This article was written by Andrew Gray and Sarah Mitchell
On 12 November 2020 APRA released a revised draft of the CPS 511 (Revised Draft Standard) being the proposed new prudential framework to regulate remuneration in APRA regulated entities (including ADIs, general insurers, life insurance companies, private health insurers and RSE licensees).
The Revised Draft Standard has been released by APRA in response to feedback received as part of APRA's consultation with industry following its release of the first draft standard in July 2019 (First Draft Standard) (see our earlier article on this). The Revised Draft Standard is accompanied by a Response Paper which outlines APRA's response to the first round of consultation on the Draft Standard.
This article examines the key changes to the First Draft Standard, the key implications for boards and areas of potential improvement to focus on through the further round of consultation.
There are some welcome changes to the proposed new framework in the Revised Draft Standard with APRA responding in a positive manner to industry feedback. The Revised Draft Standard adopts a more "principles based approach" removing some of the more prescriptive and highly criticised elements of the First Draft Standard. The key changes are as follows:
- In a widely expected move the much criticised cap on financial measures as criteria for variable reward (previously proposed to be capped at 50%) has been replaced by a more principles based requirement which requires determination of each component of a person's variable remuneration to give 'material weight' to non-financial measures where remuneration is performance related, with adjustments (to nil) for adverse risk and conduct outcomes, based on clearly defined risk criteria.
- There has been some reduction in the scope and length of mandatory deferral periods for regulated employees of significant financial institutions (SFIs) as follows:
|First Draft Standard||Revised Draft Standard|
|CEO||60% deferred for 7 years with pro rata vesting from year 4.||60% deferred for 6 years with pro rata vesting from year 4.|
|Senior Managers and Executive Directors||40% deferred for 6 years with pro rata vesting from year 4.||40% deferred for 5 years with pro rata vesting from year 4.|
|Highly Paid Material Risk Takers||40% deferred for 6 years with pro rata vesting from year 4.||40% deferred for 4 years with pro rata vesting from year 2.|
The deferral periods above may also include the period over which performance is assessed where the performance measures are forward looking which is a further improvement against the previous proposal and effectively reduces the deferral periods originally proposed by a further year.
These changes were made in response to significant industry concerns regarding the potential impact on staff recruitment and retention noting similar requirements do not exist outside of APRA regulated entities.
- Clawback – the requirement for the introduction of a clawback mechanism for SFIs (for 2 years post vesting of variable remuneration) has been retained notwithstanding the wide spread concerns regarding the practical and legal impediments to enforcing clawback arrangements. APRA has taken on board some feedback by qualifying the circumstances in which clawback is required by adding a materiality threshold to reflect that clawback should only be a tool utilised in exceptional circumstances and have also removed the requirement to extend the clawback period for a further 2 years where an employee is under investigation which would have left remuneration at risk for a period of up to 10 years for a CEO. However, the criteria are still potentially wide ranging and no action has been suggested to address the difficulties enforcing these mechanisms.
- Board oversight and governance – while industry recognised the need for board oversight of remuneration in the previous consultation, concerns were raised regarding the burden this may impose on boards and the risks of requiring the board to step into an area or management decision making. APRA has responded by confirming that the board should only be required to approve individual remuneration outcomes for the CEO, senior managers and executive directors and that the remuneration for highly paid material risk takers (HPMRTs) may be approved on a cohort basis. The definition of HPMRTs has also been narrowed. The Revised Draft Standard retains the requirements for both annual compliance reviews and triennial reviews to ensure a "deeper dive" into an entity's remuneration framework.
Reporting and Disclosure
APRA plans to introduce reporting and disclosure requirements for all APRA regulated entities to supplement existing remuneration disclosure requirements (eg the remuneration report for ASX listed entities and specific requirements that exist for superannuation entities and under 'Pillar 3' requirements).
APRA is considering the following enhanced reporting requirements:
- Remuneration governance and oversight: disclosure of qualitative information about remuneration policy, adjustment tools and the process to determine remuneration outcomes;
- Remuneration design and outcomes: disclosure of quantitative information (on a aggregated basis) for cohorts of employees;
- Consequence management: disclosure of quantitative information (aggregated for groups of employees) covering remuneration adjustment for employees.
APRA has invited feedback on these proposals raising a number of specific questions for consultation in the Response Paper.
These changes are likely to impose an additional compliance and reporting requirement on boards (similar to that which currently arises in respect of the remuneration report of ASX listed entities). If this is not carefully managed the disclosure of consequence outcomes may also lead to a public naming and shaming of executives which may present further talent risks for the industry and temper the use of remuneration adjustments as a consequence management tool (although reporting on an aggregate basis may reduce these risks). It is not entirely clear that the public disclosure of this information will serve any useful purpose other than leading to the usual shallow and uninformed critique of the proportionality of consequence outcomes by third parties who are not in a position to meaningfully appreciate and understand the range of factors a board will take into account when determining remuneration adjustments which are becoming increasingly prevalent in response to material risk issues (see our previous article on this topic).
Areas of focus
While there are some positive developments in the Revised Draft Standard there continue to be opportunities for improvement to deliver a more balanced response. The key areas of focus should be as follows:
- Ensuring alignment between various regulations: many of the elements of the Revised Draft Standard cover the same territory as the remuneration requirements under the Banking Executive Accountability Regime (BEAR) and the proposed Financial Accountability Regime (FAR) but there are material differences between the requirements. Although APRA is at pains to explain there will be consultation with Government to ensure alignment of these concepts a failure in the political process and inconsistent requirements in this area will present a complex regulatory mess which will be highly undesirable and the need for clear, uniform and consistent requirements should be an area of focus in the further consultation period and a baseline requirement before change is implemented;
- a reasonable transition period to allow employers to adapt to the new framework particularly given the magnitude of the change proposed and that APRA proposes to supplement the Standard with additional guidance which will need to be released in a timely manner to ensure industry has a workable understanding of the new requirements and can make the required changes to remuneration arrangements in a timely way that minimises the impact of this transition on individual employees;
- continued focus on the clawback requirements to ensure these mechanisms are only required to be exercised in genuinely exceptional circumstances. The inclusion of a "materiality threshold" does not really offer much practical guidance and APRA's statement in the Response Paper that clawback should only apply after other adjustment tools have been exhausted (which is a sensible approach) does not seem to be reflected in the language of the Revised Draft Standard.
- ensuring the proposed enhanced disclosure requirements do not present an unnecessary additional burden on boards or present a further risk to the attraction and retention of talent in an industry which is already becoming undesirable to work in due to a level of regulation that is out of step with other industries.
The consultation period for the Revised Draft Standard will close on 12 February 2021.
APRA proposes to release the finalised CPS 511 by the end of June 2021 with the finalised prudential guidance to support CPS 511 to be released by the end of 2021.
A phased implementation approach is proposed for CPS 511 as follows:
|Institution type||Proposed commencement|
|ADIs (or group headed by an ADI or authorised non-operating holding companies (NOHC)) that are SFIs – 1 January 2023||1 January 2023|
|General insurer, life company, private health insurer or RSE licensee that are SFIs (or group headed by such or an authorised or registered NOHC)||1 July 2023|
|All other APRA regulated institutions||1 January 2024|
Under transitional arrangements, CPS 511 is not proposed to apply to a person's variable remuneration if the opportunity to earn the variable remuneration arose before the commencement date of the new Standard. APRA has commented that the new standard will not require renegotiation of existing employment contracts at the commencement date of the finalised standard, but that all new and renewing contracts entered into after the implementation date must be compliant. APRA has indicated that it expects entities to start adopting the new requirements "as soon as possible, to ensure that there is a timely transition of all remuneration contracts to a stronger remuneration framework".
We will keep you informed of further developments in this area.