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Remuneration and bonus arrangements

This guide provides an insight into the risks associated with fixed and variable remuneration and considers the controls that may need to be in place for risk mitigation. 

Background
Top tips
Key risks
Key controls


Background

The financial crisis began in 2007 in the subprime mortgage market in the USA, and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008. The crisis is generally believed to have been caused by excessive risk-taking by banks and by bundling together sub-prime loans into new financial instruments (‘mortgage-backed securities’) which were so complex that the risks were poorly understood, even by the rating agencies and regulators. The impact of the banking crisis was felt worldwide and led to bail-outs of financial institutions, and other monetary and fiscal policies, to prevent a possible collapse of the world's financial system.

One of the root causes of the excessive risk taking is that remuneration packages encouraged bankers to make money from deals without full consideration of the level of risk to their clients or their bank. The variable remunerations, ‘bonuses’, paid to bankers appeared to be out of all proportion to the profits made for the bank or with the investment gains made by their clients. The bonuses were being paid regardless of whether the investment sold was a good one, or whether it lost money for the client and/or the bank. Therefore, it was concluded that the system encouraged bankers to take inappropriate risks and may have tempted them to potentially behave unethically towards their clients. 

This placed fixed and variable remuneration packages into the public spotlight and, in some industries, led to regulation. There is considerable reputation risk for all organisations which do not have an ethical and equitable remuneration policy in place. Below are some recent examples where unethical behaviour caused by an inadequate remuneration policy has led to financial loss and reputational damage:

Wells Fargo

This was a case where a sales incentive (variable remuneration) induced staff to fraudulently create client accounts because they were rewarded for reaching sales goals on newly created accounts. This led to 1.5 million unauthorised accounts being created without the clients’ knowledge, a $185m fine and board changes. Wells Fargo have said that they will not be using sales-based target incentive schemes in the future. 

BT

BT announced that it had discovered ‘inappropriate behaviour’ in its Italian subsidiary which cost BT £530m by the time the improper accounting practices had been investigated and this led to a fall of 20% of its stock market value. The improper accounting increased the bonus payments paid to senior staff and, as a consequence, BT propose to claw back bonus payments made to the senior management, which could amount to £75m. 

BP

BP’s Chief Executive Bob Dudley has had his pay cut by £5m after a shareholder revolt. 

Banking

Because bankers are still seen as being greedy, big bonuses are still media targets: Last year 453 staff at HSBC each got at least €1million, then worth £780,000. Taxpayer-saved RBS handed out £373million for 2015, while Lloyd’s staff got £354million. 

Public sector

The UK public sector is not immune from media attention either, as this story about NHS pay rises illustrates.

Even where there has been no evidence of wrong doing, a remuneration package can still be seen by the shareholders as being excessive – and they can take action!

There are also advantages to having a good remuneration policy in place. An organisation needs to be able to attract and retain talented employees in order to be successful and meet their objectives; a good remuneration policy helps an organisation to achieve this. This is the case for all levels of employees, not just senior executives. 

Therefore, it is important to have a policy that allows remuneration packages to be set at levels which achieve sufficient levels of recruitment and provides recognition and rewards for existing employees. Many organisations benchmark their remuneration against similar sectors/organisations to achieve the level of remuneration which meets their needs.


Top tips

1. Consider the audit approach

Who should carry out the audit – is the information of top executive’s remuneration too sensitive for the in-house audit team and would co-sourcing be a better option?

  • Who should see the testing results – they may be very sensitive and need to be kept confidential?
  • Where should the working papers be filed – confidentiality should be a priority, even perhaps preventing other auditors from seeing them?
  • With whom are the audit findings going to be discussed/escalated – the findings may relate to top management and perhaps, you wouldn’t want to widely discuss them?
  • Who is going to be the recipient of the report? Is the HR director senior enough, should it go to the CEO, or even the Chairman of the Board?

2. Legislation and regulation

Find out if your industry/sector has legislation/regulation covering remuneration that you need to comply with, e.g. EU Regulation 604/2014 covering risk takers: are you required to publish the remuneration of top executives/risk takers; should any bonus payments be capped; are there trade union/staff council agreements in place; are cost of living rises mandatory?

3. Governance arrangements

Identify the governance arrangements for your organisation, e.g. is there a remuneration committee, if not why not and who approves remuneration?

The remuneration committee is a delegated committee of the board which consists of three (or two, for small companies) independent non-executive directors; their terms of reference should include approving the remuneration policy, setting, or recommending, executive remuneration and approving amounts available for fixed and variable remuneration.

4. Remuneration policy

Is there a remuneration policy covering all employees, including senior executives?

  • Fixed remuneration: is the process transparent and fair across grades, geographical location, diversity etc.?
  • Does the policy set remuneration at levels appropriate to attract and retain talent; how is this measured/monitored?
  • Variable remuneration: such as bonuses, commissions etc. – does it encourage unacceptable levels of risk taking, e.g. high sales targets?

5. Check that remuneration is linked to the performance appraisal process 

Is it fair, transparent and evidenced?

6. Check that trade union/staff council agreements are factored in

Have trade union/staff council agreements been included into the process, including mandatory rises for inflation? Consider whether there may be ‘hidden’ elements in top executives’ compensation, such as school fees, car hire etc., think about how you can identify these.


Key risks

Financial

  1. Organisations need to balance staff compensation with earnings. An effective remuneration policy and procedures helps to recruit and retain staff employees which in turn, aids productivity/achievement of objectives, whereas the opposite may cause staff dissatisfaction, loss of key employees, leading to reduced revenues, possible industrial action or the organisation to cease operating altogether.

  2. Remuneration policies can encourage inappropriate risk taking, e.g. encouraging fraudulent creation of customer accounts (Wells Fargo), or selling inappropriate products (UK PPI miss-selling). This can result in large fines from Regulators and reputational damage.

  3. Variable remuneration provides an opportunity for fraud, both in the calculation and the payment process. For example, amounts may be adjusted upwards or allocated unfairly for personal gain or amounts set aside for variable remuneration are not accounted for properly or accurately shown in financial reports.

Reputational

  1. There is significant focus on compensation packages from the general public and the media. Adverse publicity on the compensation packages of employees may damage an organisation’s reputation leading to a financial impact, loss of market share or an investigation by Regulatory bodies.

Key controls

Control

Possible response

Sound governance arrangements are in place for your organisation

 

 

 

 

 

 

The UK Corporate Governance code requires that there is a remuneration committee. 

Is there a remuneration committee, if not why not and who approves the remuneration arrangements?

If there is remuneration committee are the members non-executive directors?

Are there conflicts of interest in the remuneration approval process?

Are there ‘toxic pairs’ where a committee chair and members sit on more than one committee and can approve each other’s remuneration?

Is anybody able to decide their own variable remuneration? 

There is a remuneration policy covering all employees, including senior executives

 

 

Ensure that the policy is transparent and fair across grades, geographical location, diversity etc.

For variable remuneration: such as bonuses, commissions etc. ensure that the calculation process is formalised, transparent, rigorously applied and does not encourage inappropriate risk taking, e.g. based on high sales or growth targets. 

There is a process in place to apply the remuneration policy

 

 

 

 

 

 

 

 

 

Check that the policy has been applied equitably:

Test for evidence of intentional or unintentional (conscious/unconscious) bias, e.g. women awarded lower bonuses, older workers not awarded pay rises etc.

If linked to company/divisional performance or a ‘balanced scorecard’, check that the reported results can be verified.

If linked to the performance appraisal process, check that it is fair, transparent and evidenced.

Check that trade union/staff council agreements have been included into the process, including mandatory rises for inflation etc.

Check that there are no ‘hidden’ elements in top executives’ compensation, such as school fees, car hire etc.

Is a proportion of the variable remuneration required to be non-cash and retained for a period of time before vesting? Is there a process to prevent inappropriate release or claw back released amounts?

The applicable legislation/regulation covering remuneration for your industry/sector is known and complied with

 

 

 

 

 

 

Examples:

EU Regulation 604/ and EU Directive 2013/36/EU2014 covering the remuneration of risk takers and assurance functions;

The Equality Act 2010 (Gender Pay Gap Information) Regulations 2017 and The Equality Act 2010 (Specific Duties and Public Authorities) Regulations 2017 apply to organisations with 250 or more employees.

The Sarbanes–Oxley Act contains a provision to claw back bonuses.

Ensure that the requirements are met, e.g. bonus caps are applied or remuneration is published, and that compliance is monitored.

Check that trade union/staff council agreements have been included into the process, including mandatory rises for inflation etc.

The ‘Risk Takers’ in your organisation are identified and their remuneration is agreed/approved by the appropriate governance body

 

They might be senior management, strategy planners, brokers, salespeople, assurance providers, including the HIA.

Check that their performance objectives do not encourage inappropriate risk-taking or if they do, they are not linked to financial reward.  Pay particular attention to sales incentives/targets, growth targets. In addition, for assurance providers, ensure that their remuneration is not linked company performance.

A process is in place to disseminate the variable remuneration accurately

 

This is an opportunity for fraud. Follow the remuneration process throughout the end to end process (recommend documenting through a formal process flow). 

Check that amounts paid can be reconciled to the amounts agreed and that the payments are shown in financial reports.

Benchmarking is carried out to set compensation levels The remuneration policy should aim to attract and retain talented employees. Check that the benchmarking carried out is appropriate and informs the remuneration process.

 


Additional reading

Supplemental guidance

Auditing Executive Compensation and Benefits

Guidance

Reward and recognition

External resources

UK Corporate Governance Code 

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Content reviewed: 29 August 2017