Shaping the future with confidence: Your business post-Financial Services Royal Commission
Remuneration: the cornerstone of culture
The Royal Commission's final report (the Report) reiterates the long-standing sentiment held by Australia's financial regulators – that to prevent misconduct, financial services entities need to foster a culture that prioritises customers over profit.
The Report found that culture was, to a large extent, driven by remuneration structures that incentivise employees to act in ways that may or may not be consistent with the needs of their customers.
Commissioner Hayne has recommended that significant changes be made to the current remuneration practices of financial services entities. This article sets out the key recommendations and the impact that these changes are likely to have moving forward.
Last year, the Commission's examination of misconduct and senior executive remuneration contributed to a reporting season hit by public showings of shareholder dissatisfaction, with many of Australia's largest financial services entities receiving a first strike against their remuneration reports at their AGMs. Now more than ever, companies need to be aware of the landscape surrounding executive remuneration.
Despite a consistent focus on remuneration issues throughout the hearings, the Report concludes that no financial services entity has identified an 'ideal' or 'optimal' system of executive remuneration, and the Commission does not purport to do so either. In particular, the Commission accepts that there is no perfect split between fixed and variable remuneration. As a result, a certain level of flexibility is retained and there is an acceptance that one model may not work for all financial institutions.
Instead, the Report's focus in relation to executive remuneration is largely on the need for APRA to supervise and regulate executive remuneration in practice, rather than continuing to focus on system design. The Report recommends that APRA update its prudential standards to expressly require:
- entities to manage misconduct, compliance and other non-financial risks through the design of their remuneration policies;
- the board of a financial services entity to make regular assessments of the effectiveness of its remuneration system to encourage the management of non-financial risks and reduce the risk of misconduct;
- entities to establish provisions to allow them to claw back senior executive remuneration that has already vested; and
- setting limits on the use of financial metrics in connection with long-term variable remuneration.
In support of these changes, APRA is encouraged to do more to gather information about the way remuneration systems are being applied in practice, and whether systems are actually encouraging sound management of non-financial risks and reducing the risk of misconduct.
The Report is also critical of the level of information that boards obtain in relation to their remuneration systems, due to both the lack of information provided to them by management and as a result of their own failure to seek more detailed information from management. It asks that APRA and each entity consider how they can improve the quality (not quantity) of information boards receive.
Despite asking several witnesses about the utility of the 'Two Strikes' rule, Commissioner Hayne concluded that this question falls outside the scope of his Terms of Reference and did not make any recommendations on this topic.
Central to the Commissioner's discussion of remuneration of front-line staff is the notion that a company's remuneration structures reflect its values and that employees will perceive rewarding sales ahead of (or instead of) any other behaviour as a indication that that is valued by their employer above all else. The Commissioner identifies that it is crucial to design reward frameworks to take into account not only what employees do but how they do it.
The Report finds that front-line employees have the ability to shape the culture of an organisation from the ground up and are the first (and often only) point of contact for clients of these institutions. With this in mind, the Commission has stressed the need for remuneration models to be designed carefully, with consideration given to the intended and unintended consequences of each remuneration component made available.
The Report echoes sentiments contained in the Interim Report about the importance of proper management, rather than financial incentives, to motivate customer-facing staff. Positive feedback, encouraging employees to take pride in their work and clients, the provision of additional responsibilities and the enticement of promotion are all management tools the Commissioner points to as a means to foster desired behaviour.
To improve front-line remuneration practices, the Report recommends that all financial services entities adopt each of the recommendations set out in the 2017 Sedgwick Report, 'both in letter and in spirit'. This includes:
- the removal of variable rewards that are directly linked to sales;
- eligibility to receive personal incentive payments being based on an assessment of the individual’s contribution across a range of measures, of which sales (if included at all) will not be the dominant component;
- that the use of financial metrics in a balanced scorecard attract a maximum weighting of 33 per cent by 2020; and
- variable reward payments comprise a relatively small proportion of the employee's fixed pay.
The complete adoption of the Sedgwick Report recommendations is unlikely to become a statutory requirement. However, all of the Big Four banks have already committed to implementing the Sedgwick recommendations in their entirety, so this recommendation simply endorses their current plans to address remuneration issues.
Ultimately, the Report does not advocate for one remuneration model over another, but encourages financial services entities to regularly challenge remuneration assumptions and continue to work on ways to motivate their staff to act in the best interests of their clients. As a result, the key recommendation in relation to remuneration of front-line staff is that financial service entities should review the design and implementation of their remuneration systems at least once each year.
Mortgage broker remuneration
During the public hearings, significant criticism was levelled at the remuneration structures in place around mortgage brokers, particularly in relation to the payment of commissions. The Interim Report made a number of robust statements about the inherent risk that a structure that involves payment of commissions by lenders to brokers is likely to cause brokers to behave in ways that lead to poor customer outcomes. It is unsurprising, given this lead-up, that the Report makes some of its strongest and most drastic recommendations in the area of broker remuneration.
The Report states in no uncertain terms that commissions paid by lenders to brokers amount to conflicted remuneration of the same kind as has been banned in the financial planning space. In particular, throughout the Report the Commissioner is scathing about the utility of trail commissions, at one point referring to them as 'money for nothing'. In respect of broker remuneration, the Report recommends that if trail commissions are to remain, clawbacks from borrowers should be prohibited.
The Commissioner recommends the progressive abolition of all forms of both trail and upfront commission, and the ultimate adoption of a 'borrower pays' remuneration model. The Commissioner recommends that:
- within about 12 or 18 months, lenders should be prohibited from paying trail commission to mortgage brokers in respect of new loans; and
- within a further 12- to 18-month period, lenders should be prohibited from paying any other commissions to mortgage brokers.
He argues that the adoption of this recommendation will:
- see the market determine the appropriate price for broker's services based on the value of the service to borrowers;
- create an incentive for brokers to give borrowers value for money and look beyond the entities with which they may have become accustomed to dealing; and
- induce brokers to search out the best deals available.
The Report recommends that a Treasury led working group should be established to monitor the changes and make adjustments as necessary, with a particular focus on the effects of the changes on interest rates, competition between lenders and brokers, and developments in the residential mortgage market.
In its response to the Report, the Government has agreed to ban trail commissions from July 2020, but has reserved its position on phasing out upfront commissions (which make up the majority of banks' payments to mortgage brokers). However, the Government has indicated that it will require the upfront commissions to be linked to the size of the loan being drawn (a practice that has already been implemented by most lenders).
While the Opposition committed in principle before the release of the report to adopt all the recommendations contained in it, the Commissioner's proposal for a customer-pays model may come as a surprise to many. It will be interesting to see whether, in advance of a federal election in which the housing market is likely to be a key focus, there is political appetite to adopt such a significant change.
The Commission's focus on the conduct of financial advisers, particularly in respect of inappropriate advice and fees for no service, foreshadowed the making of significant recommendations in this area. Aside from criticising ongoing fee arrangements and trail commissions, the focal point of the Commission's recommendations relate to the issue of conflicted remuneration.
The Commission observes that, on their face, the conflicted remuneration provisions appear to be comprehensive; however, it notes that there are numerous exceptions to their application. It states that these exceptions must be examined if conflicts of interest in the financial advice industry are to be reduced or eliminated.
The Commission provides recommendations in respect of the following key exceptions:
- (Grandfathered commissions) the Report finds that grandfathered commissions cannot be justified in light of the conflicted remuneration provisions, and calls for their repeal as soon as practicable;
- (Life insurance) the Report recommends that while ASIC conducts its review into conflicted remuneration relating to life risk insurance products, it considers reducing the cap on commission in respect of these products. It further states that unless there is clear justification for retaining these commissions, the cap should ultimately be reduced to zero;
- (General insurance, consumer credit insurance and non-monetary benefits) the Report recommends that while ASIC conducts the review to improve the quality of advice (as proposed at Recommendation 2.3), it should also consider whether the exception to the ban on these products is justified.
The finding in relation to grandfathered commissions is particularly unsurprising. Aside from them being arguably at odds with the principle of acting in the best interests of the customer, all four of the major banks supported the legislated industry removal of grandfathered commissions. In response to the Report, the Government has already indicated an intention to ban grandfathered commissions effective from 1 January 2021.
The Commission is reasonable in terms of the timing it proposes for these particular reforms by attempting to stagger them, noting that 'that the financial services industry will need time to absorb a number of changes over the next few years'.
What legal and practical issues arise in implementing changes to remuneration structures?
Although no specific changes are prescribed by the Report, there is strong encouragement for financial institutions to challenge and rethink their approach on a regular basis, to ensure that they are, in fact, achieving the important objective of using remuneration to prevent misconduct and promote desirable conduct.
When carrying out this kind of regular review and making any resulting changes, financial institutions should keep in mind the following:
- Before embarking on any program of change, institutions will need to understand very clearly the source of their remuneration structures.
- Where the source of a remuneration component is:
- an employee's contract, the terms on which that remuneration is provided cannot be unilaterally changed by the employer, and changes to these terms require the agreement of employees – to the extent that, for example, a commission structure has contractual effect, a withdrawal of the commission benefit would likely have to be offset with an increase in fixed remuneration in order to secure the employees' agreement to the change;<.li>
- an industrial instrument (and enterprise agreement or award), the terms on which that remuneration is provided cannot be unilaterally changed by the employer and changes to these terms need to be made by the Fair Work Commission;
- a non-contractual policy, the terms on which that component is provided can more easily be amended by the employer unilaterally; and
- a representation, the terms on which that component is provided can more easily be amended by the employer unilaterally (but not without the risk of a misrepresentation / misleading and deceptive conduct claim).
- Even where the terms on which a remuneration component is provided can be amended by the employer acting unilaterally, the employer may be required to undertake consultation about the changes with their employees and the Financial Services Union (in accordance with an applicable industrial instrument).