Remuneration CommitteeForum Position Paper 4 – August 2015Linking pay with performance

This paper is sponsored by:

This position paper is compiled from the discussions of the Remuneration Committee Forum working group comprising remuneration committee members and experienced remuneration advisors. The information contained in the position papers disseminated by the Forum is of a general nature and is not intended to address the circumstances of any particular individual or entity. The views and opinions of the Forum do not necessarily represent the views and opinions of the sponsor, EY, the Institute of Directors in Southern Africa and/or individual members. Although every endeavour is made to provide accurate and timely information, there can be no guarantee that such information is complete or accurate as of the date it is received or that it will continue to be accurate in the future. No reliance should be placed on these guidelines, nor should any action be taken without first obtaining appropriate professional advice. The Forum shall not be liable for any loss or damage, whether direct, indirect, and consequential or otherwise which may be suffered, arising from any cause in connection with anything done or not done pursuant to the information presented herein. Copyright rests with the Forum, and extracts of this paper may be reproduced with acknowledgements to the Forum.

The Remuneration Committee Forum (the ‘Forum’) is constituted as a forum of the Institute of Directors in Southern Africa (‘IoDSA’), and is sponsored by EY. The activities of the Forum have specific focus on the governance, accountability and role and duties of remuneration committee members.

The objective of the Forum is to serve as a platform for dissemination of guidance to remuneration committee members. Such guidance will typically cover the following:

• Matters that relate to the function, duties and composition of remuneration committees; and

• Matters concerning remuneration committees in the public domain.

The dissemination of such guidance will typically take the form of position papers and roundtable discussions.

Forum meetings are chaired by a representative from the Sponsor. The current members of the Forum are:

• Mr R Harraway EY (Chair)• Mr T Anderson Independent • Mr C Blair 21st Century• Mr D Couldridge Element Investment Managers• Mrs J Cuffley Orient Capital• Ms J Dixon IoDSA (Secretariat)• Mr A Johnston Altron Group Ltd• Mrs M Machaba–Abiodun EY• Ms P Natesan IoDSA • Dr R Nienaber South African Reward Association (SARA)• Mr B Olivier Vasdex• Mr M Pannell HayGroup• Ms S Tosh Standard Bank • Ms V Vandayar IoDSA

• Mr M Westcott PE Corporate Services

2

Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Purpose and scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

The remuneration model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Assumption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

The ‘strategy-remuneration’ chain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Understand value creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Set the remuneration philosophy and policy . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Develop the performance measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Implications for disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Trade-off decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Final thoughts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Appendix A:

Categories of non-financial measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Appendix B:

Getting performance based pay right – Trade-off decisions . . . . . . . . . . . . 10

3

Introduction There is currently much criticism directed towards executive pay . This criticism generally falls into one or more of the following categories:

• the level of total remuneration is not aligned with the level of performance;

• performance and value creation is not defined or understood . Consequently, the performance measures used to assess organisational performance and inform incentive awards do not align with value creation for stakeholders;

• the incentive scheme motivates short term behaviours at the expense of long term value creation; and/or

• the incentive scheme could result in excessive risk taking .

The first two categories above have been confirmed as top focus areas by Remuneration Committees in 2012, 2013 and 20141 . The challenge of aligning pay with performance is becoming more complicated given an uncertain global economy, increasing shareholder activism, the short term performance demands of shareholders and regulation . This is further compounded by the increase in external pressures on organisations to conform to a pre-approved list of incentive scheme design features driven by peer group analysis and proxy adviser guidelines .

When pay runs away from performance, trust in the organisation is damaged by the perception of unjustified rewards to executives, particularly in contrast with the experience of the wider workforce . Effective Remuneration Committees know that linking pay with performance is a legitimate expectation of stakeholders and understand that regular reviews and modifications to the incentive scheme are necessary . Investor confidence will be gained when the Remuneration Committee makes the effort to transparently communicate continuous improvements in the annual integrated report with the intention of seeking better alignment . By ensuring alignment with performance, responsible remuneration can be delivered to executives .

Ultimately, shareholders will support sustainable value creation over the long term through appropriate incentive schemes that support the specific business strategy .

Purpose and scopeThis paper has been developed to provide practical guidance to Remuneration Committee members on linking executive pay with performance .

This paper is more relevant for profit seeking organisations, and is not intended to detail recommendations on incentive scheme design, or the merits of any particular incentive scheme vehicle, performance measure or performance management methodology . It should be read together with the King Report on Corporate Governance for South Africa and King Code of Governance Principles for South Africa 2009 (collectively referred to as ‘King III’) and its related Practice Notes2 .

Background

The remuneration modelIn South Africa, remuneration is characterised by two elements:

• Guaranteed remuneration: This is delivered through either ‘basic salary plus benefits’ or a ‘total fixed cost to organisation’ approach; and

• Variable remuneration: Variable pay is the main vehicle for achieving ‘performance-based pay’ . Variable pay is typically delivered through a short and a long term incentive scheme . The use of share based incentive schemes in particular has grown over the past two decades which has contributed significantly to the total value of remuneration delivered to executives .

AssumptionFor the purposes of this paper it is accepted that incentives increase levels of commitment and higher levels of incentives will have a greater performance impact than lower levels . The assumption is therefore made that executives are motivated by inter alia money .

1 . EY 3rd Remuneration Governance Survey: 20142 . http://www .iodsa .co .za/?page=kingIII

4

The ‘strategy-remuneration’ chain The remuneration philosophy and policy should be driven by the business strategy and informed by market practices . Figure 1 below illustrates this concept by outlining the steps that should be followed in order to align the business strategy with remuneration . The remuneration philosophy is the foundation to the design of the incentive scheme which should then deliver outcomes in line with the business strategy . The incentive awards should be regularly tested against the intended outcomes and continuous improvements made to ensure alignment with business results .

Effectively linking pay to performance is founded on an understanding of two fundamentally important concepts:

• Value creation: the Board and management should understand how value is created; and

• Value creating performance measures: the Board and management should identify those measures and targets that correlate with performance . The incentive scheme should be designed to reward achievement against those targets .

Understand value creationRevisiting the basic valuation of the organisation is a helpful starting point to understand how the organisation creates sustainable value over the short, medium and long term and therefore to inform the development of the ‘performance measures or targets’ . A value driver analysis will ensure that both board members and management have the same understanding of what drives value in the organisation, the timeframes over which value will be delivered and how it will be measured .

As mentioned previously, a common criticism of executive pay is that too little emphasis is placed on understanding how the company creates value . Without this, there is the danger that pay could be linked to inappropriate performance measures, driving management to pursue non-value adding initiatives or to take excessive, short term focused risks in an attempt to achieve the targets .

Typically, value drivers are incorporated into the organisation’s strategy and cascaded to the business units, the departments and individual targets to ensure that the jobs and activities of all employees are aligned with the overall organisation strategy .

Consistent with an integrated thinking of performance, value creation should include an understanding of how value is created through all forms of capital: financial, manufactured, intellectual, environmental, human, social and relationship, and natural3 . Creating a healthy corporate culture can be as powerful a driver of organisational value as financial measures such as profitability or return on assets . Additional categories of non-financial measures are included in Appendix A .

Value drivers tend to be lead indicators of performance, are predictive in nature, and allow the organisation to make adjustments based on results . They may prove difficult to identify and capture . Examples of lead indicators of performance include: hours spent with customers; number of sales calls; proposals written; absenteeism; response time; safety training; and development work on new products or endeavours .

Ultimately, the pay outcomes should be linked to shareholder value creation over the long term . Shareholder value over the longer term is typically measured by the absolute and relative appreciation in the share price and dividends, namely ‘total shareholder return’ (‘TSR’) .

3 . International Framework of the Integrated International Reporting Council

Figure 1: The ‘strategy-remuneration’ chain

1. Context 2. Design 3. Deliver

Understand the market

and business strategy

Understand how value is

created

Set the remuneration

philosophy & policy

Develop the measures and

targets

Design and model the incentive scheme

Assess performance

against business results

Communicate the pay results

Implement the incentive

plan

Review & Improve

5

Set the remuneration philosophy and policy The remuneration philosophy defines the objectives and purpose of each remuneration element, the proportion (‘pay mix’) of each of those elements in total remuneration, the chosen competitive stance, and critically how the remuneration strategy supports the unique business strategy and plans .

Each remuneration element carries different strategic intentions . Long term incentives aim to reward the achievement of performance measured over a period of at least three years from the time of the award, whilst short term incentives typically reward performance measured over a year . When considering the pay mix, the Remuneration Committee determines how much should be fixed and how much should be variable, as well as the balance between long and short term incentives . This mix depends on the maturity of the organisation, its business strategy and the level of the employee . For instance, a start-up organisation may have a higher proportion of variable pay to guaranteed pay compared to a more mature organisation . Staff below executive level will typically qualify for less variable pay opportunity as a percentage of the total remuneration package .

A performance-based executive remuneration philosophy will generally contain the following features4:

• increases to guaranteed pay/base salary and variable pay awards are not an entitlement – they are contingent on and vary with achieving or exceeding predefined performance targets . The pay for performance link is enhanced where incentive awards have value only once targets are met . Where the targets are exceeded, more than the target incentive would be paid, and is sometimes subject to a maximum . Where the targets are not achieved in full, a pro-rata incentive is paid, but typically only if a threshold performance level is achieved;

• performance conditions apply to the vesting of all or a substantial portion of long term incentive awards;

• payment of a portion of the short term incentive may be subject to a deferral over a period beyond a year;

• there is differentiation in pay between high and low performers . To achieve this, incentive awards are made once there has been a moderation and/or cross calibration exercise assessing the performance of employees on a relative basis . Thus, many employees may not get an award or an increase . Consequently, a robust performance management system should be in place that is fairly and consistently applied across the workforce . This also helps to ensure equal pay for work of equal value;

• non-performance based pay such as retention awards, sign-on and loss of office payments receive separate and transparent justification and disclosure;

• incentive schemes contain claw back provisions allowing for recoupment of remuneration in the event of financial or governance failures or accounting restatements; and

• benchmarking remuneration to a comparable peer group is used only as a guideline of what the market is willing to pay at certain levels of performance .

Develop the performance measuresOnce the value drivers have been identified, the value creating performance measures and associated targets should be developed . These performance targets will then be included in the design of the incentive scheme . This linkage makes pay-for-performance possible and will result in an employee’s achievements being aligned to the objectives of their job and of the business strategy .

Compared to a value driver analysis, performance indicators focus on results, normally characterising historical performance, and are normally easier to identify and capture . Examples of performance indicators include: profitability measures; market share; revenue, recordable case rates in safety records and quality of products or services rendered .

4 . See the IoDSA Position Paper 2: The Remuneration Policy

6

The choice of performance measures should be guided by the following principles:

The choice of performance measures should be guided by practical considerations, such as:

exerting effort is not the same as achieving targets or results – care should be taken to avoid rewarding for effort; measures that focus on operating performance can be more reliable than accounting measures . Operating performance measures are less susceptible to accounting distortions from once-off events such as asset impairments and restructuring charges that are non-operating . For example, EBITDA is a better measure of the profitability of the operations than net income and will give a truer measure of the impact of a challenging market on the operations; the choice of measures should be unique to the business and its business cycle . For instance, for an organisation in a turnaround position, critical employees can become a ‘flight risk’ due to the uncertainty and the ‘soft’ value of their unvested long term awards . To help maintain focus the strategic goals should be emphasised in the short term incentive . Time vesting for immediate retention value and internal absolute focussed performance measures in the long term incentive scheme could be appropriate . Early-stage high-growth companies may have a focus on research and development and generating revenues and market share . Late stage, maturing companies may have a focus on revenue and cash generation; and the financial measures should align with creating value in excess of the cost of capital .

Implications for disclosureA transparent link between the business strategy, value drivers, the performance criteria for the incentive scheme, actual performance and actual total remuneration (‘the strategy-remuneration chain’) should be evident in the remuneration report . In this regard, a ‘value creation statement’ could be included in the financial statements, proving to stakeholders how the company creates value .

The main performance measures, the reasons for selecting them and how they support the strategy should be disclosed in the remuneration report . Disclosure of achievement against those targets should also be made . The remuneration outcomes and the remuneration policy should also be disclosed together in one place in the remuneration report .

Stakeholders will inevitably make pay-performance comparisons using the data provided in the remuneration policy and report . The pay-values disclosed in the remuneration report are a mix of actual base pay and benefits, short and long term incentives, and accounting grant date fair values of equity grants . The pay-values relate to different time periods . For instance, the value in respect of long term incentives relates to future performance or vesting periods . Comparing all pay-values to performance at year end is not appropriate and guidance should be provided in the report to address this .

Trade-off decisionsGetting performance-based pay right is a delicate balancing act that requires significant judgment in making the right trade-off decisions . This places a great deal of pressure on the Remuneration Committee in exercising that judgement . Appendix B lists a number of these decisions for further guidance .

Figure 2: Principles for choosing performance measures

Linked to the value drivers

• Cascaded from the value driver analysis

Quantitative • Quantifying both financial and non-financial performance measures removes subjectivity and conveys the same meaning to all

Accessible • The measurement data should be easily accessible • The measure should not involve a costly system to collect data

Easily understood • If the chosen measure is difficult to understand/communicate it will not provide the desired result

Relevant • The measure should accurately depict the objective to be evaluated• Avoid compound indices as much as possible as they tend to hide the details

Common definition • The meaning of the measures chosen should be understood by the entire organisation in the same way

7

Final thoughtsThere is no one way to demonstrate alignment between pay and performance . However, it is best to employ both quantitative and qualitative techniques to demonstrate this alignment, for instance:

• quantitative approaches involve the choice of the right performance measures in the incentive scheme design; and

• qualitative approaches focus on the right pay mix, and the techniques for clear and transparent disclosure of the link between pay and performance .

To meet their collective responsibilities, the Board and the Remuneration Committee should consider the following practical steps:

• schedule time in the annual work plan of the Remuneration Committee to have sufficient upfront engagement with management on the business strategy, so that the targets and performance conditions can be formulated5;

• develop consensus with management on the measures that will be indicators of the success/failure of a chosen strategy and business plan;

• plan periodic reviews throughout the year of the target-setting process to ensure that there is appropriate rigour and scrutiny to the targets and associated pay-outs . Ensure management provides a robust internal and external analysis of target difficulty (based on analyst expectations, strategic goals, historical performance, forecast of future economic conditions, or peer group analysis of relative performance);

• conduct ‘what-if ’ analyses on the ranges of potential performance and the impact on possible pay-outs (both upside and downside) . Targets should be approved only after there has been sufficient questioning of the up and downside potential (modelling) and the likely value of the pay-outs under a given set of assumptions . This should be conducted before the design is finalised;

• ensure that there is a regular assessment of ‘reward risk’ to ensure that the incentive schemes work as intended;

• get ‘beyond the money’ . For staff with satisfactory cash remuneration, non-financial motivators can be more effective than extra cash in building long term employee engagement . Remuneration Committees should continuously assess the balance of financial and non-financial rewards and should be willing to challenge conventional wisdom that ‘money is what really counts’ . Non-financial rewards typically require more interaction and time commitment between managers and staff;

• effective scheme communication . Participants in the incentive scheme should know what is being measured and how, before the measurement period begins . They should also receive regular reports during the period on progress against the targets . The communication should endeavour to show how individual performance is aligned to the identified performance measures; and

• minimum share ownership and holding requirements for executives can be effective ways for aligning the interests of executives with shareholders . The benefit of long term share incentive schemes is lost when executives sell the shares they have been granted . Given the difficulty of predicting future per¬formance over the next five or more years, focusing on beneficial ownership and holding requirements, potentially even past termination or retirement, is sensible and can also act as an ‘economic claw-back’ when corporate performance is overstated .

5 . See the IoDSA Position Paper 1: A Framework For Remuneration Committees, Appendix A

8

Appendix A: Categories of non-f inancial measures Business development (new products, clients, markets, geographies)

Community engagement/corporate social responsibility

Competition/market share

Corporate culture

Customer satisfaction

Employment Equity or BBBEE

Employee engagement levels

Environment, health, and safety

Ethics

Executive talent management/succession

Human capital

Innovation/innovative culture

Legal/regulatory compliance

Logistic capabilities

M&A execution and integration

Operations

Product quality

Project milestones

Reputation

Risk management

Sustainability

Safety performance

Tone at the top (leadership)

9

Appendix B: Getting performance based pay right – Trade-off decisions

Trade-off decision Description

1‘Performance risk’ vs ‘retention risk’

‘Performance risk’ is the risk for the organisation and shareholders that reward is not appropriate in light of the performance achieved . This can result from poorly designed incentive schemes that motivate short term behaviours at the expense of value creation or that result in windfall or ‘unearned’ remuneration .

‘Retention risk’ is the risk of not providing enough variable pay opportunity and can lead to a loss of talent .

The design of the incentive scheme should provide enough performance leverage with sufficiently challenging targets so as to motivate executive decision making that is not excessively risky and detrimental to the long term value of the organisation and also does not encourage a ‘pay for pulse’ culture .

2

‘Line of sight’ vs accountability and absolute vs relative

‘Line of sight’: Executives should have control of, or the ability to influence, the performance measure . Performance measures that are relative or based on market fluctuation or share price movement are not in their ‘line of sight’ .

Accountability is more easily driven by absolute measures as they are more controllable and can directly link to the business strategy .

Relative performance measures require no forecasting of the future . Relative measures can lower the risk of paying too much when the market is rising, but will still pay something when the market is down .

3Internal vs external

Performance measures should have a balance of internal (organisation) and external (market) measures .

Using market based measures, such as share price performance, to measure executive performance can be challenging since share prices are highly sensitive to investor expectations and macro-economic factors over which management has limited control . Market-based measures can increase the objectivity of the measures, such as sovereign ratings or customer satisfaction survey ratings .

A scheme based on TSR aligns interests with shareholders, but not necessarily with the business strategy . A scheme based solely on internal measures could align with the business strategy, but could also pay out in a year that shareholder returns are low because the overall share market is down . If however the company’s TSR outperforms those of its peers (i .e . on a relative basis), this may be acceptable .

4

Financial vs non-financial performance measures

Consistent with a holistic and integrated understanding of performance, performance should be defined by a balance of financial and non-financial (strategic or qualitative) measures .

Relying too much on financial targets risks putting short-term success ahead of long term sustainable performance, often measured by demonstrated values or other qualitative measures .

Non-financial measures could be used as modifiers or gatekeepers (or circuit-breakers) . Modifiers may be employed in the design of incentive schemes after certain quantitative thresholds are met and act to enhance or decrease incentive awards . It may also be appropriate to have the achievement of predetermined non-financial measures, such as health and safety indicators, as an overriding condition (‘gatekeeper’) before any incentive can be awarded . See Appendix A for examples of categories of non-financial measures .

10

Trade-off decision Description

5

Motivating executives vs satisfying shareholders

Most goal-based incentives are payable for performance above a minimum expectation . In these cases, a range of performance options is approved each year by the Remuneration Committee which includes threshold and stretch performance levels, which in turn equate to a minimum and a maximum (capped) pay-out .

Setting incentive goals at the appropriate level of difficulty and predictability is essential to the success of the pay-for-performance objective . The goals need to be difficult enough to motivate superior performance and meet shareholder expectations, without being out of reach of the executives . The pay opportunities should then be linked to the performance levels .

Setting the performance options on a performance/pay-out scale requires significant business judgment on:- The performance range: both symmetry and width around the target; and- The slope (or ‘leverage’): the pay-out opportunity calibrated to the performance achieved .

Where there is more difficulty or predictability in setting the performance range, the range should be wider, between threshold and maximum performance . This will increase the probability of hitting performance within the range, and hence motivation, but the incentive opportunity should also be lower .

6 Long vs short term

The right balance between short and long term targets can positively impact the short term retention of executives and the long term sustainable performance of the organisation .

Whilst both the short and long term measures should be consistent with value creation for shareholders, they should ideally not be duplicated, as this can cause a double incentive payment .

7

Formulaic vs discretionary (both positive and negative)

The Remuneration Committee should always have the final decision, subject to Board ratification, on whether awards should be made under the incentive scheme to protect against unforeseen events .

Discretion in deciding pay-out levels should however be limited, and the boundaries should be disclosed to shareholders .

When it is exercised, it should be easily explained, particularly when increasing any pay-out levels .

Where there is more uncertainty in setting reliable performance ranges there may be a greater need for discretion .

Formulaic awards can result in inappropriate incentives, as they are never perfectly in line with intended pay-outs and can result in either windfall gains that are not ‘performance-based’ or in no pay-out despite excellent performance .

Unfettered and arbitrary discretion should be avoided .

8Simplicity vs complexity

Striking the right balance between focus and complexity is a real challenge in the design of incentive schemes . A scheme that is too simple may not address enough of the nuance and complexity in the business . An over-engineered scheme loses its effectiveness in driving the right behaviour .

Measures and targets don’t need to be defined in a way that is highly detailed . Relatively few measures should be included in the design to ensure focused effort . On the other hand, it is necessary to include a mix of performance measures to avoid placing too much weight on a single metric that could be ‘gamed’ by management . For example, measures of performance based on accounting, shareholder, and absolute and relative aspects of performance should be considered together to provide a holistic and integrated view of business performance and value creation .

The targets should also include organisation and individual targets .

9 Growth vs return

The performance measures should have a balance of growth and return measures . Return measures include capital efficiency measures such as return on capital, return on assets, or return on equity . Growth measures include market share, revenue and number of customers .

The incentive scheme should not be focused solely on growth at the expense of returns . Early-stage companies will sometimes focus on growth and market share rather than returns . Acquisitive companies may be challenged to use return-based measures, such as return on equity, because there is often a delay between when capital is deployed and when the earnings develop .

11