Context

In July 2019, the Australian Prudential Regulation Authority (APRA) released a discussion paper and a new draft Prudential Standard (CPS 511) for consultation, proposing stronger and more prescriptive prudential requirements for remuneration across all APRA-regulated entities in the banking, insurance and superannuation sectors. The proposed changes were intended to lift industry standards and to implement APRA's response to certain Hayne commission recommendations.

Among other changes, the initial draft standard proposed to: a) cap financial metrics for variable pay at 50%; b) impose minimum deferral periods for variable remuneration of up to 7 years for senior executives in larger, more complex entities and increase the scope for boards to recover remuneration for up to 4 years after it has vested; and c) require boards to approve and actively oversee remuneration policies for all employees and regularly confirm they are being applied in practice to ensure individual and collective accountability.

Consultation closed in October 2019. You can find our summary here.

Revised, less prescriptive standard released for consultation

On 12 November APRA released a response paper outlining the key themes to emerge from feedback on the initial draft standard and APRA's response, and a revised draft standard for consultation.

A principles-based, rather than a prescriptive approach

A key change overall in the revised draft is the shift away from the prescriptive approach in the initial proposal to an expressly 'principles based' approach which is intended, APRA states, to allow boards more flexibility to implement the new requirements in a manner that is appropriate and proportionate to their particular business while still raising industry standards in line with the Hayne recommendations.

A proportionate approach

The revised draft standard proposes to apply a proportionate approach where requirements are based on the size and complexity of entities rather than the industry sector in which they operate. The revised standard proposes to impose heavier obligations on significant financial institutions (SFIs) including heavier obligations around remuneration design, minimum deferral periods and clawback, while lightening the compliance burden on smaller entities.

Smaller entities (Non-SFIs) will not be subject to new requirements impacting variable remuneration, minimum deferral periods, clawback, or requirements to conduct annual compliance checks or tri-annual effectiveness reviews of their remuneration frameworks. The proposed requirements for non-SFIs are at p18-20 of the revised draft standard.

APRA plans to 'determine' and notify entities that are SFIs in Q3 2021 – ahead of the proposed phased commencement of the changes.

Commenting on the shift in approach, APRA Deputy Chair John Lonsdale said that it strikes the appropriate balance between raising standards and ensuring that the new requirements both proportionate and sufficiently flexible. He said,

'APRA’s revised standard on remuneration is deliberately principles-based to provide boards with flexibility to tailor remuneration frameworks to their entities. However, with this flexibility comes an obligation that boards actively oversee remuneration policies for employees and ensure that there are appropriate consequences when people fail to meet expectations. The standard is designed to promote effective risk management that aligns the interests of customers, shareholders and the broader community, to deliver high performance in a sustainable manner. Once implemented, we expect the standard to deliver stronger incentives for individuals to manage non-financial risk, appropriate financial consequences where material risk incidents occur and increased transparency to drive stronger board accountability for remuneration outcomes'.

Requirements for SFIs – Some key changes

Non-financial metrics must be given 'material weight'

The proposed 50% cap on the use of financial metrics put forward in the initial draft CPS 511 has been replaced in the revised version with:

• a formal requirement for financial measures to be given 'material weight' in both short term incentive plans and long term incentive plans. That is, under revised CPS 511, SFIs will be required to give material weight to non-financial considerations for each component of an individual's variable remuneration.
• a formal requirement to have a process in place to enable variable remuneration to be reduced to zero where individuals are found to be responsible for 'risk and conduct incidents'. APRA comments that complying with this new requirement will require existing practices to be 'tightened to ensure effective and consistent application'.

Commenting on the shift in approach APRA maintains that though less prescriptive, 'APRA has maintained its focus on non-financial risks, by requiring entities to give material weight to these measures in remuneration design, rather than a prescriptive hard limit'.

Shorter deferral periods

APRA initially proposed that where variable remuneration is over $50,000 entities be required to defer:

• 60% of a CEO’s total variable remuneration for seven years (with pro-rata vesting after four years)
• 40% of senior manager, executive director and highly-paid material risk takers (HPMRT) total variable remuneration for at least six years (with pro-rata vesting in the last two years).

The proportions to be deferred for each of these groups in the revised standard are unchanged. However, in response to industry concerns about the impact of longer deferral periods on staff recruitment and retention, the proposed deferral periods in the revised draft have been shortened.

Under the revised standard proposed deferral periods are:

• 60% of a CEO’s total variable remuneration for at six years (with vesting after four years on a pro rata basis). APRA comments that this change more closely aligns with the usual term of Australian CEOs and that the pro-rata vesting from year four aligns with the Banking Executive Accountability Regime (BEAR) requirements which sets a four year deferral period as well as with Financial Stability Board (FSB) principles.
• 40% of senior manager and executive director variable remuneration for five years (with pro-rata vesting after four years). APRA comments that the proposal for pro-rata vesting from the fourth year aligns with BEAR requirements and is consistent with FSB principles. APRA explains that the proposed deferral period for senior managers is shorter than that proposed for CEOs to reflect the fact that 'a senior manager has a comparatively lower impact on the entity’s risk profile and accountability'.
• 40% of HPMRT total variable remuneration for at least four years (with pro-rata vesting in the last two years). APRA comments that the proposed shorter deferral period is intended to reduce the various 'undue impacts' raised in submissions on staff recruitment and retention, while still requiring entities to strengthen existing accountability practices.

To address concerns about the potential for misalignment of timing between the payment of tax (at termination) and the receipt of earnings (at end of deferral), revised CPS 511 also proposes to allow partial vesting of the tax amount at termination.

Clawback

The revised standard proposes various adjustments to the drafting of clawback requirements to clarify that 'clawback would only be considered for exceptional circumstances'. Changes include:

• removing the requirement to extend the clawback period for another two years for those under investigation though APRA states that this would be 'considered better practice.
• clarifying that clawback would only be used in exceptional circumstances and 'after other adjustment tools have been exhausted'.
• revising the clawback criteria, which have been extended and aligned to the malus criteria. Amendments include adding a materiality threshold to reflect that it is a tool that would only be utilised in exceptional circumstances and clarifying the focus on conduct and adding material error or misstatement as grounds for clawback.

Enhanced board oversight

APRA comments that the revised standard has 'removed some prescription and sharpened its focus on overarching principles' to ensure that boards and the remuneration committee bring sufficient rigour and challenge to the oversight of the remuneration framework within their organisation.

Amendments in the revised standard are also intended to clarify the responsibilities between management, the board and board remuneration committee, without unnecessary prescription.

Board approval of remuneration outcomes

The revised standard will still require boards to approve remuneration outcomes, following committee recommendations in the interests of strengthening board engagement, oversight and accountability. However, in response to feedback, APRA has adjusted requirements around approval of highly-paid material risk takers (HPMRT) pay to allow 'cohort reviews' and narrowed the definition of HPMRTs. APRA plans to outline better practice examples for cohort reviews in forthcoming guidance.

Explaining the change, APRA states that it

…'does not consider it an effective use of a board’s time to understand every employee’s individual remuneration arrangement or individually approve the remuneration outcome of each person in a specified role, other than the CEO, senior managers and executive directors'.

Service providers

The initial draft CPS 511 proposed to strengthen an entity’s oversight and risk assessment of remuneration arrangements with third-party service providers in a number of respects to ensure entities 'make prudent assessments of how the service provider’s remuneration arrangements may result in actions or risks that could adversely impact an entity’s risk profile, sustainable performance, beneficiaries or customers'.

In response to feedback, the revised standard makes clear that entities are required to make an overall assessment of a service provider’s remuneration arrangements. That is,

'They are not required to influence the remuneration arrangements of third-party service provider employees or contractors. The revised proposal requires a risk assessment and provides entity discretion on the process. Revised CPS 511 also enables an entity to determine its own actions to mitigate risks.'

Forthcoming guidance will include better practice examples.

APRA has retained the annual review requirement

The revised standard retains the annual compliance review requirement (which is expected to be conducted internally and to take the form of a self assessment) on the basis that 'a routine appraisal of the remuneration framework against the standard will strengthen its operating effectiveness'.

In addition, APRA notes that the scope of triennial reviews has been 'sharpened' to 'ensure a deeper dive into the entity’s remuneration framework is undertaken, which leverages the experience of an operationally independent, appropriately experienced reviewer'.

Board reporting

On the issue of board reporting, APRA has retained the original drafting in CPS 511. In APRA’s view, it is the responsibility of the board remuneration committee to guide management about appropriate reporting of information, as part of its role to provide oversight of the remuneration framework. APRA’s intent is that entities focus on insightful, rather than voluminous, information and analysis that validates remuneration decisions. APRA plans to outline examples of better practice in CPG 511,

Enhanced disclosure requirements

To reinforce accountability, APRA plans to introduce new requirements that will require entities to publicly disclose how they are complying with key principles in the revised standard. APRA plans to consult on proposed new requirements in 2021.

Timing and next steps

• Consultation on the proposed changes closes on 12 February 2021. APRA plans to release a final version of CPS 511 in Q2 2021. Phased implementation of CPS 511 will commence from 2023.
• APRA intends to release draft guidance (CPG 511) for consultation in Q1 2021 with the aim of releasing finalised guidance in Q4 2021.
• APRA intends to consult on new reporting and disclosure requirements from Q4 2021 to Q1 2022, with a view to releasing finalised requirements in Q4 2022.

Proposed three stage phased roll out of the new requirements starting with the most complex entities

• 1 January 2023: ADIs that are SFIs and groups headed by these SFIs
• 1 July 2023: Insurers and RSE licensees that are SFIs and groups headed by these SFIs
• 1 January 2024:All other entities (non-SFIs)

[Sources: APRA media release 12/11/2020; Consultation on remuneration requirements for all APRA-regulated entities; Response paper: Strengthening prudential requirements for remuneration; Revised draft prudential standard: CPS 511 Remuneration]