The changes to finance sector reward systems likely to result from the global financial crisis are not just an issue for reward specialists. Development, employment law and reward teams need to work together to ensure a fit between new reward structures and the approach to performance and talent management.
Long-lasting impact of the FSA's review
City bonus structures are seen as partly to blame for the current financial crisis by giving staff incentives to pursue risky policies that undermined the impact of systems designed to control risk. This year there has been unprecedented media coverage of bonuses, especially in those institutions which have benefited from substantial bailout payments in recent months. In the US, President Obama opted to impose a cap on remuneration for senior executives in banks that have benefited from more than $500m in federal funds. European governments have followed suit. President Sarkozy for example has announced a clampdown on bonuses for bank traders - he wants banks with pay systems deemed to encourage excessive risk-taking to put aside more capital. In the UK the government has - so far - avoided imposing caps, but has exerted considerable influence in both the amount of bonus paid and the means of delivering the bonuses.
In February, the Chairman of the Financial Services Authority (FSA), Lord Turner, saw the interest taken by government in the pay arrangements of the institutions in which it has become a major stakeholder as entirely understandable. However he sought to distinguish this from the FSA's own commitment to ensuring that all the firms it regulates put in place reward structures that clearly link bonuses to performance over the long term.
As part of the Turner Review, a wide-ranging review of finance sector regulation, the FSA published its draft code of conduct on remuneration policies in February, and has now begun a comprehensive programme of consulting with finance sector employers. In March the FSA published a detailed consultation paper on remuneration, incorporating the draft code. Finance sector employers have until May to submit comments to the FSA. Subject to any changes resulting from the consultation, the code is likely to apply to all FSA-regulated firms from November, in time for the 2009 performance and bonus review cycle. Remuneration committees will be expected to report on their compliance with the code to the FSA.
The implication is that businesses that don't satisfy the FSA that their reward arrangements follow good practice will be hit financially through higher regulatory fees and/or the requirement to maintain a higher level of capitalisation - so there's a real imperative to act. There's also a strong steer that firms should make their report on remuneration policies available to shareholders ahead of the annual vote on directors' remuneration. Foreign firms with UK subsidiaries will be expected to comply with the code in respect of their UK operations. See the box below for more detail on the draft code.
And of course, just as the impact of the credit crunch is being felt globally, the FSA's focus on remuneration structures reflects the general trend among finance sector watchdogs around the world. The FSA is part of an international group looking at remuneration structures. So it is clear that the FSA's review will have much wider and longer-lasting implications for banks than the current furore over bonuses.
Key points from the FSA's draft code on remuneration policies
The draft code sets out ten specific principles that will be used to assess firms' remuneration policies in future. Five of these principles are especially relevant to a wider HR audience:
- The assessment process for the performance-related component of... remuneration should be designed to ensure assessment is based on longer-term performance.
- Non-financial performance metrics should form a significant part of the performance assessment process... (and) should include adherence to effective risk management and compliance with the regulatory system.
- Remuneration for staff in the risk and compliance functions should be determined independently of other business areas.
- The majority of any bonus should be deferred... if, when compared with the fixed component of an employee's remuneration, the bonus is a significant proportion of that fixed component.
- Any deferred element of the variable component of remuneration should be linked to the future performance of an employee's division or business unit.
The full consultation paper, including the draft code, is available on:
http://www.fsa.gov.uk/pages/Library/Communication/PR/2009/038.shtml
The implications for HR professionals
HR will need to understand how business risk is measured and monitored, and what constitutes an acceptable level of risk. This is especially true for reward professionals, but also for HR teams tasked with developing robust performance management systems, and for anyone engaged in identifying and coaching high fliers. Businesses still need to take risks to survive and prosper. Successful businesses will be those that manage these risks most effectively. Executive coaching and talent management systems must give the appropriate weight to risk-taking and risk management skills.
Individual performance will need to be tracked across a number of years to smooth out the impact of peaks and troughs in volatile markets. The code suggests using a moving average of results to assess employee performance. This needs some thought about how meaningful performance information (mainly financial) can be maintained over a multi-year time-frame, and how to take account of information on other factors (business re-organisation, market shifts, decisions taken by other people) that may effect how transactions undertaken this year are viewed in the future.
Do existing performance review systems provide the right information for bonus decision-makers? They should cover the way in which results are delivered (behaviours/working methods) as well as what is achieved in terms of financial targets. The code highlights a 'balanced scorecard' approach as a good way to achieve this. Adherence to relevant risk and compliance guidelines may need to be more explicitly covered within the performance review process. Firms will need to be able to demonstrate that performance measurement systems are effectively communicated and implemented, and that they place sufficient weight on non-financial measures.
Performance measurement for risk and compliance staff will need particular attention. The code aims to ensure that performance-related remuneration for these groups does not undermine their ability to make independent decisions. Performance measures for this group will need to be robust, relevant, and distinct from metrics used elsewhere. The FSA may also expect employers to include mechanisms to claw back bonuses not only before they 'vest' (i.e. are paid to the individual), but also after the individual has received them. This will pose substantial legal and practical challenges to employment policy professionals, not least in the UK where employment legislation means that reclaiming pay from employees is extremely problematic.
HR teams can seize the initiative
Remuneration structures are bound to be high on the agendas of finance sector CEOs in the wake of the publication of the Turner Review, so there is bound to be pressure on HR teams to show that they are on top of the issue. Fortunately there are a number of actions that can be initiated immediately to ensure that HR remains on the front foot:
- Don't leave it to the reward professionals to develop a response, get HRD, employment policy and reward teams working together from the outset.
- Build your understanding of financial management information - how risk is measured in different parts of the business, how individual or team financial performance is tracked.
- Review existing bonus structures, performance and talent management systems and identify what action needs to be taken. Consider actions that can be taken to mitigate the legal risks involved in implementing new reward structures. And coordinate this review globally across all the jurisdictions in which your business operates.
- Monitor the evolving market practice closely. Your competitors will be tackling exactly the same issues, there may be lessons to be learned from their approach and in any event it will be important to maintain a competitive position for your reward structures.
- Involve key business stakeholders, e.g. sales leaders and risk managers, and get their input and buy-in to the changes you plan to make.
- Don't leave successful implementation to chance - put a robust project management framework in place.
A footnote - the impact of the code beyond the finance sector
Undoubtedly the FSA's code will have the biggest impact on firms within the finance sector. However, one of the principles in the draft code addresses the performance measures used in executive remuneration plans in all business sectors. The concern is that the typical measures for such plans - earnings per share and total shareholder return - are not adjusted for long-term risk factors. In the original version of the draft code, the FSA flagged an intention to press for a review of these plans in the wider corporate sector. Any wider review is likely to impact other HR specialists in much the same way as their peers in the finance sector, albeit with a more specific focus on the population for whom long-term incentives form part of the reward package.