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Published 07 January 2013 11:14, Updated 14 January 2013 07:17
Australia’s controversial ”two-strikes” rule misses the point as it fails to deal with the problem of chief executives whose personal incentives cause them to take more – or less – risk than the company itself wants, says business professor and former banker Geoff Martin.
The federal government’s 2011 rules that allow shareholders to cause a board spill if it receives two successive no votes of 25 per cent on their remuneration report, but the focus is more frequently on the headline number a board and executives receive, rather than the type of risk that remuneration encourages, says Martin, an assistant professor at Melbourne Business School.
“It’s improved the focus on executive compensation, but my main problem with this whole debate is... the debate comes down to the headline number,” Martin says. “It’s not argued out on the basis of ‘You’ve given him too much options and not enough stock,’ it’s more about ‘You’ve given him $10 million and he only deserves $5 million’.”
A quarter of Australia’s top 300 bosses were forced to drop or forgo their annual cash bonuses this year, with boards pushing executive pay into long-term shares and options to avoid investor protests, The Australian Financial Review’s 14th annual survey of executive salaries last year showed. The total packages of the chief executives of the top 300 listed companies averaged $2.47 million this year, a pay rise of 6 per cent from $2.33 million the year before.
Too many boards take a “cookie-cutter” approach to executive remuneration and offer chief executives stock options that encourage the boss to take more risk than may be good for company, as the boss aims to meet short-term targets that will boost the value of their options, Martin says. In contrast, chief executives given a greater proportion of pay in shares or cash are likely to be more conservative as they already have more to lose from risky behaviour, he says.
There are moves afoot to improve disclosure by boards about remuneration. Last month, the Treasury released draft legislation that would require companies to provide greater details of the way remuneration for key management personnel is calculated.
Boards should start the new year by checking whether they have given their chief executives incentives that encourage risk-taking or a more conservative stance, and ensure that payment fits with the board’s own outlook for the economy and their company, Martin says.
“If (the board wants to position the company for growth in a recovering economy), they’re probably looking to have that CEO have good incentives to take risk,” Martin says. “You’re happy for chief executives to have stock options that aren’t worth that much. But if they’ve taken the conservative view that says: we just want to wait and see ... and the CEO is sitting on stock options not worth a lot, they need to look at rebalancing those incentives.”
While there is no Australian data available on executive pay in listed companies, analysis of US data for the years between 1996 and 2009 Martin co-published in the Harvard Business Review in October last year, quantify the extent to which prospective and current wealth affected a chief executive’s appetite for risk.
“For each standard deviation increase in prospective wealth, we found, annual risk taking rises by about 33 per cent, and for each standard deviation increase in current wealth, it falls by 18 per cent,” the report says.
Since 2006, cash compensation to chief executives in the US has declined, while compensation in both shares and stock options has increased in equal measure, Martin says. The increase in options - and the greater propensity for risky behaviour it brings - is inconsistent with the caution companies have shown by sitting on cash and being hesitant to invest it, he says.
In a statement to BRW, the Australian Securities & Investments Commission said the two strikes rule had improved communication by companies their shareholders on the issue of remuneration by requiring a vote on a remuneration report required to include “a discussion of the relationship between the board’s remuneration policy and the company’s performance”.
The regulator also said Australian Prudential Regulation Authority governance standards require companies such as banks and insurance companies “to have a documented remuneration policy which specifies the type of behaviour that performance based remuneration should encourage as well as the fact that it should be designed to align with prudent risk taking”.