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The Three Things Every RemCo Chair Needs To Understand

Randal Tajer • Dec 15, 2020

As we head into the year-end bonus determination period, it is worth reflecting on the fundamental issues Non-Executives and Senior Managers need to consider when setting year-end incentive remuneration payments. Since the financial crisis of ’08, layer upon layer of regulation has been heaped on firms to prevent excessive risk taking or payouts at levels that misalign with customer, stakeholder and employee interests.

Thankfully, after almost annual changes to the regulatory environment, we have entered a period of relative stability in which we can catch our breath and reconsider the fundamental structure and alignment of our remuneration programmes. Now, rather than simply asking “Do we comply?”, we can focus on “Does it work?”. Recognising that we have adjusted plans to  deliver  remuneration in compliance with regulations, we must now reconsider if we still determine remuneration in a way that best suits the business, its stage of development and the competitive environment.

Understanding if we have the appropriate variable pay structures in place can be addressed through three basic questions:  How do we Fund, Allocate and Distribute remuneration in our organisation?

Funding of Remuneration

Funding of remuneration considers how income from business results is shared with employees. Starting with Revenue, total remuneration costs should be expressed as a percentage of pre-remuneration EBITDA – at budget or plan. Next, the proportion of this amount that will vary based on performance should be set, and how it will vary, established. Generally, the greater the proportion remuneration is of total expense, the greater the proportion that should vary based on results. The more “human capital intensive” the business, the more it relies on the collective performance of individuals and the more that the remuneration of these individuals should vary in line with these collective results. In businesses where capital investments, working capital and intellectual property are the value drivers of performance, the variable portion of pay should be lower as individuals below the C-suite have less influence on these factors.

Ideally, the incentive fund is the target overall remuneration payable less the fixed remuneration expenses (i.e. salary, allowances and benefits). This is the starting point for the year-end review. If budget is achieved, the target incentive fund will be available. It is also, however, important to establish up front how this fund will vary with variations in performance. Rarely is straight line funding appropriate at the enterprise level. Paying out a higher or lower bonus pool for higher or lower results only works up to a point. Practically, a “cap” may be required to limit payments for exceptional years where results are not entirely due to employee efforts. Similarly, a “floor” or minimum bonus pool can ensure funds are available to reward those who individually performed well, even if overall results were poor. In any case, funding should always be tied to the core economic performance of the business and not be based on non-economic measures such as market share, budget milestones or ‘discretion.’ These types of measures have a place in incentive design, but not in the determination of the actual funds available to pay to employees.

Allocation of the Fund

Allocation of the Fund is the process by which the economically generated fund is divided between various groups within the organisation. Senior management, different business lines, staff and back office roles, etc., should all have a predetermined share of the overall pot and an understanding of how this will vary based on their results. This stage is more judgmental and often does not always follow the strict economic guidelines appropriate to determination of the overall fund. How the fund is divided will depend on the stage of business (start-up, core franchise, run down, etc.) and how the funds will be earned is the basis for the business-specific objectives.

As a result, allocation can reward those responsible for the economic results that generated the fund, as well as achievement of Key Performance Indicators (KPIs) that demonstrate strategic progress. As such, allocation should consider the outcomes that lead to increased funding, but can also look to more qualitative measures that will lead to future economic success. New customers, product launches, market share and other KPIs can be used to direct funding to those achieving the organisation’s strategic objectives, thereby ensuring its long-term economic health.

While not necessarily directly tied to economic outcomes, allocation must respect the economic realities of the business. We have seen several examples – often in Banking – where ‘sales credits’ are counted several times. In one extreme example, each dollar of revenue was ‘allocated’ five times to different business sectors. While this ‘solved’ the problem of recognising that several teams were involved in every transaction, it created an economic fallacy. As this firm traditionally paid out 40% of revenues, by counting each dollar five times, it created expectations that funds equal to 200% of actual revenues would be paid out. Sometimes this sort of double counting can make sense, but it must always be ‘reality checked’ to assure real economic alignment.

Distribution

Distribution of the allocated funds takes the incentive consideration down to the individual level. Two primary concerns are addressed here: how to slice the fixed sum fund to the individuals to whom it has been allocated – essentially a comparative process; and how to deliver the payment to recipients – cash, shares, deferral/holding periods, etc. This second point, delivery, has been the focus of much regulation with implementation of deferral minimums, extended holding periods, claw-back and forfeiture conditions and other constraints on when incentives may actually be considered ‘free and clear.’ These factors are intended to continue to tie recipients to the ongoing success of the enterprise and ensure short term payouts do not undermine longer-term success.

The ‘slice’ of the allocation that each individual is awarded should be based on objective measures of how much was contributed to the results, a comparison to the contributions made by others and the overall allocation made to the group – this needs to be a zero-sum exercise. Unfortunately, this relative comparison stage is where many organisations fail to align individual results to the reality of business outcomes. In one large Wealth Management client, 87% of staff met or exceeded their performance objectives, yet the division lost money for the first time in 20 years. The business head actually argued that “given these individual efforts, extra incentive funding should be made available.”

Delivery of incentives should follow the economic horizon of the outcomes rewarded. Trading a share has a short horizon once the equity is off the books; mortgages, insurance underwriting and other longer-tail relationships can make the economics of a deal change dramatically following the actual transaction with the customer. Rewarding individuals for these events without structuring the delivery to recognise this on-going exposure can be devastating as the financial crisis showed. Unfortunately, as companies failed to address this issue preventatively, regulators in the UK and EU have imposed a one-size-fits-all approach to delivery. While these have generally erred on the side of caution by being more restrictive than a business situation-specific approach would require, its generic approach has actually restricted companies’ ability to truly match incentives delivery to economic timescales and results.

The good news is that we have now seem to have reached a point of relative stability in the UK/EU regulatory expansion process. So as stated at the outset, it is a good time to look back at the fundamental Funding, Allocation, and Distribution processes in your organisation and see if they are aligned with and reinforce the best economic interests of stakeholders.  Good decision-making processes in these areas will ensure that year-end remuneration discussions are results and outcome focused rather than post-hoc negotiations.

So what would a ‘fundamental’ review look like from a practical perspective? As RemCo member responsibilities are non-executive and not intended to inhibit the actions of senior executives, this review should focus on the processes and structures in place to make remuneration decisions in the areas of funding, allocation and distribution. In our experience, these processes are often vaguely articulated, detached from other organisational processes and unclear in terms of accountability and operational metrics.

To make this process practical, our view is that an important role of the RemCo is to carry out a regular ‘health check’ of how well these three issues are addressed. This process would include the following steps:

Document the standards
While there may be differing answers for each company, these answers should be built into the planning process and be approved by the Finance Committee. Questions to include: Are standards/targets clearly articulated for compensation funding? How does funding vary based on results? If funding represents a start-up or investment stage of a business, when should this value be reviewed? Do business heads understand the allocation process and is it set in advance of the performance year? What factors may impact these figures and how are they adjusted? These, and other areas described above should be clearly spelled out and the circumstances allowing them to be reconsidered articulated. All too often well designed plans are overridden post-hoc to deliver bonus payments not consistent with results.

Check for Alignment
Having answers to these key issues is only the first step in assuring effective delivery of remuneration. Does the allocation process reflect the funding approach? The example of double counting revenue is one example, but many others exist. Allocations based on market share or margin may reduce overall enterprise profitability. Rewarding cost reduction at the expense of top line growth can limit performance in future years and poorly conceived caps on allocation can reduce performance below that otherwise attainable. Aligning the elements of remuneration requires a careful consideration of how the business levers that drive pay will impact the ongoing capability of the organisation to perform.

Line of Sight
If well documented and aligned, remuneration programs should provide a clear line of sight – how business results will impact pay – to leaders and staff. This can be undermined, however, when senior management is not transparent in a hope to retain flexibility or a fear that disclosing various funding levels or allocation approaches will raise uncomfortable questions from staff. Staff who believe they will be rewarded through a secret process are less motivated and likely to operate in a risk averse style that may not be appropriate to the business objectives.

The RemCo and Executive Managers should assess how well and how appropriately these issues are addressed. Importantly, thought needs to be given to the impact of substantial regulatory impositions on the determination and delivery of pay. Well articulated performance and payouts developed in alignment with the economic goals of the organisation should be well communicated to provide a clear line of sight to all bonus recipients.

In summary, as we go into the year-end bonus process, remember that remuneration decisions should be based on a set of pre-agreed outcomes for a given level of results. If management believes it is better to “wait and see” before committing to remuneration levels, they are setting themselves up for a negotiation with staff in an environment rife with conflicts of interest.

Article content Copyright    ©  2019 Randal W Tajer

For more information contact:   randal.tajer@mcr.consulting

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