The level of scrutiny around executive pay in the UK, from both shareholders and wider stakeholders, shows no sign of declining. This AGM season will also take place against a challenging backdrop of global macroeconomic uncertainty, sustained high levels of inflation and volatile currency markets, an ongoing cost-of-living crisis, and UK equity market fragility. In addition, the remuneration issues which require disclosure are ever more complex, for example on ‘windfall gains’ or the incorporation of ESG metrics into incentive arrangements. In this context, therefore, ensuring clear and compelling disclosure in the Directors’ Remuneration Report (“DRR”) is more important than ever.
To support reward teams and remuneration committees in this task, we have developed our list of seven areas of focus for the DRR this year. Each represents what might be a key objective for this year’s DRR, based on our assessment of the current market landscape (including from the latest September year-end disclosures) and shareholder sentiment (both from published guidance and insights from our regular engagement with key institutions).
The focus here is not on the decisions themselves, but rather on supporting effective external communication of those decisions in the DRR.
1) Providing context and rationale for executive director salary increases
We anticipate that salary increases for executive directors will be one of the key areas of focus during the forthcoming AGM season, as we discussed in detail in our recent thought piece.
The latest shareholder guidance indicates, in the context of the current environment, an emerging preference for salary increases for executive directors, if they are needed at all, to be lower than the average rate for the company’s wider workforce. It is also expected that, in the words of the Investment Association, “all salary increases, and particularly significant salary increases, will have to be carefully justified in the wider stakeholder context for the company.”
Our analysis has shown that a market trend towards a ‘discounted’ approach to executive director salary increases (i.e. where the increase was below the average employee increase) had already emerged during the course of 2022 and this has continued into the September year-end company sample (with the vast majority of FTSE 350 companies reported to date adopting a discounted approach). Many in this sample have provided a more comprehensive supporting context than what would typically be expected, including many of the points set out below.
In respect of any executive director salary increase, even on a discounted basis, have you provided sufficient supporting rationale and context?
In addition to disclosing the average employee percentage increase, could further supporting context also help (for example – illustrating the range of increases within the business rather than just the average, ensuring that any mid-year or off-cycle increases are included in the all-employee data or the narrative, disclosing any other one-off payments which may have been made to employees to support the cost-of-living, and referencing any other relevant information such as commitment to the Real Living Wage)?
If your increase is above the employee average, or indeed simply above the ‘normal’ increase of prior years of circa 3 percent, have you provided a supporting narrative which shareholders are likely to find compelling?
2) Disclosing alignment and engagement with the wider workforce
The relevance of the all-employee perspective extends beyond just salary increases. For a number of years, remuneration committees have been encouraged to understand, and take into account when considering executive pay, the remuneration practices and outcomes for the wider employee population, and this expectation has become even more firmly entrenched since COVID-19 and remains highly relevant in the context of the current cost-of-living crisis. Transparent disclosure in this area can help to share these insights with the reader of the DRR.
In addition, under the UK Corporate Governance Code (Provision 40), companies are expected to disclose “what engagement with the workforce has taken place to explain how executive remuneration aligns with wider company pay policy.” While there is a range of practice in the market, which is still developing and evolving, most companies tend to leverage existing employee engagement channels, such as employee forums, workshops or focus groups, which may also be used by the ‘Designated NED’ for broader employee engagement. In its recent review of corporate governance reporting, the Financial Reporting Council (FRC) noted an improvement in disclosure in this area last year, but noted that “Effective engagement in the context of Provision 40 relates to more than explaining companies’ remuneration policy to the workforce [and] should demonstrate that the engagement is two-sided. It was disappointing to see that only a minority of companies reported that there was a channel for employees to feedback to the board in relation to remuneration. Better reporters used effective mechanisms to facilitate two-sided engagement.”
In addition to the various disclosures above about workforce remuneration which provide supporting context for executive director salary increases, consider whether any of the following could be included in your DRR, if applicable:
Illustration of how remuneration principles and/or structures cascade down through the business
Disclose the extent of employee participation in incentive arrangements – for example, where bonuses are being paid at the senior executive level, to what extent are they also being paid in the business? Equally, how many employees participate in all-employee share plans? Can such insights support a narrative around alignment and ‘gain sharing’ through the business?
Consider referencing Gender Pay Gap outcomes and actions. In addition, while it now appears unlikely that mandatory Ethnicity Pay Gap reporting will be required, companies could consider voluntarily reporting if the data are available (although recognising that this can be rather more complex than the Gender Pay Gap).
On employee engagement on remuneration, clearly the disclosure will need to accurately capture the activities actually undertaken in the year. Companies may wish to consider, if relevant, whether more can be done to illustrate the ‘two-sided’ nature of the engagement, reflecting the recent FRC observations.
3) Justifying the annual bonus outcome
While investor scrutiny of bonus outcomes should be expected in any year, we anticipate an even greater degree of focus on this area this year. In part, this reflects the current economic environment and cost-of-living context. In addition, we are aware that some shareholders are expecting to see what might be described as a ‘return to normal service’ after an unusually ‘lenient’ AGM season last year when, as a reminder, bonus pay-outs on average across the listed market were the highest they had been for a number of years. This may have partly reflected ‘softer’ targets due to the prevailing impact of COVID at the time the targets were set – both in terms of creating an environment of uncertainty where it was challenging to judge stretch and/or creating a desire in some businesses to somehow ’compensate’ for lost value in other areas of the package as a result of COVID. If we see similarly high levels of bonus outcomes this year, we would expect greater shareholder pushback, particularly where the outcome does not align with their perception of strong performance in the current environment.
It is now well-established best practice for remuneration committees to consider whether the ‘formulaic’ bonus outcome is appropriate based on a broad assessment of overall performance in context. Where the formulaic outcome is not supported by this assessment, shareholders expect pay-outs to be subject to a discretionary downward adjustment, and we have seen examples of some companies making such adjustments in recent years. The remuneration committee’s broad assessment should consider whether the value being received by executives ‘feels right’ in the context of a range of contextual factors, such as the underlying performance of the business, the macroeconomic and trading environment, and the stakeholder ‘experience’. This year, this is likely to take into account the perspective of employees as they navigate an ongoing cost-of-living crisis and, from a shareholder perspective, the trajectory of the share price over the year (with many companies losing value over the course of the year). An effective DRR will ensure sufficient disclosure of how this broader assessment was undertaken, and the impact it had on the overall outcome.
Where discretion is applied, clear disclosure is recommended. This area was also flagged in the FRC’s recent review of corporate governance reporting, where it was concluded that good quality disclosure will provide a clear background, details of “how [the committee] has considered the experience of material stakeholders”, and “an explanation on how the resulting level of the award was determined”. The FRC also suggest that where discretion has not been used, this should also be made clear within the DRR.
On the retrospective disclosure of the bonus targets themselves, we expect a continued shareholder focus on the outcomes for any personal component, reflecting the sentiment summarised in the update to the Investment Association’s guidance last year (“companies should demonstrate how [personal objectives] link to long-term value creation and should not be for actions which could be classed as ‘doing the day job’ ”) and by this ISS comment, which is representative of an observation they will often make (“the reporting reads as an assortment of curated outcomes selected after the fact, rather than a clear demonstration of performance against a set of pre-defined criteria. Also, some of the objectives could be considered to fall within the remit of an executive directors’ day to day duties, and thus it may be questioned why these should trigger a bonus award”).
Is the bonus outcome supported by disclosure of a broader assessment of performance which goes beyond simply referencing the ’formulaic’ outcome? For example – the underlying performance of the business, other KPIs, and the employee and shareholder experience.
Is the impact of changes in the economic environment, such as heightened inflation and a weakened Pound, addressed in the disclosure, particularly if they have acted as a tailwind to company performance?
If the outcome of any bonus measure is significantly above the target for maximum pay-out, does the disclosure acknowledge and justify this?
If discretion is being exercised, is the rationale and impact clearly disclosed?
Is the disclosure for any personal or non-quantifiable element robust? As far as possible, we advise focusing disclosure on how the personal objectives link to achievements delivered by the business as the strategy is executed, rather than the development of the strategy itself.
4) Explaining the approach to LTIP vesting, including on ‘windfall gains’
Many of the same themes identified above in respect of the annual bonus also apply to the vesting of Long Term Incentive Plan (LTIP) awards, most notably the expectation that remuneration committees will review the formulaic outcome in the context of broader overall performance and the stakeholder experience.
There is one additional complexity this year in the form of an issue which has come to be known as ‘windfall gains’, and which we expect to be one of the main areas of investor focus during the season. We recently published our guide on windfall gains, which provides a comprehensive discussion of the background, the various stakeholder perspectives, and a framework which can be used for assessing the risk of a windfall gain. Put simply, where 2020 LTIP awards were granted following a material fall in the share price (such that a significantly greater number of shares were granted), shareholders expect remuneration committees to consider, if the share price subsequently rebounded, whether a ‘windfall gain’ may have occurred at the point of vesting in 2023 (and to make a discretionary adjustment if so). It is a complex issue, with judgment required.
On disclosure, the Investment Association’s recent guidance to committee chairs stated: “Committees should clearly articulate to shareholders how they have considered the impact of any potential windfall gains when determining vesting outcomes and why any reduction is appropriate. If the Committee has decided not to adjust for windfall gains it should explain and disclose its rationale for doing so.” Ensuring a compelling disclosure of the remuneration committee’s approach, particularly for those with a higher risk of a perceived ‘windfall’, will be critical.
As with any LTIP vesting, shareholders will also be looking for assurance that the final outcome ‘feels right’ in the context of broader performance over the period. Of particular relevance to these 2020 LTIP awards will be to ensure that any performance target set during the significant period of uncertainty in the initial phase of the pandemic in early 2020 can be seen to be, in retrospect, to have been sufficiently stretching and robust.
Is the LTIP vesting supported by disclosure of a broader assessment of performance which goes beyond simply referencing the ‘formulaic’ outcome? For example, as for the annual bonus, the underlying performance of the business, other KPIs, and the stakeholder experience over the three year period.
Have you disclosed the remuneration committee’s approach to ‘windfall gains’ assessment? If no adjustment is being made, has the rationale been clearly articulated? If an adjustment is being made, is the committee’s thinking on the level of adjustment clearly set out?
5) Ensuring effective prospective disclosure on next year’s incentives, including ESG
In addition to reporting on the incentive outcomes for the reporting year, the DRR will also disclose the approach to incentive awards for the year ahead, typically covering the performance measures (or underpins for restricted shares), their weightings, and (at least for the LTIP) the proposed target ranges. It is good practice to ensure that any changes are fully explained.
This year, we expect to see continued adoption of Environmental, Social, and Governance (“ESG”) performance measures into incentive plans. For example, by the end of this AGM season, we anticipate that over 80 percent of the FTSE 100 will have included ESG measures in their annual bonus and more than half will have included such measures in the LTIP. For companies choosing to incorporate ESG this year, or indeed for those who already have, investors consider it increasingly important to clearly articulate the link to the company strategy and the approach to ensuring robust performance assessment. The Investment Association’s recent guidance also references the need to “avoid unnecessary complexity” when ESG measures are included (and we are aware of some emerging sentiment among some investors indicating a preference for a single ESG metric over a ‘balanced scorecard’ approach). In this context, ensuring clear and effective DRR disclosure of more complex arrangements is therefore increasingly important.
For those yet to adopt, which in our view is sensible if the company’s ESG strategy is still under development or refinement, it should be noted that the Investment Association expect these companies to “clearly articulate the journey they are on to incorporate ESG metrics into variable pay and how they will evolve this approach in future years.”
Companies may also want to consider their approach to the timing of disclosure for ESG performance targets. Although the default requirement in the DRR regulations would require bonus targets to be disclosed prospectively, the vast majority of the market relies on the ‘commercial sensitivity’ carve-out to avoid prospective disclosure, and report the targets only retrospectively. While it is clear that many financial targets are genuinely commercially sensitive, it is less obvious that ESG targets are too. Some shareholders and proxy agencies have therefore started to push for prospective disclosure of ESG bonus targets (e.g. Glass Lewis guidance states: “Where quantitative targets have been set, we believe that shareholders are best served when these are disclosed on an ex-ante basis, or the board should outline why it believes it is unable to do so”. Although not yet a voting issue for most shareholders, investor sentiment is shifting and some companies have already made the move to prospective disclosure, a trend which we expect to continue this year.
Are any changes to the performance measures or weightings in the bonus or the LTIP appropriately explained, including by reference to the alignment with business strategy?
Are any changes to LTIP targets, particularly reductions, explained and consistent with the broader investor messaging in the annual report and elsewhere? Is any disconnect with analyst consensus being addressed?
If ESG measures are used, is the link to strategy clearly shown? Note that this principle would apply equally to financial metrics.
On ESG targets in the annual bonus, have you considered disclosing targets on a prospective basis? If not, does the DRR explain why?
6) Creating a “user-friendly” DRR
Many parts of the DRR are highly prescriptive, with the content and form laid out in the Companies Act reporting regulations, and subject to audit sign-off. But other parts of the DRR afford significant flexibility to deliver and manage key messages. When one considers that shareholders and proxy agencies will read hundreds of DRRs over the AGM season, it makes sense to invest the time to ensure the DRR is as effective and efficient as it can be in communicating the company’s specific narrative.
In the FTSE 100, around 80 percent of companies now include an “At a glance” section (with around 60 percent of the FTSE 250 doing so). While the content of these sections varies considerably, they generally summarise data points from the full DRR in a compelling and accessible graphical and / or tabular format. For example, they might include a summary of the remuneration policy and components of pay, overview or breakdown of pay for the year, and a summary of the incentive outcomes and the link to strategy and performance. In our view, the best ‘At a glance’ sections are highly bespoke to the company, ensuring that they cover the specific key messages for that company in that year in a thoughtful way, rather than simply reflecting a standard ‘template’. Ideally, in combination with the remuneration committee chairs’ introductory letter, they should effectively operate as a compelling ‘executive summary’ of the full DRR.
Other ways in which the DRR can be refined to make it as ‘user friendly’ as possible include the use of a ‘Q&A’ section where the remuneration committee chair addresses key questions and issues for the year; a sensible order to the report, for example where important sections are not ’buried’ at the back of the report; and clear and simple disclosure of the remuneration package for the year ahead early in the report.
Do you have an ‘At A Glance’ section? If so, could it be made more bespoke to better align with your key narratives for the year?
Is information about next year’s remuneration package easy to find in one place?
Is there a sensible order to your DRR?
7) Responding to shareholder concerns
Where there has been a ‘significant’ vote against a remuneration resolution during the year (i.e. 20 percent or more), the DRR should seek to address this. This would typically include an explanation of any shareholder engagement. In the FRC’s recent review of corporate governance reporting, it suggested that high-quality reporting here should focus on “1. Actions – how the remuneration committee or the board engaged with shareholders to consult on remuneration matters 2. Impact – what impact has such engagement had on remuneration policy and outcomes.”
Even where there has not been a ‘significant’ vote against, it is nevertheless good practice to review whether any shareholder concerns from the previous DRR / vote can be addressed through improvements to disclosure this year. This could involve reviewing any input received from shareholders on last year’s DRR, and in particular from any that did vote against. It can also include reviewing commentary from shareholder bodies and proxy agencies to understand whether any concerns raised (or where an area has been flagged as ‘to be kept under review’) can be mitigated via enhanced DRR disclosure.
If you received a ‘significant’ vote against in the prior year, does the DRR address this?
Have you reviewed shareholder and proxy agency feedback for any potential improvements to DRR reporting?