INSIGHT

New draft APRA Prudential Standard (CPS 511) set to reshape group-wide remuneration frameworks and incentive arrangements for ADIs, superannuation funds and insurers

By Simun Soljo, Sean Cole
Corporate Governance Financial Services APRA

In brief 8 min read

APRA has released a discussion paper on its new prudential standard on remuneration (CPS 511), which will have far-reaching implications for variable remuneration structures across all APRA-regulated entities. The prudential standard will operate alongside and supplement the Banking Executive Accountability Regime (BEAR) requirements for ADIs and the future legislative equivalent for RSE licensees, life, general and health insurers. Boards and the Remuneration Committee, in particular, will need to take note as APRA seeks to mandate an expanded range of responsibilities in relation to the operation of the remuneration framework of their organisation.

How does it affect you?

  • The proposed APRA Prudential Standard CPS 511 Remuneration will require significant changes to remuneration arrangements across APRA-regulated entities. Signature reforms include:

    • a proposed cap on the use of financial performance measures in variable remuneration arrangements across the regulated group (not only senior executives); and

    • minimum deferral periods for variable remuneration components of senior executives employed by 'Significant Financial Institutions', as well as mandated clawback periods (see further detail below).

  • Infrastructure to support remuneration review processes and information flow to substantiate variable remuneration outcomes will be required. Regulated entities will be expected to demonstrate a coherent link between the entity's remuneration objectives, risk management framework (financial and non-financial risks) and the measurement of performance at an individual, divisional and group level, and that measurement will need to be reflected in variable remuneration outcomes across the organisation.

  • CPS 511 is expected to be finalised later this year and commence on 1 July 2021 (with a deferred commencement date for the private health insurance industry).

  • In advance of the commencement date, APRA expects regulated entities will review their existing remuneration frameworks so that any new arrangements and practices are consistent with the spirit and intent of the new standard once the final version is released.

  • For ADIs, the prudential standard should be considered in the context of the BEAR framework - malus and deferral arrangements set under BEAR appear likely to require revision (subject to the outcome of the consultation process). Accountability statements and the accountability map may require updating if responsibilities change as a result of implementing the new prudential standard.

  • For RSE licensees, life and general insurers who are awaiting details of the BEAR equivalent to be legislated, it is not clear whether implementation of both the new standards on remuneration and the equivalent BEAR requirements will run on a concurrent timetable, but we think this likely. If so, implementing the new prudential requirements will add complexity to the process of preparing the accountability map, accountability statements and other supporting documentation underpinning the BEAR framework.


Overview of the proposals

Regulation of variable remuneration

  • 50% cap on financial measures While APRA is not proposing to cap the amount of variable remuneration or fixed salary amounts of employees or executives of regulated entities in absolute terms, the scope of CPS 511 is far reaching – it is proposed that all variable remuneration arrangements across the group be prudentially regulated regardless of the seniority of the employee:
    • for each employee's variable remuneration component, measures linked to financial performance cannot exceed 50% of all performance measures, and each individual financial performance measure cannot comprise more than 25% of total performance measures;1
    • all variable remuneration arrangements across the regulated group must be designed to satisfy a checklist of design criteria2 and will be subject to an overarching obligation to take appropriate steps to assess and mitigate conflicts in their design (such as metrics focused on volumes or sales);3 and
    • the ability to accelerate unvested variable remuneration will be subject to CPS 511.4
  • What will constitute a financial measure? Revenue, profit, volume-based, share value or share return-based measures (such as total shareholder return (TSR) or return on equity (RoE)) will fall in the category of financial performance measures proposed to be subject to the 50% limit. Risk-adjusted measures and an RSE licensee’s investment return measures for members will be excluded.
  • Manipulation to achieve non-financial measures? Mandating a requirement for 50% non-financial performance measures has drawn criticism from stakeholders concerned that non-financial measures can be manipulated and may be seen as rewarding business as usual responsibilities. APRA's response is that these issues should be managed via remuneration design and limiting the weighting of non-financial measures which have adverse financial outcomes.5

Remuneration outcomes – adjustments to variable remuneration

  • If remuneration objectives are not met, or there is a significant unexpected event which impacts a range of measures,6 variable remuneration outcomes must be adjusted downwards (all employees, not just those in senior executive roles), whether by way of in-period adjustments, malus, clawback or overriding discretion.
  • There is a further overarching requirement to ensure that variable remuneration is paid or vested only if it satisfies a number of criteria covering prudential, conduct and risk management outcomes, as well as group-wide, divisional and individual performance results. For RSE licensees, there is the additional hurdle that variable remuneration can only be paid or vested if it does not compromise promoting the financial interest, and reasonable expectations, of beneficiaries.7

Heightened oversight of executive remuneration

  • The Remuneration Committee will be required to assess and make recommendations to the Board annually on both the remuneration arrangements and variable remuneration outcomes on a broader category of employees who fall within a 'Special Role'.8
  • The Special Role category will cover senior managers9, those who fall within the 'material risk-taker'10 category and risk and financial control personnel.11

'Significant Financial Institution' and mandatory deferral and clawback requirements

  • APRA proposes to categorise ADIs with more than $15 billion in total assets; general and life insurers with more than $10 billion in total assets and RSE licensees with more than $30 billion in funds under management as Significant Financial Institutions (SFIs).12
  • Implications for SFIs include:13
    • CEO remuneration: 60% of total variable remuneration shall be subject to a deferral period of 7 years (with pro-rata vesting from year 4).
    • Certain employees and executives falling within a Special Role: 40% of total variable remuneration shall be subject to deferral period of 6 years (with pro-rata vesting from year 4).
    • Clawback: Variable remuneration must also be subject to mandatory clawback for a period of at least 2 years from vesting (or, where a person is under investigation, a further 2 years).

Expanded scope and operation of the remuneration framework

  • As mentioned above, as compared to the current prudential remuneration policy requirements, the scope and coverage of the remuneration framework for APRA-regulated entities will be significantly expanded.
  • There is a specific requirement for the remuneration policy to provide a description of the structure and terms of remuneration arrangements that apply across all employees of the relevant group and certain service contractors (not just senior executives and other specified roles under current prudential standards).14

Responsibilities of the Remuneration Committee and Board

APRA will mandate that the Board will be responsible for the overall remuneration framework and be directly involved in overseeing the remuneration arrangements and approval of remuneration outcomes of persons falling within the Special Role category.

  • The scope of the Remuneration Committee's responsibilities will be expanded, including a requirement to ensure (or a relevant oversight function must ensure) that comprehensive reporting is in place to allow it to assess whether remuneration outcomes of all remuneration arrangements  align with the entity’s remuneration objectives.15
  • The Remuneration Committee must ensure that the findings of an annual remuneration framework review and triennial independent effectiveness review of the remuneration framework are addressed and implemented.16
  • APRA will mandate that the Board will be responsible for the overall remuneration framework and be directly involved in overseeing the remuneration arrangements and approval of remuneration outcomes of persons falling within the Special Role category.

Issues raised (and to be addressed?)

  • Alternative model to the 50% cap on financial measures for variable remuneration? One alternative model APRA has flagged would be to rely on Board discretion in the application of modifiers in performance scorecards, and APRA is open to submissions on this (and other models) as an alternative to mandating a 50% limit on financial measures.

    We expect submissions to APRA will focus heavily on this aspect. Submissions may advocate for broader discretion to apply modifiers in performance scorecards; flexibility to deploy a higher percentage of financial performance measures where tied to longer-term incentives; or carve-outs for variable remuneration arrangements for less senior positions.

    We note that Royal Commission Recommendation 5.3 specifically recommended limits be set on the use of financial metrics in connection with long-term variable remuneration – APRA has not distinguished between long or short-term variable remuneration components in mandating the 50% cap on financial performance measures.

  • Board discretion Regulated entities and their Boards should appreciate that under the proposed standard, they are afforded a degree of discretion in designing and administering the framework, provided it is consistent with the principles reflected in the standards (such as the selection of financial and non-financial measures within the caps, the mix of fixed and variable remuneration components, and the method of adjusting variable remuneration components and design of deferral, clawback, malus or other adjustment tools (aside from an express clawback and deferral regime for senior executives of SFIs)).

    With this discretion will come the obligation to demonstrate the link between the entity's remuneration objectives, management of prudential and conduct risk, measurement of performance and the results of that performance measurement reflected in variable remuneration outcomes across the organisation.

  • Remuneration outcomes There is little delineation in the prudential standard between areas for which an employee may be responsible and a variable remuneration outcome. For example, CPS 511 could be read as requiring a reduction of every employee's variable remuneration outcome (even those in an outperforming division) in response to an incident of material misconduct in another division.
  • Disclosure and transparency APRA is considering additional prudential reporting and disclosure requirements, including publication of a regulated entity's remuneration policy and the specific performance metrics used to set variable remuneration for senior executives and their current and historical values.

    While ADIs are currently subject to remuneration disclosure measures under the prudential standards, this would be an expansion of disclosure obligations applying to superannuation funds and insurers from a prudential perspective.

  • Interaction with BEAR Some aspects of the prudential standard go further or modify the requirements imposed on ADIs under BEAR (deferral requirements and criteria for malus are two specific areas identified by APRA). APRA is seeking submissions on these and any other interaction issues with BEAR.

CPS 511 will be a stand-alone prudential standard covering all APRA-regulated entities created by shifting the remuneration requirements from the governance standards in CPS 510 and SPS 510 into CPS 511. For superannuation funds, APRA acknowledges that, with the proposed removal of remuneration requirements from SPS 510 into CPS 511, superannuation-specific issues of scope, terminology and operational structures may require further refinement in CPS 511.

What's next?

APRA is seeking submissions by 23 October 2019 on the proposals set out in its discussion paper.

A prudential practice guide and reporting and disclosure standards will be developed for consultation in early 2020.

Footnotes

  1. Draft Prudential Standard CPS 511 Remuneration, paragraph 38.
  2. Ibid, at paragraph 37(a) to (e).
  3. Ibid, at paragraph 39.
  4. Ibid, at paragraph 40.
  5. See section 4.2 of APRA's Discussion Paper Strengthening Prudential Requirements for Remuneration (23 July 2019).
  6. Ibid, at paragraph 41.
  7. Ibid, at paragraph 42.
  8. Ibid, at paragraph 48.
  9. A 'Senior Manager' means a person (i) who has or exercises any of the senior management responsibilities, within the meaning of Prudential Standard CPS 520 Fit and Proper and for an RSE licensee, Prudential Standard SPS 520 Fit and Proper, for the entity in their capacity other than as a director; and (ii) who is a director within the meaning of the Corporations Act.
  10. Means a person whose activities have a material potential impact on the entity’s risk profile, performance and long-term soundness, and, in addition for an RSE licensee, means a person whose activities have a material potential impact on promoting the financial interest, and reasonable expectations, of beneficiaries.
  11. Means a person whose primary role is risk management, compliance, internal audit, financial control or actuarial control.
  12. See section 2.1 of APRA's Discussion Paper Strengthening Prudential Requirements for Remuneration (23 July 2019)
  13. Ibid, at paragraphs 53 and 54, with a carve-out for variable remuneration components of less than $50,000 in a financial year.
  14. Ibid, at paragraphs 18(c) and 19.
  15. Ibid, at paragraph 29.
  16. Ibid, at paragraph 34.