FSA issues draft pay code

Last October, Financial Services Authority chief executive Hector Sants sent a ‘Dear CEO’ letter to around 28 financial services companies and banks on the hotly-debated link between remuneration and risk management.

In it, he said the FSA was not interested in setting new remuneration levels, writing new regulations, or coming up with strong guidance against which banks and trading companies could benchmark their pay policies. Instead, it intended only to “assist and encourage” firms to review their remuneration practices.

However, to coincide with the unveiling of HM Treasury’s Asset Protection Scheme it has now published its draft code of practice on remuneration policies, setting out in stronger-than-expected terms what its subjects must do to avoid unwanted attention from the regulator. Scheme beneficiaries are required to adjust their policies accordingly.

The FSA urges compensation committees, executive boards, risk managers, compliance and HR departments to work together to forge a stronger relationship between pay and risk from the outset of structuring individual and team remuneration packages. All FSA-regulated companies will be required to adopt the code, which will be published in full shortly.

The draft sets out ‘specific principles’ ­ on governance, performance measurement for the calculation of bonuses and long-term incentives, and composition of remuneration ­ aimed at compelling regulated firms to acknowledge the link between these functions and to curb “excessive” risk-taking.

“If a firm’s remuneration policies are not aligned with sound risk management, it is likely that those policies will provide incentives for employees to act in ways that might undermine it,” the FSA says. “The need for firms to offer competitive remuneration packages is recognised, but industry comparators should be a secondary rather than a primary factor in the determination of remuneration policies.”

Some of the draft code gives strong direction on what it will look for from financial companies and some of it refers to the need for directors to link best practice with ethics. The FSA says the code will not concern itself with remuneration levels as such; this, it says, is a matter for boards.

Governance
The draft states that boards and relevant remuneration committees should have the skills and experience to reach an independent judgement on the suitability of the remuneration policies, including the implications for risk and risk management.
• Remuneration committees (or equivalent bodies) should normally include one or more independent non-executive directors with practical skills and experience of risk management. The risk function should provide these individuals with regular reports on the implication of the firms’ remuneration policies for risk and risk management.
• Non-UK firms with UK subsidiaries will be expected to have a body of oversight for remuneration policies to assess risk links within that subsidiary.
• It may ask firms to provide an annual statement on remuneration policies, including the implications of policies on the firm, assessment of their impact on behaviour and group risk profile. The FSA may seek to discuss the report with the chair of the remuneration committee and for this to be made available to shareholders ahead of the annual vote on director remuneration.
• Risk, compliance and HR should have “significant input” in setting compensation for business areas.
• Compensation for risk and compliance staff should be determined independently of the business areas and they should have different performance criteria.

Performance measurement
• Measurement of performance for long-term incentive plans, including those based on share performance, should be risk-adjusted.
• Common measures of share performance including earnings per share and total shareholder return are not considered to be adjusted for longer-term risk by the FSA. It is to press for a review of the use of unadjusted share performance measures in longer-term performance-based remuneration schemes in the corporate sector.

Composition of remuneration
• The fixed component of remuneration should be a sufficiently high proportion of total remuneration to allow a fully flexible bonus policy. If the fixed component (ie, base salary) is too low a proportion, it will be much more difficult to cut or scrap bonuses in a bad year.
• In the case of bonuses that are a significant proportion of the fixed component, it would be good practice for not less than two-thirds of that bonus to be deferred for a minimum vesting period appropriate to the nature of the business and its risks, and that the deferred element be linked to future performance at the relevant division or unit overall.
• Deferred compensation paid in stock meets the code if the scheme meets appropriate criteria, including risk-adjustment of the stock performance measure in its guidance on measurement performance for bonus calculation. Deferred compensation paid in cash should be subject to performance criteria too.
• Linking remuneration composition structures to future performance of a business unit or division is “usually preferable” to future performance of smaller departments or teams.
“Most business undertaken in banking is subject to future risk and uncertainty,” the FSA says. “If variable compensation is paid out without any link to future performance, the employee has less incentive to take future risk into account and the firm is exposed to the risk of paying out variable compensation which will prove not to be justified by results.”