Bosses' bonuses: Are executive incentives too generous?

By Fiona Rotherham

Executive incentive schemes aim to boost company performance. But is it too easy for top bosses to get a reward?
As well as their high salaries, senior managers are often given skin in the game through employee share schemes.
As well as their high salaries, senior managers are often given skin in the game through employee share schemes.

As well as their high salaries, senior managers are often given skin in the game through employee share schemes.

The idea is to to align their interests with those of the shareholders - a better return for the investors means more money for the executives. But are the schemes too generous, and is earning a reward too easy?

While exact numbers are not known, most listed companies are believed to have employee incentive schemes. They are also popular with start-ups which can't offer generous salaries.

For example, A2 Milk, the specialist milk provider and New Zealand's best-performing stock last year, has paid out just under 5 per cent of its total equity - some A$5.54 million ($6.2 million) - to key executives under incentive schemes.

For the first time, the company's 2015 report gave full details of chief executive Geoffrey Babidge's A$525,300 fixed salary and short-term incentives of A$51,000.

As investors benefited from A2 Milk's soaring share price - up 240 per cent in the past 12 months - Babidge cashed in some of the incentive shares doled out since he joined A2 in 2010.

Annual reports and NZX disclosure notices show he paid just over $1 million for 15 million shares.

He has reaped $8.4 million selling 7.5 million of them in five sales since 2013, one as recently as last week, and has retained 2.5 million fully-paid shares and 5 million partly-paid shares (beneficially owned).

A2 Milk regularly granted partly-paid shares under its long-term incentive scheme from 2009, although it wasn't profitable until 2011 and pays no dividend.

Companies often use discounted shares as an incentive for executives, not only to align their interests with those of shareholders, but also to retain talent. However, soft or poorly defined schemes can dilute a company's stock for no benefit.

New Zealand listed companies face less onerous reporting standards than their counterparts in Australia. Adding to the pressure on Australian companies, a "two strikes rule" also means an entire board can be put up for re-election if more than a quarter of shareholders vote against a key management remuneration report at two consecutive annual meetings.

Geoff Babidge.
Geoff Babidge.

A2 Milk's disclosure of executive remuneration has improved markedly only since it dual listed on the ASX last year.

Disclosure of remuneration packages is part of the NZX's review of corporate governance reporting requirements, which it wants to align with the ASX and Financial Markets Authority guidelines. The NZX plans to release a consultation paper on proposed code changes this year.

Meanwhile, the Shareholders' Association is concerned that some incentive schemes are too generous when a company isn't out-performing its peers (see opposite page).

The association was behind a successful push last year for Kathmandu to toughen its CEO incentive scheme, which gave new boss Xavier Simonet low targets to reach in turning around the struggling outdoor goods retailer.

Whether tighter rules and better designed schemes are enough is a moot point: a February Harvard Business Review article suggested companies should stop paying executives for performance altogether.

Organisational behaviour and strategic management professors Dan Cable and Freek Vermeulen said it was unclear why so much of CEOs' packages included performance pay in addition to fixed salaries.

Their study found performance pay often resulted in worse, rather than improved, company performance and led to shenanigans such as cooking the books, particularly when executives were just shy of targets to gain their bonus.

However, Milford Asset Management executive director Brian Gaynor supports incentive schemes for executives, and directors getting at least some of their fees in shares.

"In any company having an IPO, one of the first questions we'll ask is whether it's going to have a scheme for staff long term or short term," he says. "But you have to construct them carefully."

In the past, he says, schemes were "way too generous". "They're not all perfect now but they're far better than they were."

JB Were NZ equities manager Rickey Ward agrees "the devil is in the detail" with executive incentives.

"Some have fallen down in how they get entitled to the shares - the alignment is not always right and many have a lower hurdle to entitlement to options than what investors expect."

[Incentive schemes] are not all perfect now but they're far better than they were.
Brian Gaynor

The best schemes combine return on invested capital and earnings growth with share price performance, he says. Other analysts say companies should avoid share price hurdles that could result in abnormal behaviour such as aggressive accounting, share buybacks, and highly leveraged, low-quality acquisitions.

Governance is key, and a board's audit and remuneration committees need to be independent, Ward says.

In one example, former Ebos chief executive Mark Waller was on the remuneration committee even though his package included performance-based incentives that sometimes exceeded his base salary.

A2 Milk's 2015 annual report shows Babidge got 11 million partly paid shares under its long-term incentive scheme, 6 million issued at 10c apiece in 2010 and the rest at 64c in 2013. These days, A2 shares are worth about $1.90 on the NZX.

The scheme also had an anti-dilution deal where cornerstone shareholder Freedom Foods was compensated when partly paid shares were issued. It got $500,000 of partly paid shares in 2013, the year A2 ended the arrangement by giving Freedom 400,000 fully paid shares and a March 2014 deadline to pay for the partly paid stock.

A new scheme adopted last year gives Babidge up to 30 per cent of his annual pay in short-term incentives, subject to achieving unspecified performance targets.

Not all incentive schemes end up in the money, though. Brewer Moa issued 1.75 million unlisted redeemable shares to directors, key executives and agents/distributors with an issue price of $1.25 in 2013 after its IPO, only to see the price tank. The options were cancelled.

Chief executive Geoff Ross, a majority shareholder though the Business Bakery, says companies he has been involved in, including 42 Below, have always had share schemes to motivate staff.

Moa has since devised a more generous employee scheme which allows 1.2 million share options to be issued over three years at a 28.2c exercise price, well under the current 62c share price. The options are in four bands, ranging up to 100,000 for top executives, and vest annually.

"We were pretty unanimous it should be for all staff as we all share in creating greater shareholder value," Ross says.

Auckland Airport was another that last year changed its long-term incentive scheme, though its legacy "phantom share" scheme has two years to run. The phantom scheme meant executives didn't actually own shares, but reaped the benefit when the stock price rose. When exercised three years later, once performance hurdles were met, Auckland Airport paid cash based on the premium between the current share price and the original, notional issue price.

The scheme was devised largely to retain past CEO Simon Moutter, who left for Spark, taking up only half of the 2 million phantom shares offered.

Adrian Littlewood.
Adrian Littlewood.

Auckland Airport's 2015 annual report said current CEO Adrian Littlewood got 3.5 million shares from 2012 to 2014 at various prices under the phantom scheme. AIA's current share price is $6.55, up from $2.52 at the start of 2012.

Last year the board capped Littlewood's potential financial rewards to bring the scheme in line with that of other corporates, at 2.5 times his 2012 fixed salary and twice his pay for 2013 and 2014. In 2015 his remuneration totalled $2.26 million.

By June 30, the company's estimated potential payments under the phantom options were $10 million, up from $6.8 million the prior year.

Under the new long-term incentive scheme, executives are loaned money to buy shares at market price, which are held on trust until vesting. The shares are split 50:50 between achieving a total shareholder return over three years higher than the company's cost of equity, and its total shareholder return relative to the performance of nine other airport companies.

Once shares are acquired, the executive gets a grant based on a percentage of salary which, after tax, is used to repay the loan. Littlewood was issued 60,139 shares in October.

The airport is assessing whether its scheme meets new IRD rules before approving any further grants.

Setting the bar at the right height

Incentive payments are given too easily, for average performance, says the Shareholders' Association.

Chairman John Hawkins says short-term CEO incentives should be limited to one third of base pay.

"More than this drives a short-term mindset," he says.

Long-term and short-term incentives added together should not exceed 100 per cent of the base pay and should apply only for "true outperformance", he says.

The association likes long-term incentive plans to include achieving a total shareholder return above the median for a comparison group, such as industry peers.

Vesting should begin modestly when total shareholder return exceeds the comparison group's 51st per centile, then increase progressively to full vesting when the return reaches the 75th per centile level or more - better than at least three quarters of the comparison group.

John Hawkins. Photo / Dean Purcell
John Hawkins. Photo / Dean Purcell

The association wants more weight given to achieving a long-term improvement in company performance, as measured by things such as earnings per share or return on funds employed.

That's rather than just a rise in company share price, which can be affected by many external factors.

"The current 50 per cent vesting at the 50th per centile is pretty soft - it effectively generously rewards average performance," Hawkins says.

"And too many schemes (especially short-term incentives) are not very clear on what the hurdles are and how this is measured."

As investors expect a degree of alignment between executive remuneration and performance, publishing a remuneration policy allows them to see "if the reality matches the rhetoric", the association says.

It supports the NZX adopting a "comply or explain" rule, with companies' behaviour measured against best practice corporate governance, as in Australia and Britain.

However, the association wants to avoid "the long-winded and confusing" reporting that is common in Australia.

"The local situation varies between a two-line comment which says nothing about how remuneration is decided through to an 8-10 page explanation that appears designed to confuse rather than inform," it says.

The group is "beta testing" a CEO remuneration reporting format with interested companies, which could become a voluntary standard.

Would you like tax with that

Inland Revenue is talking to a "small number" of taxpayers it believes are in tax-avoiding employee share schemes, after issuing an alert that some are not being operated in accordance with Parliament's intentions.

Employees participating in incentive schemes generally buy discounted shares and pay tax on any capital gain, based on the market value.

The IRD is concerned about tax-reducing arrangements that bring forward the time at which the employee acquires the shares, compared to when this really occurs. It is also investigating the level of control employees have over the shares, voting rights during vesting, exposure to real commercial risks from share ownership, and whether they have taken an option or fully paid for the stock.

"Some schemes allow people to acquire shares from day one, where they lock in the future capital gain, but do it in a way that it's a one-way bet so they can walk away if the shares go down in value," says Deloitte tax partner Patrick McCalman.

EY tax partner Rohini Ram says the IRD is now asking some employees to repay what is retrospectively owed, even if they have since left the company concerned.

A ruling last year on Chorus' executive share scheme, a common structure used by listed companies, indicates how tax rules might be applied, McCalman says.

Chorus makes interest-free loans to a share scheme that buys stock on market on behalf of executives. The trustees hold them for three years. Once performance hurdles are met after three years, Chorus pays the executives a cash bonus equal to the gross value of the original loan, the after-tax amount repays the loan and the shares are transferred to the executive.

Inland Revenue effectively ruled the Chorus executives should be taxed in the same way as other investors, rather than as employees. The department is due to release a discussion paper clarifying and proposing changes to the tax treatment of such schemes.

"Once they have simplified what the tax rules are going to be, organisations will stop looking at schemes on the basis of whether they are tax effective and more how they drive behaviour," Ram says.

The existing tax exemption, DC12 ESS, is unpopular because it has to be employee-wide and has a $2340 cap on how much an employee can spend on shares in a three-year period.

McCalman says if changes are made, the IRD should "do it properly" rather than tinkering, with Australia's simple A$1000 annual tax concession a possibility.

He'd like the IRD to avoid a one-size-fits-all approach, as New Zealand's many small-to-medium-sized enterprises are often cash-strapped, with illiquid shares, unlike larger, listed companies.

- NZ Herald

Get the news delivered straight to your inbox

Receive the day’s news, sport and entertainment in our daily email newsletter


© Copyright 2016, NZME. Publishing Limited

Assembled by: (static) on production apcf03 at 26 Oct 2016 22:15:42 Processing Time: 501ms