There’s no shortage of theories purporting to tell us how to effectively structure executive remuneration packages. Reinforcement theory suggests boards should try to identify beneficial past behaviours, then create incentives to ensure they’re repeated. Agency theory, on the other hand, would have us focus on those areas where the interests of executives and the organisation diverge with a view to ensuring they’re brought into alignment.
Unfortunately, none of the competing theories accurately describes the clearest observable trend in executive remuneration, and understanding that is key to understanding why some trustee boards may have a problem with executive remuneration.
Research data suggests that remuneration of senior executives tends to be driven less by reward for results or effort than by an asymmetric pattern of negotiation. The key to this asymmetry is that boards tend to benchmark remuneration against those organisations that happen to be higher-paying and higher-status at each particular point in time, with the result that remuneration tends to rise disproportionately during the good times while failing to reduce proportionately when things fall flat.
For chief information officers and chief executive officers, those higher-status organisations tend to include the top investment performers from time to time. But since higher investment performance also means higher investment risk, this practice can have serious and unintended consequences.
APRA’s superannuation Prudential Practice Guide 511 for remuneration seems to have been written with an eye to drawing these unintended consequences to the attention of trustee boards. It begins with a reminder that trustees are required to perform their duties in the best interests of beneficiaries to a high standard, and then launches into a discussion on the importance of remuneration practices being consistent with the best interest duties rather than perceived market practice.
But I wonder how many boards explicitly consider their best interest duties when considering CIO and CEO remuneration?
Consistent with best interest
To ensure remuneration practices are consistent with the best interest duties, APRA suggests that boards consult the Principles for Sound Compensation Practices – Implementation Standards issued by the Financial Stability Board, with special regard to structuring remuneration so as to limit incentives that encourage high-risk behaviours.
This goes beyond the largely mechanical obligations set out in Superannuation Prudential Standard 510 (SPS 510) and, in the case of CIOs especially, should include ensuring that any performance bonuses reward on-target performance more than overperformance, and risk-adjusted performance rather than absolute performance.
While it might seem odd at first not to reward high earnings simply because they are high, we need to remember that superannuation investment performance is not a race. What’s more, treating it like a race is far more likely to land a trustee in breach of s. 52(6) of the Superannuation Industry (Supervision) Act (SIS Act) than on a podium at an awards ceremony.
Section 52(6) sets out statutory covenants to formulate, review and give effect to an investment strategy that amount to a requirement for superannuation investments to be managed on a true-to-label basis. It may not be universally understood by trustee directors that exceeding performance targets could be as undesirable as underachieving, yet it seems clear that performance targets that are consistently over-reached may well be the most reliable indicator that risk labels are being ignored by CIOs.
Since no CIO or CEO has yet worked out how to separate investment risk from return, consistently over-reaching performance targets is also a strong and early indicator that the s. 52 (6) covenants may not be met, exposing the trustee to SIS and Corporations Act penalties.
It follows from this that boards that set executive remuneration based on benchmarking against higher-paying and higher-status organisations are, whether they realise it or not, engaged in a performance arms race in which members are pushed into higher risk categories and boards are pushed further from their best interest duties.
Avoiding that sort of trap is what APRA is attempting to achieve by requiring in SPS 510 that trustees set performance remuneration based on factors that include protecting the interests of beneficiaries, protecting the long-term financial soundness of the licensee, and investment risk management rather than naked performance. After all, basing performance bonuses on achieving highest performance is the philosophy that helped make Barings Bank and Lehman Brothers what they are today.
David Galloway is the operation and governance manager at First Super