Bosses incentive schemes guided by herd mentality
A couple of months ago, the global asset manager BlackRock published results of its research into long-term incentive schemes used by corporate Australia.
It looked at 148 companies in the ASX200 and compared how remuneration schemes for their executives had changed since 2005.
See if these results surprise you.
It found long-term incentive schemes (LTIs) had recently become more complicated. In 2005, 66 per cent of the companies sampled used only one performance measure. By 2011, roughly the same number of companies used more than one.
But it also found that most companies were unwilling to design remuneration schemes that properly fitted their company or industry, and were instead "herding" around a standard model.
Why would they be doing that?
According to BlackRock's Pru Bennett, boards know that if they adopt the standard model then they're more likely to get approval from advisers.
As the paper notes, just under half the companies that received 95 per cent or greater support for their remuneration report in 2011 used the standard model. That's despite the model becoming more complicated.
So remuneration consultants were reinforcing conformity, often against the interests of companies and shareholders.
The paper has this little anecdote: "A company told us recently that it was using EBIT [earnings before interest and tax] as a performance measure for short-term incentives. Why not consider using another measure we asked?
"Our remuneration consultant told us, 'that's what everybody else does'. The consultant had benchmarked their peers, and there was obviously a big element of comfort in reflecting peer actions."
The paper was pessimistic about the prospect for change, believing recent regulatory changes may lead boards to rely more heavily on those same consultants to avoid difficulties with shareholders at annual meetings.
Why? Because if they're questioned by shareholders, boards could say "[but] we've done everything according to our experts' recommendations".
(The regulatory changes of note were the introduction in 2005 of non-binding votes on remuneration reports at company annual meetings, and the recent "two-strikes rule" which enables shareholders to trigger a board spill if more than 25 per cent of shareholders vote against a remuneration report at consecutive annual meetings.)
Bennett questioned the effectiveness of two measures used in the standard LTI model that have become increasingly popular since 2005: earnings per share (EPS), and relative total shareholder return (RTSR).
She said boards ought to consider if long-term incentive schemes were delivering the best results for shareholders, or whether they ought to be abandoned in favour of simpler schemes that combined short- and long-term incentives.
But her conclusions were questioned by others in the industry.
The director of the proxy adviser Ownership Matters, Dean Paatsch, said he was sceptical of short-term measures that were able to be controlled or manipulated by management because they could increase risk while failing to improve value for shareholders over the longer term.
He said linking incentives to the shareholder experience might not be perfect but in many cases it was the least worst option.
But Stephen Mayne, from the Australian Shareholders Association, said it believed there should be greater focus on long-term incentives and a reduced focus on the short term.
"The short-term bonuses are too large, and more of them should be paid in shares where they're locked up for a couple of years as well.
"There's too much cash bonus going out the door," he said. "We think there needs to be a further shift towards longer-dated, equity-based incentive schemes, and a further move away from upfront, short-term cash."
But BlackRock's paper raises the question: if recent changes to the regulatory regime mean companies are even likelier to take their lead from proxy advisers and remuneration consultants, what must be done to encourage less herding behaviour?
It's interesting to note that there's a similar debate going on in the superannuation industry.
There's more than a trillion dollars invested in Australian superannuation funds in the sharemarket, and the decision about who actually manages that money is made by super trustees in corroboration with consultants.
And it's the consultants who act like gatekeepers, because every superannuation mandate is awarded with their endorsement.
But there's a view in the industry that the fund management model is broken because, at the moment, it's actually designed to lose investors' money whenever the market goes backwards.
How could that be? Because the consultants see "risk" as the prospect of underperforming the market, so fund managers construct their portfolios to closely track market indices.
That means that if the sharemarket loses 15 per cent in value, then fund managers are deemed to be performing well if they lose only 13 per cent of their clients' money, because they've still "outperformed the index".
So the industry is acting like a herd, with everyone constructing portfolios to track the market whether the market goes up or down.
Now within this regime the average fund manager does a good job managing funds consistent with the "benchmark plus" mandate. But investors end up with little choice because most fund managers are doing the same thing.
And because there's no real bond market in Australia (compared to the US), and because tax incentives greatly favour equities, Australian investors have ended up being significantly overweight in equities.
So everyone's dependent on a rising market to deliver positive returns.
That means that the public are actually forced to put money into a superannuation system that's overweight in equities, and that's managed by institutional funds that don't see loss as a risk.
Critics of the regime say "risk" should instead be seen as the prospect of making a loss, rather than the prospect of underperforming the market, and fund managers ought to be going after absolute returns rather than going for index outperformance.
Bear in mind that this critique is mostly coming from the hedge fund industry, where fees are generally higher, and where the main difference from institutional funds is in the use of "shorts" (the practice of selling a borrowed security, or currency or commodity, with the expectation that it will lose rather than gain value, as a hedge for your other assets).
But hedge funds sell themselves by saying at least they adopt an absolute return approach, where risk is seen as the prospect of making a loss, not just index underperformance.
They're both interesting debates that are worth keeping in mind.
Ross Gittins is on leave.