13 May 2020
The Financial Stability Board (FSB) has published its key takeaways from their November 2019 workshop on the implementation of compensation reforms. The workshop was attended by internationally active banks, insurance and asset management firms, trade associations and academia, and forms part of the FSB’s work in monitoring the implementation of the FSB’s Principles for Sound Compensation Practices and Implementation Standards (Principles and Standards).
1. Effectiveness of compensation policies:
- Firms are embedding the Principles and Standards into their cultures but are generally at an early stage of developing frameworks to assess the effectiveness of compensation policies and practices.
- Effective communication with employees is an important factor in driving behavioural and cultural change.
2. Risk alignment:
- Effective risk alignment is at the heart of regulatory efforts to reform compensation. All participating firms take steps to align compensation with risk but, given banking compensation was regulated earlier, banks are often more advanced on this work than other firms.
- Non-financial performance metrics are increasingly important in compensation arrangements but there are difficulties with choosing appropriate non-financial metrics, including challenges associated with measuring the outcome of ESG metrics.
- Positive compensation adjustments can be a powerful mechanism for promoting and incentivising positive behaviour.
3. Using data in compensation practices:
- Systems for gathering and analysing compensation data within firms has improved, increasing the ability of line managers to make effective decisions and accountability for, and objectivity of, compensation-related decision-making.
- New tools allow for more effective analysis of compensation data, including real-time analysis during compensation rounds, helping to deliver more effective compensation decisions, but these tools can be complicated and costly.
- Some firms are assessing how they can use data to identify correlations that may allow a more forward-looking approach.
- Firms are trying to find ways to present detailed information to senior management and boards in a manner which is concise and useful for decision-making.
- In banks, there appears to be a correlation between directors holding (and not frequently selling) shares and bank profitability. To align directors’ remuneration with a firm’s long-term interests, academic work suggests that restrictions on equity for a longer period than their tenure should be considered.
4. Compensation governance:
- Control functions play a central role in compensation processes.
- Again, given banking compensation was regulated earlier, banks are more advanced than other firms in embedding compensation decisions in governance processes, but most firms reported a greater focus on embedding compensation decisions in governance processes at board level and the increased importance of firms’ compensation policies and practices, in particular for non-executive directors.
- Firms referenced the importance of balancing consistent processes and governance with the ability to apply discretion on compensation decisions within a clear framework.
- Despite greater harmonisation of compensation regimes in recent years, key differences (e.g. deferral, bonus cap, disclosure regimes) continue to present difficulties when designing and implementing consistent compensation policies across international groups.
5. Compensation tools (e.g. in-year adjustment; malus; clawback):
- The use of malus and clawback is limited because of complexity and, in some jurisdictions, legal challenges. Clawback use is extremely limited, including due to perceived legal risks. In-year adjustment is the compensation tool used most frequently.
- Where malus or clawback is applied to an individual, this will likely have a significant negative impact on the individual’s career progression and may make it less likely that they will be hired by another firm. Therefore, to ensure decisions are fair and employees have appropriate opportunities to make representations, the process involves considerable governance, which can take time and be resource-intensive.
- Some firms noted the extent to which severance payments have become a focus since they may not provide effective risk alignment.
- The time typically taken to identify events where operational risks have crystallised (e.g. misconduct) may be a factor that needs to be considered when determining the length of deferral periods.
6. Competition for talent:
- Firms face hiring challenges for three reasons: (i) they increasingly need to hire from other sectors where compensation structures are different; (ii) the extent to which financial services firms are no longer considered employers of choice; and (iii) the extent to which factors other than compensation now influence the decisions of prospective employees, such as ESG and a firm’s purpose and culture.
The FSB compensation workshops are a useful way for firms to input into the FSB’s ongoing compensation monitoring and the takeaways can be a useful barometer for compensation-related challenges that firms are experiencing. The discussion on compensation tools and the reluctance of firms to use malus and clawback, for instance, shows that the participating firms focus on making in-year adjustments and do not fully utilise all of the compensation tools at their disposal due to perceived practical or legal difficulties.
Firms will be familiar with many of the points noted above and most of the takeaways will not cause concern. Other than the possible general reluctance to use malus and clawback, the key point of interest will be the suggestion from academia that restrictions on equity for directors should apply for a longer period than their tenure to further align director remuneration with the firm’s long-term interests. Although the Principles and Standards contain deferral and retention provisions, they do not currently provide for an explicit post-termination shareholding requirement, although UK listed financial services firms will be familiar with the recent focus on such requirements in the UK corporate governance code and the Investment Association’s Principles of Remuneration.
It is yet to be seen how, if at all, the FSB will respond to these takeaways for example, whether they decide to take steps to encourage national legislators to remove legal obstacles to malus and clawback, implement provisions that directors hold stock for a period longer than their tenure, or provide further clarity on appropriate non-financial performance measures to address the difficulties identified. Firms should keep an eye out for developments from the FSB. We will issue an alert if any such developments are announced.
If you have any questions about this alert, or if you would like to discuss your remuneration structures, please do contact us.