APRA consults on new remuneration standard

APRA has released a draft new prudential standard (Draft Standard) on remuneration for public consultation. It is aimed at clarifying and strengthening remuneration arrangements in APRA-regulated entities and is a response to APRA's recent surveillance activities into remuneration arrangements and the recommendations of the final report of Financial Services Royal Commission.

This alert summarises the key reforms proposed by APRA and the implications for APRA regulated entities.

The Draft Standard is subject to a 3 month consultation period. APRA intends to issue a final standard in late 2019 or early 2020 and it is expected to come into effect on 1 July 2021 (subject to the application of any transitional arrangements). As is usual, submissions made during the consultation process will inform the final standard.

1 Summary of key points

APRA does not propose to constrain the overall amount of variable remuneration that can be paid nor does it propose any caps on the value of variable remuneration (either in absolute or relative terms). These remain the domain of the board/company. However, the Draft Standard proposes materially enhanced and more prescriptive requirements around remuneration design features and governance.

APRA acknowledges that implementation of the new standard will require changes to existing remuneration practices and will incur cost to implement. APRA also acknowledges that this may affect how entities compete for and retain skilled staff and that there are differing views on some proposals (including whether shareholder/investor groups would be in support) but considers these are appropriate trade-offs to ensure the long term financial soundness of APRA regulated institutions.

APRA's key proposed reforms are:

(financial metrics) financial performance measures must not comprise more than 50 per cent of performance criteria for variable remuneration outcomes;
(deferral and clawback) the introduction of minimum deferral periods of up to 7 years for the variable remuneration of senior executives in larger entities, and claw-back periods of up to four years for vested remuneration; and
(governance) boards must approve and actively oversee the entity's remuneration framework, remuneration policies for all employees (not just senior executives), and their effective application.

The new mandatory deferral periods and requirement for clawback will only apply to "significant financial institutions" (SFIs). The criteria for determining an SFI remains subject to consultation but APRA proposes SFIs will comprise ADIs (with assets >$15bn), general and life insurers (with assets >$10bn), RSE licensees (with assets >$30bn) with private health insurers not proposed to be included as SFIs subject to further review.

2 Overview of the key proposals

Key Area[1]	Current APRA standard	Key proposed change	Impact on entities generally
Remuneration framework covered by APRA's standards	Remuneration policy for senior executives and limited additional staff only.	Remuneration policy for all arrangements, supported by remuneration objectives and a broad framework.	Broader scope of the new standard will require more comprehensive assessment of end-to-end remuneration design and outcomes.
Board oversight	The Board must approve the remuneration policy. The Board has responsibility for reviewing and approving remuneration recommendations for senior executives and limited other staff.	The Board must approve the remuneration policy, actively oversee the remuneration framework, approve the remuneration of senior executives and other roles and ensure risk outcomes are reflected in remuneration outcomes.	More direct oversight role for Boards. Direct role in setting clear accountability for poor outcomes. Greater use of authority and discretion to achieve objectives. Greater role in ensuring appropriate consequences for poor risk and conduct outcomes.
Variable remuneration design	Variable remuneration for special categories of employees must be designed to allow adjustments to reflect business outcomes, risks inherent in business activities and incorporate appropriate time for performance to be realised.	Minimum design requirements for all employees, which promote prudent risk management and support remuneration objectives. Financial measures limited to 50% of performance criteria for variable remuneration and are individually capped at 25%. Constraints on deferral and vesting set for SFIs.	Determination of meaningful non-financial measures. Lengthening deferral periods will require changes to existing structures. Extension of regulated employees including beyond the cohort of accountable persons under BEAR. This will result in remuneration implications for a broader group of employees.
Outcomes management	Remuneration policy must allow the Board to adjust variable remuneration downwards to zero if appropriate for employees in special categories.	Require adjustments to remuneration outcomes to align with risk outcomes; stronger review and oversight. Clawback to apply to senior roles in SFIs.	Alignment of remuneration and risk outcomes may require significant investment in capability and cultural change. Review and amendment of employment contracts and variable remuneration plans to ensure clawback provisions can be enacted.
Review	Remuneration policy must be reviewed on a regular basis.	Annual compliance reviews and triannual effectiveness reviews of the remuneration framework.	Conducting insightful reviews and acting on the insights gained will require additional resources.
Transparency	No requirements other than for authorised deposit-taking institutions (Pillar 3).	APRA intends to propose additional measures for reporting and public disclosure of executive remuneration and will consult on potential measures in 2020.	More comprehensive analysis and accountability of how an entity's remuneration framework is applied.

3 Deep dive into some of the key elements of the Draft Standard

3.1 Variable remuneration design and outcomes

Performance measures applying to variable remuneration

APRA proposes to limit the use of financial measures in variable remuneration policies and promote the use of a broader suite of measures including non-financial and risk based measures. Financial performance measures will be capped at 50% and an individual financial performance measure must not comprise more than 25% of the total measures used. This applies across the entire organisation and across the total amount of variable remuneration (not individual components).

The balance of the performance measures are to be non-financial. Specific measures are not prescribed but they should be appropriate for the business and support 'sound incentives'. APRA will not identify metrics that are more appropriate or suitable. 15 examples of non-financial metrics are outlined in the APRA consultation paper, drawing on international experience across matters addressing operational control, customer outcomes, market integrity outcomes, reputation and alignment with strategy and values.

Using Board discretion as an overriding 'modifier' to determine and make adjustments is noted (and neither endorsed or rejected) and feedback on this approach is sought through the consultation process.

The Draft Standard also requires that variable remuneration outcomes are linked to and supported by an entity's performance management system, code of conduct and consequence management processes.

Extended deferral periods for SFIs

APRA is proposing more extensive provisions for the deferral and vesting of variable remuneration for specified personnel of SFIs. For CEOs, senior managers and highly paid material risk takers in these entities, a substantial portion of variable remuneration is to be deferred as follows:

CEO: 60% of variable remuneration must be deferred for 4 years without vesting, followed by 3 years of pro-rata vesting (7 year total deferral).
Other senior managers and highly paid material risk takers: 40% of variable remuneration must be deferred for 4 years without vesting, followed by 2 years of pro-rata vesting (6 year total deferral).

These requirements will not apply in respect of a person whose variable remuneration does not exceed $50,000 tracking the equivalent monetary threshold for the variable remuneration provisions under the BEAR regime.

There are further 'at risk' periods where vested equity will be subject to clawback – see below.

There is a suggestion that accelerated vesting for ex-employees can only be limited to death, serious incapacity, serious disability or serious illness and ex-employees must remain subject to the same vesting conditions as current employees.

Adjustments – forfeiture/malus and clawback

Remuneration arrangements must remain sensitive to risk outcomes which can require adjustments that are made 'in period' (ie within the performance year), during a vesting period (ie forfeiture/malus) or after vesting (ie clawback).

Clawback periods for senior executives/staff are 2 years post vesting and a further 2 years where an individual's circumstances are under investigation. The practical limitations of clawback are noted but not seen as an impediment although longer deferral periods somewhat mitigate this practical concern.

The Draft Standard specifies that minimum forfeiture and clawback events must include:

Malus: significant downturn in financial performance, misconduct or negligence resulting in losses, significant failure of financial or non-financial risk management, breaches of the employer's code of conduct and significant adverse outcomes for customers or counterparties;
Clawback: material misstatement in financial statements, failure to meet APRA 'fit and proper' requirements, failure of accountability and breach of compliance obligations including in relation to misconduct risk.

Clawback only applies to SFIs.

3.2 Governance arrangements and the role of the Board

Expanded 'remuneration framework'	The prudential standard will apply to a broader range of employees and, effectively, across the entire remuneration framework (rather than a limited set of employees as is the case now). The 'framework' is described as policies, systems, processes and practices that support remuneration outcomes. Remuneration objectives need to be clearly spelt out and must act as the foundation for the framework and underpin the management of risks.
Role of the Board and Remuneration Committee	Currently, under APRA's prudential guidelines, the Board need only approve the remuneration policy and to adjust performance based remuneration in limited circumstances. The Draft Standard proposes stronger Board oversight and engagement by mandating: Board responsibility for the overall remuneration framework, as opposed to individual remuneration policies; Board involvement in remuneration arrangements and outcomes for the CEO and all senior executives/key staff – that means the Board must approve the remuneration outcomes of all these people on an individual and collective basis; the Board establish a clear link between remuneration arrangements and prudent risk management to ensure risk outcomes are reflected in remuneration outcomes – the practice of consulting the Board Risk Committee and CRO flows from this; and the Board be more actively involved in dealing with misconduct or compliance issued when variable remuneration outcomes are being determined. The Remuneration Committee must obtain comprehensive reporting that will allow it to assess whether remuneration outcomes align with the company's remuneration objectives and must have free and unfettered access to other Board Committees, risk and financial personnel and to engage third party experts. The Remuneration Committee must provide clear guidance to senior management on the appropriate level and timing of risk adjustment outcomes.
Regular review	At least an annual review of the remuneration framework and a comprehensive review by an "operationally independent" person at least every 3 years.
Transparency	Additional public reporting on executive remuneration is raised as a potential additional and new requirement (in addition to the remuneration report) but this will be subject to a later consultation process.

We would be pleased to discuss the implications of Draft Standard with you or assist with any submissions you may wish to make as part of the consultation process.

KWM executive remuneration team

[1] This table is based on the equivalent table in APRA's discussion paper "Strengthening prudential requirements for remuneration", which accompanies the release of the Draft Standard, page 7.