that will need approval in 2023, we would expect that remuneration issues will emerge at a significant number of companies. As such the 2023 AGM season will likely be challenging.

We believe that the source of frustration will be a function of a difference of opinion regarding remuneration rather than a failure of the voting and engagement process.”

They also note that, in 2022, only five (management) resolutions were defeated. They were all, however, related to pay.

We do not propose to discuss here the question of stewardship and the engagement process between boards and their investors but rather to highlight what we have seen so far in respect of pay decisions and where we think the greatest challenges are likely to be for remuneration committees.

What is happening?

Many remuneration committees of boards, especially those of smaller companies, are faced with the ‘double-whammy’ dilemma of share price at a low ebb and financial targets set for the annual bonus plan for 2022 which have been undermined by an array of what economists like to call ‘exogenous factors’, e.g. the continuing impact of the pandemic on markets/and or supply chains, elevated inflation, and the vagaries of changes to interest rates, corporation tax rates and currency movements. The list could go on.  On top of this, share awards made in 2020 under the long-term incentive arrangement may be about to lapse.

At the same time, Boards may be thinking that the Chief Executive and the leadership team have never contributed as effectively as they have over the last few months not to say years and, but for their efforts, corporate performance could have been far worse.

Performance-related pay systems work well when performance is good. Downturns and prolonged periods of turbulence and change easily sabotage the most carefully designed incentives. Psychologist and economist Daniel Kahneman reminds us of the role of luck in corporate performance as well as “the statistical fact of life: regression to the mean”.

While we would argue that effort should be praised but not be bonusable, we would also say that every good pay system (for all employees) should provide for some element of two-way discretion where there is a strong case. ISS takes a different view and recommended votes against most of the (relatively few) companies that, last year, exercised discretion to enhance pay outcomes in respect of executive directors. This is likely to remain a key point of contention in 2023.

This is what we have seen so far among the companies with financial years ending 30^th September 2022.

Base salary increases

• In around half of companies, the CEO/CFO increase was below the workforce increase, whilst around a quarter applied the same increase as the workforce and a quarter applied higher increases for the CEO or CFO
• Increases for CEOs are averaging 4.4% and 4.9% for CFOs.  That said, most if not all of these increases will have been determined before the latest proxy guidance was published in November 2022.  The latest guidance includes a heightened focus on executive director salary increases and now refers to an expectation that uplifts for directors will be lower than the workforce average. The average executive director salary increase may well thus be lower for December year ends
• The highest increase we have seen for a CEO effective in 2023 is just under 12% (noting that ISS was supportive based on the detailed rationale provided)
• The median increase for all employees is 5.8% and the highest all-employee increase we have seen reported is 10% (in retail banking). The lowest is 4%

2022 annual bonus payouts and vesting of 2020 long-term incentive awards

• The median annual bonus payout as a percentage of maximum remains high at just under 80%. This is consistent with the average payout for December 2021 to June 2022 year ends and, given the economic turbulence in the final quarter of 2022, the average December year-end bonus award is likely to be lower than this
• A few companies have reduced annual bonus outcomes where, for example, financial targets have been missed but non-financial goals have been largely met
• Two companies applied upwards discretion, one for a business disposal (which was supported by ISS) and the other company stripped out the impact of the pandemic alongside a reduction in bonus opportunity (again, supported by ISS although they noted that the financial element did not pay out despite the Covid adjustment)
• The median vesting of long-term incentive awards was low at 15% of maximum, with 40% of companies disclosing zero vesting and one in five maximum vesting. The variability in outcomes reflects perhaps a weaker last financial quarter for many companies and the difficulty in setting robust targets in Autumn 2020
• One company applied upwards discretion by excising the impact of Covid from its assessment of cumulative EPS. This triggered the vesting of the LTI award at just above threshold and the committee rounded the outcome down to threshold so that 25% of the shares under award vested
• The use of negative discretion in respect of LTIP awards has continued to be less common than for annual bonus

Special arrangements for all employees

There have, over the last few months, been numerous examples of special payments to employees and salary reviews targeted towards employees on lower salaries. The range of disclosed one-off payments among the ‘early reporting’ companies is £750 to £1,200. Others have brought forward salary review dates and/or introduced extra salary reviews to boost salary levels and many have enhanced benefits.

FIT’s view

We expect to see continuing moderation in salary increases for senior teams and a gap of at least one to two percentage points between increases for executive directors and the typical increase for employees. At the same time, we anticipate fewer salary freezes and for these to be largely restricted to companies where financial performance has disappointed and where profit warnings have been issued.

Where 2022 financial targets have not been met and the market’s expectations have been recalibrated via a profits warning, many would argue strongly and on principle that no bonus payments should be made to executive directors. Where dividends have been cut, employees made redundant and shareholder returns and profits are negative, it is hard to disagree. Disappointing performance may not be wholly attributable to the CEO and CFO but they are accountable and variable pay has to be seen to be earned. What though where a company has generated profit and even reached record highs and yet financial targets have been missed and the share price is in the doldrums as a result of ‘circumstances’? If the committee deemed that targets were aspirational in the first place and then have not been met because of Covid and/or the war in Ukraine and, at the same time, the leadership team has focused on ‘doing the right things’ for the future longevity of the business, then some bonus payment against the strategic goals may well be a fair outcome even if the payment is discounted somewhat.

The challenge of three-year target setting and a worsening of the economic conditions will encourage some companies to consider introducing time-vested restricted shares at the top. Those that prefer to stick with performance shares are likely to introduce more measures into their performance plans. On award levels in 2023, where the share price since the last award has plummeted (LGIM defined this as >20%), committees will need to decide whether to discount award levels somewhat (The Investment Association’s preferred approach) or grant at normal award levels with some kind of windfall gain protection (an approach which is accepted by ISS).  We think practice will be mixed here and will depend on company-specific issues (e.g. the extent and nature of the share price decline, the extent to which past awards are underwater and the stretch in the 2023 performance targets).

Where LTI award vesting levels to the end of 2022 are low as a percentage of maximum, ‘windfall gains’ arising from a pandemic-depressed share price in 2020 are likely to be less troubling than the impact on morale of all LTIP participants, especially where annual bonus has not paid out.   It has been relatively unusual for committees to intervene in respect of LTI vesting (up or down) and much more common (generally downwards) in respect of annual bonus.

It remains to be seen how consistently Directors’ Remuneration Reports will show how remuneration committees have considered potential ‘windfall gains’ when determining vesting outcomes and how any reduction or decision not to reduce is explained. Failure of the shares to vest at all strikes us as a watertight explanation. Where 2020 awards are going to vest, any companies that reported in the 2020 annual report that no haircut had been applied to award levels on the basis that the vesting outcomes would be reviewed with windfall gains in mind should check that they have followed through on this.

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