CPS 511 Remuneration governance – halfway there?

28 June 2023

APRA’s CPS 511 Remuneration requires APRA-regulated entities (banks, insurers and superannuation RSEs) to make significant changes to remuneration governance systems supporting the design of remuneration arrangements and award of variable remuneration. The new prudential standard is already in effect for large ADIs and will apply to large insurers and superannuation RSEs from 1 July 2023.

CPS 511 requires entities to:

enhance Board remuneration governance oversight;
ensure the compensation paid to third-party service providers does not drive non-financial risk and conduct risks;
design variable remuneration (for all employees) that consider non-financial risk and conduct outcomes, reflects the time horizon of risk (i.e. should deferral occur?), and grants the entity a right to downwardly adjust variable remuneration outcomes in respect to financial risk and conduct outcomes;
defer substantial portions of variable remuneration for significant financial institutions; and
ensure that variable remuneration outcomes reflect the conduct and risk outcomes (not just financial outcomes) of the entity, including by applying in-period, malus and clawback adjustment.

The changes bring the regulation of Australia’s financial service sector pay and bonus more in line with some of Australia’s peers, particularly those in Europe and the UK.

CPS 511 has commenced progressively:

So what are the key lessons learned from the first 6 months of CPS 511’s implementation and how should that shape other entities’ implementation?

Key lessons learned

Based on our experience advising banks, insurers and superannuation RSEs, the key challenges implementing CPS 511 are:

The issue	The challenge	What good looks like
Third-party service providers	CPS 511 requires an entity’s remuneration policy to set out the entity’s approach to identify and mitigate conflicts between the compensation payable to third-party service providers and entity’s remuneration framework objectives. Determining which third-parties are ‘in-scope’, when a conflict arises, and what should be done about a conflict is challenging. APRA’s policy objective is to ensure that its entities do not circumvent CPS 511’s obligations on employee remuneration through the use of third-party service providers, and also to ensure third-party service provider compensation does not negatively impact customers and the entity’s risk profile.	Good implementation ensures that third-party service providers are: bound to comply with non-financial compliance and conduct standards; actively monitored to ensure non-financial compliance standards are complied with in practice; and subject to financial and non-financial consequence, where non-compliance with the entity’s expectations is identified.
Company group arrangements	It is common for group company structures to include a single employing entity, with the services of employees provided to the rest of the companies in the group. Complexity arises where only one entity in the group is APRA regulated and bound by CPS 511. Identifying the ‘specified role’ persons for that regulated entity is challenging, particularly where employees serve multiple roles and only one may be a ‘specified role’ for the APRA regulated entity.	Good implementation ensures: a thorough specified role assessment determines the persons who provide specified role services to the regulated entity; and a defensible method is developed to determine the proportion of the person’s variable remuneration regulated by CPS 511. APRA is silent on this point, so care is warranted.
Determining deferral proportions (and when!)	Senior executives tend to be eligible to receive variable remuneration under multiple schemes (STI, LTI, retention, sign-on awards, etc.). It is common for entities to inform senior executives at the start of a performance year of their STI target opportunity and prospective deferral outcomes to provide executives with cashflow certainty. Unlike BEAR, CPS 511 broadly defines variable remuneration to mean any remuneration that is conditional on an objective (including, service and performance based conditions). CPS 511’s deferral obligation will apply to ad hoc awards like retention, sign-on, and buy-out awards. Difficulties arise where prior deferral calculations are disturbed by the grant of ad hoc awards, or where there is a material overperformance under an STI award.	Good implementation ensures: variable remuneration is designed to minimise unanticipated adverse cash flow impacts for executives arising from unexpected deferral requirements (e.g. in respect of ad hoc awards), and the timing of vesting is able to be projected with reasonable certainty; deferral calculations are performed at the end of the performance year to ensure CPS 511 compliance; and consideration is given to whether a portion of each variable remuneration award in a year should be deferred, for consistency and simplicity.
‘Material weight’ and non-financial measures	For many entities implementation of non-financial performance measures as a performance or vesting condition that have material weight in remuneration outcomes is a new concept. Determining what measures to implement, what variable remuneration to apply the measures to, how they will be assessed, and when they will be assessed can be complex. Moreover, determining the weight (material weight must be given to non-financial measures cumulatively) to place on the measures is challenging.	Good implementation ensures: non-financial measures have a strong link to enhanced risk compliance and customer outcomes, and assist mitigation of conduct risk; non-financial measures are implemented in a manner that is transparent and simple, but are as challenging as a financial measure to achieve; and weight of the non-financial measures is around 30-35% of the total weight. For listed companies, it may be appropriate to consult with institutional shareholders and proxy advisers to explain the rationale for adopting specific non-financial measures and the benefit those measures generate for the business and shareholders.
Specified role identification	Some of the definitions used to determine specified role persons (e.g. senior managers) are complex and requires a factual assessment of persons’ roles in circumstances where there is very little guidance regarding the scope of the defined specified roles in CPS 511 or its guidance. For example CPG 511 unhelpfully states, “Senior manager is defined in CPS 511 and takes into account the impact that an individual can have on the business of the entity or an entity’s financial standing. Senior managers would typically include the direct reports of the Chief Executive Officer (CEO). For larger entities, it may be appropriate to include a range of executives from the next level below direct reports to the CEO.” Determining specified roles is a difficult exercise with significant consequences for those designated as specified role persons. Also, as some of the specific role definitions have changed since earlier prudential standard (e.g. material risk taker), re-examination of prior designations or identification frameworks may be required.	Good implementation ensures: individual roles (particularly to determine senior managers) are assessed, rather than relying on a hierarchical assessment of executive seniority; systems and processes are established to assess when a person commences and ceases to hold a specified role (including when they change between specified role classes – e.g. the highly-paid material risk taker), which is integrated into the deferral calculation controls; and all ‘risk and financial control personnel’ are identified and not just a subset of risk management, compliance, internal audit, financial or actuarial control personnel.
Deferral and vesting schedules	There is a surprising degree of complexity with respect to the deferral and vesting schedules in CPS 511, including the determination of the deferral period and deferral amount. CPS 511 represents a shift away from the approach that many ADIs adopted under BEAR by requiring deferral of variable remuneration earned in respect of a performance year, rather than the year in which variable remuneration outcomes are determined or paid. CPS 511’s approach is consistent with the requirement under the current FAR Bill. Entities will also need to ensure that any pro rata vesting is consistent with CPS 511’s requirements.	Good implementation ensures: consideration is given to vesting variable remuneration on a pro-rata basis as permitted by CPS 511, rather than the full deferral period; and variable remuneration offer documents clearly specify the deferral and vesting schedule for the award, and provision is made for delayed vesting in the event of an investigation in respect of a potential adverse risk or conduct event.
Importance of a cohesive remuneration framework	CPS 511 uses the undefined term ‘remuneration framework’ to describe the totality of processes and systems regulated as part of CPS 511. In addition to a written remuneration policy meeting the requirements of CPS 511, the practical reality is that a range of supporting documents describing the systems and processes to support remuneration governance are required to comply with CPS 511.	Good implementation ensures: the ‘approach’ to mitigating conflicts between third-party service provider compensation and the entity’s remuneration framework objectives is supported by guidance to assist managers identify and mitigate those conflicts in practice; consequence management systems and processes are robust to support conduct and risk related matters; and variable remuneration incentive plans and related documentation provide the entity with sufficient flexibility to ensure variable remuneration outcomes reflect the non-financial risk and conduct risk outcomes of the entity.

What next? – Board remuneration governance and oversight

CPS 511 requires enhanced Board remuneration governance in three key respects:

Information – the Board’s remuneration committee must receive ‘sufficient’ information about financial and non-financial risk and conduct outcomes over the period that variable remuneration is deferred (i.e. up to 6 years in the case of the CEO’s deferred variable remuneration). Most entities will tend to rely on formulaic quantitative assessments for the purposes of financial performance. For non-financial outcomes a qualitative assessment will need to be made in light of all of the non-financial risk and conduct matters over the relevant period. This will require appropriate input from the risk function to ensure informed variable remuneration decisions can be made.
Consequence management – in our experience entity’s consequence management frameworks tend to be focused on misconduct related matters. The challenge for Boards under CPS 511 will be to develop a mature consequence management framework that addresses poor management outcomes and accountability failings. Information and reporting arrangements to Boards will be key in supporting these arrangements.
Determination– Equipped with the information above, the Board must ensure that their variable remuneration outcome decisions align to the entity’s financial and non-financial risk outcomes. Entities should ensure that decisions have regard to all of the available factual material when determining variable remuneration outcomes, and that there is a documented basis for the outcomes in the event those decisions are later scrutinised by APRA.

What next? - Remuneration disclosure?

APRA has indicated that it will implement a remuneration disclosure regime associated with CPS 511 in the first half of 2023. After requesting industry consultation in late 2022, we anticipate that APRA will moderate their draft remuneration disclosure regime which was disproportionately burdensome. APRA’s remuneration disclosure policy goal appears to be that public disclosure will enable third parties to examine remuneration arrangements and variable remuneration outcomes (i.e. the media). If that eventuates, Board remuneration governance in the financial services sector will be in the spotlight even more than ever.

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