Executive Pay Matters - UK

Whilst ISS 'against' recommendations for both remuneration policy and implementation report more than halved in the most recent AGM season, shareholders and proxy voting agencies alike still expressed a multitude of concerns which, almost exclusively, related to quantum increase or an apparent lack of target 'stretch' or both. Increases in opportunity without a commensurate increase in target stretch, a perceived softening of targets and / or insufficient disclosure of targets in the Directors' Remuneration Report have been recurring sources of shareholder discontent for a number of years now.

When we look at what ISS flagged as a cause for concern throughout the 2017 AGM season, top of the list (and by some margin in the case of the implementation report) were concerns relating to both bonus and LTI performance measures / targets:

Fig. 1 Issues highlighted by ISS in the FTSE 100 during the 2017 AGM season

Issues highlighted by ISS in the FTSE 100 during the 2017 AGM season

Amongst the FTSE 100:

  • Twelve companies were flagged by ISS for insufficient stretch on LTI targets
  • Twelve companies were flagged by ISS for insufficient disclosure of bonus targets.

And its not just the focus of shareholders and their proxy advisors, a key recommendation emerging from the Executive Remuneration Working Group was for increased transparency of both targets and the target setting process itself.

Current approaches to target setting

Whilst there is more shareholder focus than ever before on demonstrating, in an objective and evidence-based manner, that executive incentive plan targets are appropriately stretching, 60% of respondents in a recent Willis Towers Watson survey1 reported that they were not confident about the robustness of their target setting process.

Perhaps this is not surprising. The burden of proof for demonstrating appropriate targets lies firmly with the Remuneration Committee, supported by HR, but in many organisations, target setting is often led by finance with little or limited HR input.

Moreover it is not uncommon for target setting to be an inwardly focused process which (rightly) asks questions such as “How did the company perform against that metric in previous years?”, “What were prior year target ranges?”, “What are our internal forecasts?” but doesn’t always look to any external reference points to provide a more holistic view.

In addition to the lack of external context, proposed targets are also often presented to the Remuneration Committee with insufficient time for interrogation, debate and potential iteration.

How can you get closer to the mark?

If nothing else changes, allowing more time for explanation, debate and consideration of the targets being proposed would be a step in the right direction. The Committee should not feel pressured to sign off on targets simply because time demands they must. 

Ensuring the Committee are able to considering a range of internal and external inputs will also enable them to better assess the appropriateness of the targets being proposed. And ideally you should also be considering on an annual basis if you have the right measures against which to set those targets. As business strategies evolve and change so should the supporting incentive plan metrics.

With that in mind, we have put together a quick fire guide to improving your target setting process....

quick fire guide

1. Philosophy

Before you even start thinking about what your target should be, first determine if you are setting targets for the right performance measures.

Check that your performance measures are aligned to your business strategy: are they driving the performance required to meet your five year goals? Do they align with the goals you have communicated to your shareholders? Are you paying for the right things?

The targets you disclose in your Directors' Remuneration Report should follow the performance story which begins in the Strategy Report at the beginning of your Annual Report and Accounts.

2. Review your performance in the round

Ensure you make use of all of the facts you have available to provide your Remuneration Committee with enough reference points to make an informed decision. Targets need to be sufficiently stretching but deemed achievable by the executives themselves too in order to incentivise the right behaviours.

Understand how your company has performed against your measures in the past, know your company plan, review analyst expectations and check your competitors’ performance ranges. An example of how this might look is shown below:

Fig. 2. Assessing proposed targets against a range of internal and external reference points

Assessing proposed targets against a range of internal and external reference points

3. Scientific modelling and analysis of expected future performance

Some companies are starting to go even further. For those who have come under scrutiny for the stretch of their targets, or who simply wish to better understand the actual likelihood of threshold, target and maximum payouts being achieved, more comprehensive ‘predictive analysis’ techniques are being deployed. These provide the Committee with the reassurance that a range of scenarios have been anticipated as opposed to just the rather limited, spot-reference nature of analysts’ forecasts.

In the compensation world, use of predictive analytics has generally been limited to valuing LTI plans for accounting purposes but this is starting to change. We are working with an increasing number of companies to model expected outcomes and and so determine the probability of reaching (or outperforming) the targets they are setting.

This sort of analysis enables you and your Remuneration Committee to:

  • Test assumptions not just in relation to target (expected) levels of performance but also in relation to threshold and maximum too
  • Visualise the likely distribution of performance outcomes
  • Overlay your performance payout curve on to that illustration
  • Provide an intuitive visualisation of the likelihood of where you will fall in your performance range.
Fig.3: An illustrative output from Willis Towers Watson's Predictive Performance Model

An illustrative output from Willis Towers Watson's Predictive Performance Model

Willis Towers Watson's view:

This is a topic we have raised before, and one that isn't likely to be going away anytime soon. As a consequence of the increasing shareholder scrutiny of target stretch and target disclosure, more and more Remuneration Committee Chairs are reviewing and amending the target setting processes in their organisations to improve their rigour and objectivity.

Providing more evidence to demonstrate the degree of stretch in incentive plan targets allows for a more informed Committee discussion and will likely enhance the quality of your shareholder consultation discussions and eventual Remuneration Report disclosure too. Proactively raising ways to achieve this may well help your organisation hit the mark.

1 Willis Towers Watson 2017 Executive Pay Matters Thematic Survey