FRC makes pay a risk issue

One of the big behavioural risk issues that emerged from the recent banking crisis was the role played by incentives.  This has taxed many minds since, including the UK's Parliamentary Commission on Banking, Professor John Kay, the Cass Business School team that researched 'Roads to Ruin' for Airmic, a variety of financial and corporate regulators and, most recently, the International Monetary Fund.

The Financial Reporting Council, which regulates most UK listed companies, has made executive pay a risk issue.  Part of its recent focus on behavioural and organisational risk more generally, this specific measure is a significant and beneficial change of emphasis because it creates a feedback loop within the company as to the effect of remuneration systems on the risk profile and longevity of the company.

The 2014 Corporate Governance Code ("CGC") now states that executive directors' remuneration should be designed to

"promote the long term success of the company."

This is a change from the 2012 version which provided that it should be designed to "attract, retain and motivate directors of the quality required to run the company successfully".

Having reminded non-executive directors of the conflicts of interest inherent in taking views on pay from executive directors and senior managers, the CGC focuses on the design of performance related pay.

Reflecting the recommendations of Professor John Kay's Review of Equity Markets, the CGC recommends that:

• Remuneration schemes should allow for claw-back of amounts already paid and for withholding payments in appropriate circumstances;
• Remuneration incentives should be compatible with risk policies and systems;
• Remuneration committees should consider requiring directors to hold a minimum number of shares and to hold shares for a further period after vesting or exercise of options for a further period after vesting or exercise, including for a period after leaving the company.

This new emphasis is echoed in the FRC's 2014 Guidance on Risk Management, which encourages boards to consider whether the company's human resource policies and performance reward systems support the business objectives and the risk management system.

This approach accords with evolving best practice, but assessing the risk consequences of remuneration systems is not straightforward.  As a minimum we suggest that some basic current research findings should be part of the repertoire of both Remuneration Committees and Remuneration Consultants.

The research can be simplified to three propositions.

1. For performance that involves thinking skills as opposed to dexterity, small incentives produce better performance; but performance deteriorates as incentives grow.
2. Recent IMF research suggests that incentives that produce risk awareness and avoidance when the company is successful and solvent may produce the opposite effect when the company is in difficulties approaching insolvency.
3. The IMF research also suggests that caps on incentives may increase risk - cautiously supporting the position taken by the Prudential Regulation Authority criticising the European Union's bonus caps.

Remuneration committees face a period of change that must be accompanied by learning.

Boards are now expected to gain general expertise as regards behavioural and organisational risks.  But the FRC's Guidance on Risk also makes it clear that they should not rely unquestioningly on advice from consultants.  They should test consultants' competence - or acquire the competence themselves.  This note should provide boards with at least some assistance when assessing remuneration consultants.

Postcript 13 October 2014:  The Basel Committee on Banking Supervision proposes adopting a similar position.  Watch out for our forthcoming post.

Anthony Fitzsimmons
Reputability LLP
London

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”