On 23 July 2019, APRA released its proposed draft remuneration standard for consultation, the CPS 511. The CPS 511 will shift the remuneration requirements set out in the CPS 510 and SPS 510 into a stand-alone prudential standard that covers ADIs, general insurers, life insurers, private health insurers and RSE licensees.
The proposed reforms seek to better align remuneration frameworks with the long-term interests of entities and their stakeholders, including customers and shareholders, and addresses recommendations 5.1 to 5.3 from the Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, which were endorsed by the Government in February.
In our view, while the proposal is well intentioned, it has scant regard for the adverse commercial implications that it may cause. The accompanying discussion paper is also light on detail when it comes to important practical considerations.
APRA are now seeking consultation and will be accepting submissions up to 23 October 2019. It is important that companies voice their opinion on the proposed reforms, prior to this deadline. KPMG 3dc can assist you with your company’s submission. APRA intends to publish a Response to Submissions and final prudential standard in late 2019 or early 2020 and expects that the new CPS 511 will come into effect on 1 July 2021. For the private health insurance industry, APRA expects that the new requirements will not apply until 2022.
Set out below are the changes proposed in the draft CPS 511. Also included are areas that APRA has specifically requested feedback on. The request for input indicates that submissions will be important and that APRA is open to considering changes.
Remuneration policy and governance
The board would be responsible for the remuneration policies that apply to all employees, not just senior executives and material risk-takers.
APRA is seeking consultation on whether the proposed duties on boards and remuneration committees are appropriate.
Boards would be required to review the effectiveness of the remuneration framework on a triennial basis, while still reviewing the framework for compliance with the CPS 511 annually.
APRA is seeking consultation on whether 3 years is an appropriate period.
Senior managers (as defined in CPS 520 and SPS 520) are now covered as opposed to senior executives, while the definition of material risk taker no longer takes into consideration whether the individual has a significant portion of total remuneration based on performance. We expect this will increase the number of employees covered by the standard.
Limiting use of financial performance measures
Financial performance measures must not comprise more than 50 percent of total measures used to allocate variable remuneration. Further, a single measure must not have a weighting of more than 25 percent of total measures.
APRA is seeking consultation on whether this is an appropriate limit, and what other options APRA should consider to ensure non-financial outcomes are reflected in remuneration.
There is also an opportunity to request that APRA provides further guidance as to what it considers to be a ‘non-financial’ measure, and whether these non-financial measures can operate in tandem with financial measures (i.e. as a gateway or multiplier).
While not yet included in the draft standard, APRA’s discussion paper explicitly calls out that it is considering requiring entities to publish the current and historic values of all performance metrics used when assessing variable remuneration.
Significant financial institutions
APRA is proposing to define a new category of APRA-regulated entities termed significant financial institutions (SFIs). The proposed approach for determining if an entity is an SFI is set out below.
SFIs are required to comply with the additional deferral and clawback obligations set out below.
Deferral (SFIs only)
The deferral period for the CEO of an SFI has been increased. 60 percent of variable pay would be deferred for 7 years (with pro rata release from year 4) and for other senior managers, 40 percent of variable pay would be deferred for 6 years (with pro rata release from year 4). This is an increase beyond the requirements recently announced under the Banking Executive Accountability Regime (BEAR).
APRA is seeking submissions on the impact of the proposed vesting and deferral requirements in addition to BEAR, as well as the impact on attracting key talent.
Clawback (SFIs only)
SFIs will need to then have the ability to clawback all incentives for a further period of at least 2 years post release, and at least 4 years in circumstances involving a person under investigation (i.e. up to a maximum of 11 years after award for the CEO).
APRA is requesting feedback on the hurdles of the use of clawback, whether longer deferral instead of clawback would better address this, and what transitional arrangements may be necessary.
The changes in the CPS 511 considerably increase the obligations and workload requirements on entities covered, while decreasing flexibility and competitiveness. Some examples of increased obligations include:
On the release of the standard, APRA's deputy chairman John Lonsdale said that APRA wants to “empower boards to more effectively incentivise behaviour that supports the long-term interests of their entities."
But does the CPS 511 really support the long term interests of a company? We have set out some questions below that we feel are important to ask of APRA in considering whether the changes are supporting the long-term interests of companies.
Do these requirements motivate employees?
Through feedback from clients across a number of sectors, we know that executives place diminishing value on long term incentives the longer they are deferred for. Will executives be motivated by incentives when the deferral is so long?
How will SFIs compete for talent without increasing the quantum of remuneration?
What is the motivation for an executive to stay at an SFI, with their pay deferred for 7 years, when they could move to a financial services company that is not an SFI, or another company all together, and receive the same amount in a shorter period of time? Losing and not attracting key talent will ultimately hurt companies in the long term.
As a result, SFIs will be forced to increase their quantum to counter the longer deferral and attract and retain employees. But weren’t large pay packets in the FS sector part of the reason we got here in the first place?
Why is 50 percent non-financial the right amount?
In its discussion paper, APRA acknowledges that there is no clear consensus on the appropriate weighting for non-financial measures. Despite not having a clear consensus, it has decided that an equal weighting is a “reasonable starting point.” 50 percent is a significant portion of an award and is not necessarily a ‘reasonable’ weighting for all companies.
And what about the views of investors and proxy advisors? It is well known, and even acknowledged by APRA in its discussion paper, that these groups are generally averse to payment of incentives where financial targets are not met. Is APRA’s intent of supporting the ‘long-term interests being satisfied when, for example, a company receives a second strike because investors do not support the use of non-financial measures used?
What constitutes a non-financial measure?
In Section 4.1 and 4.2 of Hayne’s interim report, Hayne was critical of some banks categorising KPIs as ‘non-financial’ when the measures were ultimately assessed based on sales.
APRA’s discussion paper lists a number of “examples of non-financial metrics” that could similarly be assessed based on sales. These include cross-bank collaboration, customer loyalty, and innovation. Will APRA consider such metrics as ‘non-financial’ under CPS511 if they are assessed based on sales?
Is APRA suggesting the use of financial measures as gateways?
The discussion paper indicates that non-financial performance measures can be limited in scenarios of “adverse financial outcomes”. This is akin to the use of financial measures as a performance gateway. The cliff outcome created by a financial gateway could be considered to create greater risk than a typical financial measure (where vesting occurs on a sliding scale). Is this consistent with their objectives?
How do we measure non-financial for the long term?
Further, from conversations with clients, we know that non-financial measures are difficult to select, and even more difficult to successfully measure. Many companies have difficulty in selecting and defining a non-financial measure that makes up 10 percent of an STI scorecard. APRA is clearly underestimating the challenge of identifying non-financial measures that can reliably and transparently assess performance over a 4-year period.
The next steps are determining whether you wish to make a submission as well as the implementation of the changes. Given the CPS 511 will not come into effect until 1 July 2021, the immediate priority should be determining if you wish to make a submission.
With a short consultation period of only 3 months, written submissions on these proposals must be submitted by 23 October 2019. This will be the only opportunity to make a submission, with the final standard to be released in late 2019 or early 2020. It is therefore imperative to begin discussions on any objections to the CPS 511, so that they can be raised in a submission before this date.
KPMG 3dc are assisting with client submissions to APRA, in order to ensure that they are aware of the commercial consequences of their proposals.
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