In response to investor focus on broadening the scope of performance assessment beyond short-term financial results, ASX-listed companies have been increasingly incorporating non-financial measures into executive remuneration structures.

Regulation has also influenced the integration of non-financial performance measures in the Australian market. In particular, the implementation of CPS 511, the prudential standard on remuneration set by the Australian Prudential Regulation Authority (APRA), has catalyzed significant changes in the remuneration structures of financial institutions by mandating the integration of non-financial measures.

In this post, we provide background on the use of non-financial measures in the Australian market, and outline a potential framework for implementing such measures in line with emerging best practice.

Note: APRA’s CPS 511 leaves some room for interpretation regarding what constitutes a non-financial measure. Based on our understanding of APRA’s intention for CPS 511, for the purposes of this post, we consider non-financial measures to include all performance measures excluding those that are explicitly financial, share price/shareholder return, or market share related.

The Ongoing Discussion: Non-Financial Measures in Executive Pay

Despite becoming increasingly widespread, the use of non-financial measures in executive remuneration continues to spark debate.

Common criticisms of non-financial measures include that:

  • They are frequently unquantifiable and lack both specificity and robustness.
  • They result in inflated incentive payouts without achieving shareholder value creation and are awarded for achievements that are covered by an executive’s regular responsibility.
  • They reduce the emphasis on financial performance, a shift resisted by some investors who view traditional financial metrics as more directly relevant to shareholder value.

Proponents of non-financial measures argue that well-designed non-financial measures can facilitate executive focus on building a more sustainably profitable business by mitigating an excessive focus on short-term financial results.

A Framework for Implementation

At CGI Glass Lewis, we recognize the limitations of traditional remuneration structures that focus heavily on short-term financials. We also recognize the potential for non-financial measures, like any other type of performance assessment, to be misused if they are not closely aligned with strategic and business priorities. After analyzing dozens of remuneration structures that have adopted non-financial measures and engaging with remuneration committee chairs and the investor community, we set out what we perceive as best practices for Australian companies implementing these measures.

A best practice approach to linking non-financial metrics to remuneration involves adopting measures that are directly relevant to a company’s priorities. To this end, we identify three subcategories of non-financial measures and potential implementation approaches for each category:

The above framework offers avenues to integrate a range of non-financial metrics, including those that are more discretionary in nature, in a way that is relevant to a company’s priorities. This framework is neither exhaustive nor definitive. Some examples can apply across multiple sub-categories, and there will be situations where what is conventionally viewed as a long-term project could reasonably be integrated into the short-term incentive. For example, some companies will set short-term emission targets or other incremental milestones that contribute to a larger goal. In determining whether to recommend support, our benchmark policy approach will continue to emphasize a clear, logical rationale for any performance measure, along with a direct link to financial materiality.

CPS511: Market Implementation

The response of Australian financial institutions to the CPS 511 remuneration standard illustrates some of the ways that non-financial measures can be employed, along with some of the concerns that have been raised.

Notably, CPS 511 mandates that APRA-regulated entities assign substantial weight to non-financial measures in all performance-based remuneration. Its introduction prompted the four major Australian banks to reallocate a portion of the short-term incentive opportunity to a longer-term restricted share grant. The restricted rights are subject to non-financial performance gateways such as the bank’s avoidance of risk failures and other, typically discretionary, assessments. The restricted share grants are also reduced in value to reflect the lower level of risk associated with these awards. This is consistent with the license maintenance approach described in our framework table above.

CPS 511 also prompted some APRA-regulated entities to amend their remuneration structures in other ways, such as incorporating reputation scores and customer metrics into their LTI plans. This may indicate a genuine need for long-term transformation in such areas. However, for many of these entities, there does not appear to be evidence of any impaired reputation or customer relationship.

It may be the case that these companies view ongoing reputation management and customer metrics as directly relevant to their long-term operational performance. Alternatively, it may be the case that some of these metrics were introduced as long-term measures in an attempt to find quantifiable and objective metrics that could be used to comply with CPS 511 without necessitating more extensive changes to the incentive structure. While entities taking this approach have succeeded in meeting regulatory requirements, they have also introduced questions about the relevance of these metrics.

Financial Gateways

A common mechanism to bolster the robustness of the incentive scorecard is the adoption of a market or financial gateway, which set a minimum financial threshold that applies across the non-financial weightings. This ensures that if overall performance falls below the minimum financial threshold, no awards will be paid, addressing concerns that non-financial measures may be used to inflate incentive payouts or compensate for subpar financial performance.

In implementing such a mechanism, remuneration committees must carefully calibrate the threshold to strike a delicate balance—sufficiently challenging to address any perceived conflict between non-financial and financial performance, yet not overly stringent to devalue the significance of the non-financial measures from the perspective of the executives. The use of an “all-or-nothing” structure can raise concerns, and there may also be specific situations where applying a financial gateway could be seen as inappropriate due to the overriding priority of factors such as safety performance.

Ultimately, the benefit that financial gateways provide, of safeguarding against inappropriate payouts, is already factored into performance assessments through the board’s implicit discretion over outcomes. Nonetheless, explicitly integrating these considerations into the remuneration structure would enhance transparency and address external stakeholder concerns regarding the robustness of non-financial measures.

On the Horizon

The Australian government has recently mandated climate-related financial disclosures through amendments to the Corporations Act 2001 (Cth) and related legislation, with the first reporting period starting on or after 1 July 2024 for the largest entities. This significant legislative development is expected to create more opportunities for the inclusion of quantifiable non-financial measures that can be confidently applied and compared across companies. This, in turn, will likely foster positive applications in executive remuneration overall. However, to meet investor expectations companies must ensure that these metrics are implemented in a way that aligns with their specific business strategies and goals.

 

Philip Foo CFA also contributed to this report.