New Financial Reporting Lab report on Performance Metrics – what Remuneration Committees should take away

The Financial Reporting Lab was launched in 2011 to provide an environment where investors and companies can come together to develop pragmatic solutions to today’s reporting needs. The Lab has worked with 65 different companies, 60 investment organisations and over 300 retail investors to bring insight and understanding to a number of key areas of disclosure.

At the beginning of 2018, it launched a project to look at the investor’s perspective of performance metrics. In June, it published a brief report carrying guidance for companies about the way their reports can best serve the needs of investors. In November 2018, it produced a fuller report, Performance metrics – Principles and practice, which contains examples of good practice for various aspects of reporting.

The Lab identifies five principles for reporting, designed to consolidate the views of a range of investors. The findings are of high importance for the choice and application of metrics for management incentive plans and the linkage of the Annual Remuneration Report to the company’s Strategic Report. MM&K has studied the Lab’s findings carefully in order to provide guidance to remuneration committees.

Principle One: Aligned to Strategy

Understanding how the management and board measure the success of its strategy is crucial for shareholders. Performance measures, especially in terms of management incentive plans, provide insight into the company’s business model, strategy, and the potential for creating long-term value.

“Many investors expect a clear link between the metrics used by management to monitor and manage performance and remuneration. Some investors expressed more scepticism about the application of wider metrics on remuneration, as they felt that the boundaries and reliability could be less clear, giving an impression that these could be more easily managed”.

The Lab gives two examples of companies explaining the link between KPIs and remuneration. Great Portland Estates plc present their KPIs with an ‘alignment with remuneration’ narrative, explaining links to annual bonuses and long-term incentives. InterContinental Hotels Group use symbols to identify the link between their KPIs and long-term and annual remuneration.

RemCos should ask themselves:

• Is there a clear link between the metrics that drive our business model and strategy and our remuneration policy?

• Further, do our management incentive plans’ performance metrics clearly link to our company’s strategy and value drivers?

Principle Two: Transparent

“Transparency” is considered a key principle, which adds to understanding and builds credibility. Understanding how metrics are calculated and defined, and clear explanations of why metrics are used and reported, are key to the transparency of a metric.

“There is a range of views about the use of metrics for remuneration that have been further adjusted from the KPIs and metrics reported elsewhere. There is a view among some investors that such adjustments are not appropriate. Other investors are more accepting of ‘adjusted adjusted’ metrics, as they consider that they can help them more accurately assess the value added by the current executives”.

The Lab urges companies to “provide full explanations and justifications for the metrics used to determine remuneration outcomes, particularly where these have been adjusted from metrics disclosed elsewhere”. In terms of management incentive plans, this is essential. If shareholders cannot understand or trust a performance metric, then they cannot use it to reliably assess potential long term value.

RemCos should ask themselves:

• Is it clear to shareholders why management incentive plans’ performance metrics are used and how they drive the company’s strategy?

• Are we transparent about the way in which our metrics are calculated and defined?

Principle Three: In Context

Information that is presented in context allows for an understanding of the positioning of a company. This information could relate to the context of the performance achieved, the context of the company in the market, or some other context-setting which aids an understanding of the company and its prospects.

“Providing information on a company’s aims builds credibility and can help create alignment and understanding of incentives, provided that they do not encourage management to short-term targets. Ranges or longer-term objectives are well received where specific numbers might prove commercially sensitive or difficult to determine”.

The Lab advises that where companies feel they cannot disclose specific targets they may be able to provide ranges and longer-term targets. An example shows Halma plc presenting current targets, a graphical illustration of the past five years performance, and the link to remuneration. Another example comes from Anglo American; they provide information about progress towards their targets.

RemCos should ask themselves:

• Do we explain performance measures in relation to targets and what we actually achieved? Is the reasoning behind incentive plan pay-outs sufficiently explained?

• Do we explain what performance our metrics are trying to achieve in the future, and provide an understanding of our overall long-term objectives?

Principle Four: Reliable

The Lab’s fourth principle, “Reliable”, relates to trustworthiness and credibility. It is about understanding which metrics are used, how they are put together and who has oversight over the process.

Some companies report that strong oversight processes over externally reported information could prevent them from reporting other information that could potentially be of use to investors. The Lab takes the view that just because information is not audited does not mean it is not of interest. Instead of omitting them, explaining the levels of scrutiny to which metrics have been subjected is valuable. Rentokil Initial plc is given as an example, they disclose internal employee engagement scores alongside relevant external metrics from Glassdoor.

RemCos should ask themselves:

• Do we provide an overview of how our management incentive plans’ performance metrics have been developed and monitored to allow investors to assess their reliability?

• Do we outline where we have had oversight and/or considered the appropriateness of metrics or adjustments relating to management incentive plans?

• Do we explain what additional scrutiny may be given to adjusted metrics being used in remuneration?

Principle Five: Consistent

“Consistent” metrics and messaging builds credibility over time. Comparisons with industry benchmarks or standards can allow assessment against a consistent base and help companies present their performance in context. Companies note that certain sectors lend themselves more easily to standardisation and comparison. However, the desire for standardisation may raise a tension for companies that are seeking to tell their story.

Some companies use benchmarks in response to the challenge of comparability. Derwent London plc is provided as an example; they illustrate five-year performance against an industry benchmark. Another, Great Portland Estates plc, also include five years’ worth of data against relevant benchmarks each year.

RemCos should ask themselves:

• Are our performance metrics relating to management incentive plans, especially long term incentive plans, consistent year-on-year? If our metrics have changed, do we provide a clear explanation as to why the change has been made and why the new metric is better? Do we provide comparatives for a number of years?

• Is a track record of performance measures provided? If not, would including one help to justify and explain executive pay to shareholders?

• Are our performance metrics consistent with an industry standard or our close competitors? If not, do we explain why our metrics are more appropriate?

Identifying appropriate performance measures and setting targets for executive incentive plans is essential for a company with ambitious goals. MM&K have extensive experience advising on and designing incentive plans and their performance measures. If you would like to discuss these issues and what they mean for your company, please contact Harry McCreddie

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