UK: Report on the impact of the Directors’ Remuneration Report Regulations
A report for the Department of Trade and Industry

1. Introduction and context

This ‘Report on the Directors’ Remuneration Report Regulations 2002’ (‘Report’), describes research undertaken by Deloitte and Touche LLP (‘Deloitte’) on behalf of the Department of Trade & Industry (‘DTI’) and according to terms of reference agreed with the DTI.

The ‘Directors’ Remuneration Report Regulations’ (‘Regulations’) apply to quoted companies with financial years ending on or after 31 December 2002. As stated by the DTI, the purpose of the legislation is to:

• enhance transparency in setting directors’ pay;

• improve accountability to shareholders; and

• provide for a more effective performance linkage.

The Regulations require quoted companies to produce a detailed annual directors’ remuneration report, and to hold a shareholder vote on that report. The first votes on the directors’ remuneration report took place at AGMs between March 2003 and March 2004.

In addition to the legal requirements of the Regulations, the Association of British Insurers (‘ABI’) and the National Association of Pension Funds (‘NAPF’) issue guidelines on executive remuneration that act as a reference point both for shareholders in engaging with companies and making voting decisions, and for companies in the design of their remuneration policies. The Confederation of British Industry (‘CBI’) has also issued best practice guidelines on severance packages, and the Combined Code, responsibility for which now lies with the Financial Reporting Council, also provides guidance on best practice in the governance of directors’ remuneration.

The purpose of this Report is to identify:

• the extent to which companies are complying with the Regulations;

• whether companies’ remuneration policies and practices have changed in light of the Regulations; and

• any areas where disclosure requirements could be further improved.

The Report focuses on the effectiveness of the Regulations, but takes note where appropriate of additional relevant governance frameworks, such as those of the ABI, NAPF, CBI and Combined Code.

The recommendations set out in this Report are based upon the views expressed to Deloitte by shareholders and on Deloitte’s analysis of the levels of disclosure in recently published remuneration reports.

The inter-relationships between shareholders (for the purposes of this Report the term ‘shareholders’ refers to larger mainly UK based institutional shareholders, who own the majority of UK shares) and companies in respect of directors’ remuneration policy matters are illustrated in the following diagram:

The Regulations provide a framework which assists shareholders to assess how well remuneration is governed. They are not and cannot be, in themselves, a substitute for governance.

The shareholder vote on a company’s remuneration report, which includes the forward looking statement of policy, provides the Board and its remuneration committee with an annual signal as to how strongly its intended policy, and its actual practice in the past year, are supported by its shareholders.

Meeting the requirements of the Regulations does not necessarily mean that the disclosure of a company’s remuneration policies and practices will be clear. Shareholders would like to see the rationale behind the policy explained in understandable terms. This is particularly the case in the context of large, complex, international and multi-faceted businesses.

As will be seen from the analysis of the current level of disclosure and the analysis of shareholder views later in this Report, most companies comply with most of the Regulations, and shareholders believe that the introduction of the Regulations has improved the level of disclosure. However, the analysis also shows that in many cases companies, while complying with the Regulations, rely on standardised language which may not be helpful. This suggests that regulation, in itself, does not necessarily lead to better explanations of either remuneration policy or practice.

The research in this Report seeks to distinguish between remuneration reports which comply with the minimum requirements of the Regulations, and those which go further and explain not only what the policy is, but why it is the way it is. Recommendations arising from the research recognise that there are some specific disclosures that could be improved by increased clarity in the Regulations but in other areas regulation may not be the best way to effect this.

Across different companies executive directors’ remuneration consists of various combinations of elements such as salary, performance-linked bonus, performance-linked shares or share options, and pensions. The design of the remuneration package and the balance of these elements will be influenced by the sector in which the company operates, the strategy and culture of the company, shareholder expectations, company and employment law, income tax rules and accounting standards.

It is not always easy to disclose and explain all of these elements in a straightforward and easily understood way. The range of different practices also means that it is impractical to codify all of the information that a shareholder may find helpful. The example below illustrates some of the communication complications in just two areas of remuneration.

In order to explain the cash elements of remuneration it might be ideal to have details of performance targets for the year ahead and the potential cash bonuses that might arise. In practice, executive bonuses are very often largely earned in relation to the level of profit achieved within a comparatively narrow range. However, information on a prospective profit target for the year ahead may be both commercially and market sensitive. It may therefore not be appropriate to disclose the exact nature of the link between a future bonus payout and the performance required to achieve it. Companies may feel less constrained in disclosing retrospectively what targets had been set for the previous year and the results achieved in respect of these targets.

It is particularly difficult to disclose the value of long-term awards made during the year. This is because the value will be dependent on whether performance targets have been met, as well as the share price at the time of vesting, which is likely to be at least three years from the date of award. Mathematical models such as the widely used ‘Black Scholes’ and ‘Binomial’ models may be used to estimate the values. However, the estimations that emerge from such models often deviate widely from the eventual actual values.

Communicating the gains made from previously awarded long-term incentives can also be problematic. An executive may have exercised¹ a share option in the past year and gained, for example, £100,000 in cash prior to income tax. However, that share option may have earned its value over a ten year period, during which time the executive will probably have contributed to the increase in share price. It could be argued that the executive has earned £100,000 from the sale of that option in the past year but it could be just as easily be argued that the £100,000 has been earned over a ten year period, which is roughly equivalent to £10,000 per year.

The main conclusions and recommendations are set out in the next section.

The DTI’s terms of reference directed Deloitte to focus on the FTSE 350, i.e. the 350 largest companies by market capitalisation listed on the London Stock Exchange as at August 2004.

The context for that focus is that the Combined Code (Section A.3.2) defines for its purposes any company outside the top 350 as ‘a smaller company’. Furthermore, the top 350 companies account for some 96% of all FTSE listed companies in financial terms, as measured by market capitalisation.

The top 350 companies are also referred to as the FTSE 100 (i.e. the largest 100 companies) and the FTSE 250 (i.e. the next largest 250 companies).

• Most of the top 350 FTSE companies are now complying with the Regulations – they are disclosing what the Regulations require.

• Beyond the basic requirements of the Regulations, the analysis suggests that about half of the top 350 FTSE companies use the remuneration report to communicate their remuneration policies in an effective way.

Are companies submitting their remuneration report to a vote at their Annual General Meeting, separately from votes on any other matters?

Are companies correctly disclosing what the Regulations require in the remuneration report?

Does the remuneration report enable shareholders to assess the effective linkage of remuneration to company performance?

Based on feedback from shareholders, the level of consultation between shareholders and companies has increased to a large extent as a result of the Regulations, and shareholders are also of the view that there has been significant improvement in the clarity of disclosure about directors’ remuneration.

The rate of change in a number of areas of remuneration policy in the last two years suggests that the Regulations have had an impact. These include:

• a rapid and almost complete reduction in directors’ notice periods to one year or less;

• a number of well publicised situations where remuneration committees have changed their policy or practice as a direct result of shareholder voting;

• insistence that performance conditions be taken into account in the vesting of share options and long-term incentive awards in the event of a change in control;

• more generally, scaling the vesting of awards so that only a proportion of any award will vest for a target level of performance, with full vesting requiring the achievement of more stretching performance; and

• the removal of the opportunity to re-test performance conditions in share option plans.

Although commentators have variously suggested that there is currently a degree of governance fatigue within the corporate sector which might be exacerbated by further regulation, the results of the analysis, and shareholder consultation, have identified areas currently not covered by the Regulations and ABI/NAPF/CBI guidelines where refinements to the current disclosure requirements could be considered.

Shareholders have indicated that the link between pay and performance is currently not sufficiently clear. However it is also apparent that shareholders’ preference is for improvements to be made through the development of industry guidelines such as those published by the ABI and NAPF, rather than through further regulation. Although the rate at which companies are responding to new guidelines published by the ABI and NAPF would almost certainly speed up if further regulations were introduced, it may be more appropriate to assess this again in one or two years’ time, in order to allow time for the Regulations and the guidelines to take full effect.

Additionally, the current wording of the Regulations could be improved in a number of places, in order to provide greater clarity as to what is required. The next sections of this Report set out the detailed findings, conclusions and recommendations reflected in the above summary.

The research, findings and conclusions set out in this Report are based on two strands of work, as agreed with the DTI:

• detailed analysis of companies’ latest annual reports undertaken by Deloitte; and

• a survey of the views of shareholders, institutional shareholders’ representative bodies, the Confederation of British Industry and the Investment Management Association (‘IMA’).

The survey involved completion of a questionnaire and a meeting at which issues arising were discussed in further detail.

The research did not involve direct consultation with companies. It is recommended that further consultation be undertaken with companies and with professional bodies of those directly involved in preparing remuneration reports, including the Institute of Chartered Secretaries and Administrators (ICSA), the Chartered Institute of Personnel and Development (CIPD) and the accounting bodies.

Twenty four institutional shareholders, the ABI, NAPF, CBI and IMA assisted Deloitte’s research through the provision of their views.

Appendix 1 ‘List of respondents to questionnaire’ provides details.

Appendix 2 ‘Respondents’ views on the Directors’ Remuneration Report Regulations’ provides details of the questions asked of the respondents, and summarises their responses.

Deloitte’s executive compensation research unit has studied in detail the disclosures of the top 350 companies regarding remuneration over a period of many years and has developed and utilised a five-level scale by which to rate the effectiveness of communication of a remuneration report. The perspective of this scale is from that of a reader who is reasonably informed and knowledgeable about the matters described in remuneration reports. It assesses the overall effectiveness of communication rather than strict legal compliance.

The Deloitte communications effectiveness analysis is explained in more detail later in this Report.

In a number of areas, in recognition of the wide variety of companies’ remuneration policies and practices, the Regulations are not prescriptive and companies can choose how to interpret them. In these areas disclosures range from those which:

• address the Regulations in letter and spirit and provide readers with a genuinely comprehensible insight into most aspects of their executive remuneration policy and practice; to

• comply with the letter of the Regulations and/or use standardised language, or in some cases do not reach even these standards; it is not clear what their executive remuneration policy is aimed at achieving.

Remuneration reports consist of two sections. One section is subject to review and formal verification by the auditor. Included in this section are the quantified details of what has been paid to directors in the reporting year. The second section, which is not subject to audit, covers areas such as remuneration policy and performance linkage.

The audited section of a remuneration report requires relatively unambiguous statements of fact such as amounts of salary and fees paid, and details of share option and share awards made during the reporting year. In all the companies studied for this Report, these facts are by and large disclosed as required. The research has not attempted to assess the veracity of these facts.

The unaudited section of remuneration reports requires descriptions of, for example: the remuneration policy; performance conditions related to incentives; a performance graph; and details of service contracts. It is the unaudited section of remuneration reports that this research focuses on.

The following table summarises the extent to which companies’ remuneration reports now comply with the minimum requirements of the Regulations.

The table sets out 22 compliance headings and shows that disclosure standards of 90% or more are being achieved under 11 of 22 headings for FTSE 100 companies, and under 9 of the 22 headings for the FTSE 250 companies.

The areas of material interest where least compliance is being achieved relate to:

• the reasons for choosing performance conditions for share options and other long-term incentive plans;

• the methods used to assess whether performance conditions have been met; and

• disclosure on the details of possible future termination payments.

Although, as can be seen in the preceding table, the vast majority of companies are already complying with nearly all of the Regulations, a significant proportion are not going beyond the minimum in order to provide readers with a clear insight into their policies and practices. This is detailed in the Deloitte analysis set out in the following table and backed up by shareholders’ views set out in Section 4.2 below.

The views of shareholders on the effectiveness of communication complement the above findings.

In discussions with shareholders, the consensus was that the best quality of disclosure and communication occurred when the remuneration report was clearly drafted and, where appropriate, there was a good level of consultation with shareholders.

Shareholders have stated that consultation about remuneration has substantially increased since the Regulations were put into effect.

Shareholders have also commented that they have a significantly better understanding of companies’ directors’ remuneration since the introduction of the Regulations.

However it would be overly simplistic to conclude that the Regulations alone have brought this about. Shareholders have indicated that the vote certainly has been important, but beyond that it is the combination of the Regulations, consultation, and guidelines published by the ABI and NAPF, which are now bringing about increasingly improved disclosure quality.

A main area which shareholders feel is still lacking focus is explanation about the link between bonus payout and performance.

Shareholders, during consultation about their views, also made it clear that they would wish to see more explanation about where remuneration committees use discretion outside of ‘normal’ policy to make awards of, for example, salary increases, bonuses, or other payments.

The key themes that emerge from both the responses in the questionnaires and the subsequent discussions are that shareholders:

• do not want more regulation;

• would like better communication, but not necessarily more information – there is already a very material cost to shareholders involved in the evaluation and analysis of remuneration reports prior to reaching informed voting conclusions;

• require more explanation of the reasons behind the policies, particularly in areas where the remuneration committee may use, or has used discretion; and

• want a level and clarity of communication that provides them with confidence in both the people making the decisions and in the processes by which those decisions are made.

All of the top 350 FTSE companies put their remuneration report to separate shareholder vote in their last financial reporting period.

When the Regulations were first introduced there were significant votes against a number of companies’ remuneration reports. In a number of high profile cases it is clear that this did result in specific reconsideration of policy matters by the remuneration committees concerned.

In more recent months there have been fewer and less pronounced occasions where significant shareholder votes have been lodged against companies’ remuneration policies which may be, at least in part, in response to increased consultation between companies and shareholders.

This section focuses on the extent to which current disclosure demonstrates the link between performance and pay. Recommendations are made in a number of places, and these are drawn together and summarised in Section 8 ‘Improving the Regulations’.

It is clear from the analysis of shareholder views that the combination of Regulation and investor guidelines has improved the level of communication between companies and shareholders.

Shareholders have indicated that they have a better understanding of directors’ remuneration since the introduction of the Regulations.

However it is also clear that there is still perceived to be a lack of clarity generally on the strategy, philosophy and practice of remuneration, and more specifically around the link between performance and remuneration.

Increased disclosure requirements do not directly lead to changes in policy but experience suggests that where disclosure is required it is likely to lead to a review of not only the underlying policies, but to some extent the processes by which the policies have been determined.

In effect, the process of having to disclose the information, and in many cases explain the reasoning behind the information, may highlight inconsistencies, or raise questions, which have previously not been apparent and which may prompt a reaction from shareholders.

That the increased level of disclosure and communication has been effective can be seen in Section 7 ‘Changes in policies and practices since the Regulations were introduced’, which highlights the areas of remuneration policy where changes have taken place as a result of a combination of the Regulations and shareholder pressure. It is also clear that change has been accelerated in some areas, most notably policies on service contracts and notice periods, by the introduction of the Regulations.

One aspect which shareholders have suggested may provide more clarity on the link between performance and remuneration is providing retrospective information on the level of incentive payments, both short and long-term, and the level of performance that had been achieved to deliver that award.

There is no requirement in the statement of companies’ policy on directors’ remuneration to disclose information relating to annual bonus policies. This is an area where shareholders have made it clear that they would like to see more disclosure.

Best practice guidelines – as shown in the extracts set out below – recommend disclosure on certain aspects of annual bonus plans, and many companies are meeting these requirements to a great extent.

"The performance targets should generally be disclosed in the remuneration report subject to commercial confidentiality considerations. Shareholders understand that commercial confidence may prevent disclosure of specific short-term targets but they expect to be informed of the basic parameters adopted in the financial year being reported on. The maximum participation levels should be disclosed".

"The components of an annual bonus should be clearly defined and the individual element for example, clearly separated from broader business goals and overall corporate performance".

"The annual bonus paid to each executive director in the financial year should be disclosed in the remuneration report. This information should be supported by a) a description of the performance targets that were achieved, b) an explanation of the relationship between the performance achieved and the value of the bonus paid, c) the maximum bonus award that would have been made had all the performance targets applying to the executive director been achieved".

Most companies disclose the maximum award and a good number disclose the performance measures used. Some go further and show a breakdown of the proportion linked to corporate and/or individual performance measures, or show the actual annual bonus paid relative to the maximum that may be earned.

Disclosure of details of the annual bonus plan has improved significantly over the past two to three years as a result of shareholder pressure and, with best practice guidelines now providing detailed provisions on what should be disclosed, this should continue to improve. It should be noted that the new NAPF guidelines were only introduced earlier this year.

As mentioned above, one of the key pieces of information shareholders would like to see is a retrospective indication of the level of bonus earned in the year and how this relates to the performance achieved. Examples of companies which have already begun to disclose this level of information, as a result of the above best practice guidelines, are included in Appendix 4 ‘Examples of disclosure’. While introducing additional regulations on this aspect of remuneration policy would almost certainly speed this process up a better option may be to allow the best practice guidelines more time to take effect and to review this area again in one or two years’ time, with a view to introducing additional regulation if it is felt that companies have not sufficiently responded to these guidelines.

However the annual bonus is a significant element in the remuneration package and in 98% of FTSE 350 companies executive directors are eligible to participate in such a plan. Shareholders have indicated that they want to see some level of detail regarding the plan. It is generally accepted that it would be inappropriate for companies to be required to disclose the details of future performance conditions for reasons of commercial sensitivity. It is also worth bearing in mind that a requirement to disclose the detail of the plan could encourage companies to take a formulaic approach to the design so that there is no debate over the levels of award paid. This may not be in the interests of companies or shareholders.

It may therefore be sufficient to extend the Regulations to include disclosure on annual bonus plans along the following lines:

Extending the Regulations in this manner, in combination with the best practice guidelines which provide guidance on the level of detail shareholders would like to see, should encourage better disclosure⁵.

The details of long-term incentive and share option plans are usually well disclosed. Plans in which executive directors participate require prior and specific shareholder approval, and therefore it is usual for the full details to be included in shareholder communications. In the majority of companies, particularly the larger ones, these will be discussed with shareholders prior to the relevant AGM notice being released and shareholders will have had the opportunity to comment on, and, if appropriate, exert influence over, details of the plans.

Major changes are therefore not recommended to the disclosure requirements on the details of long-term incentive plans as existing requirements and best practice guidelines are generally sufficient. However there are some specific areas which could be improved.

There is no consensus among shareholders on whether the performance conditions used in long-term plans are adequately explained. This is borne out by the diversity of answers to questions detailed in section 4 of Appendix 2 ‘Respondents’ views on the Directors’ Remuneration Report Regulations’. These are matters which should continue to improve in response to best practice guidelines and increased communication with shareholders.

It is recommended that the explanation of performance conditions should be monitored over the next one to two years with a view to extending the Regulations at that time if it is apparent that not all companies are responding to the guidelines.

Shareholders expect a long-term plan to measure performance over at least three years, and best practice guidelines suggest the period should, where appropriate, be longer.

Many, if not most, companies already disclose this performance period, if not in the remuneration report, certainly in any shareholder communications regarding new plans. For completeness a relevant disclosure requirement could be added to Regulation 3(2)(a).

As can be seen in the analysis of the current disclosure, this is one area where the level of disclosure has been variable suggesting that there is some uncertainty over what information is required. The Regulations could be made clearer on this point by including a requirement to disclose whether the assessment is independently verified and some information on the level of discretion the remuneration committee has in deciding what level of award will be made, and in what circumstances this would be used. This would provide shareholders with comfort that robust processes are in place for determining the level of awards being made.

In order to further address the issue of the linkage between performance and pay, shareholders have identified two other key areas for consideration.

It is helpful to have an indication of the vesting schedule for awards so the relationship between vesting and performance is clearer. Many companies already disclose this in the remuneration report, and most include relevant details of new plans circulated to shareholders for approval. Requiring companies to include full details of proposed new plans in the remuneration report could assist in this. However this is effectively covered in Regulation 3(2)(a) in so much as a ‘detailed’ summary of the performance conditions should include such information and in the majority of cases is certainly how this is being interpreted. Where this is not currently the case, there is no evidence to suggest that best practice guidelines and shareholder pressure will not continue to exert influence and it is likely that disclosure will continue to improve over the next one to two years. It is therefore not recommended that any further disclosure requirements are introduced in this area at this time.

As with the annual bonus, shareholders have indicated that they would like to see an explanation of levels of long-term incentive awards vesting and the performances achieved in the relevant performance periods. Again, there are examples of ways in which some companies are already disclosing this information included in Appendix 4 ‘Examples of disclosure’. However for the same reasons as outlined above for annual bonus it may be more appropriate to monitor progress over the next one to two years rather than introducing further regulation at this time.

Few shareholders consider that the performance graph contributes to the understanding of the link between performance and remuneration. However, there is little consensus on what information would be more helpful. The most relevant information for individual companies is likely to vary considerably making it difficult to be prescriptive about what information should be presented in the graph. A number of companies include additional graphs, showing for example performance against a more relevant comparator group of companies, performance over a different time scale or graphs based on different performance measures.

It is recommended that no further regulations are introduced with relation to the performance graph, leaving companies with the opportunity to include additional graphs where relevant. As best practice in this area emerges it is likely that more companies will provide additional and more relevant information.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.