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Focus: APRA releases draft executive remuneration guidelines

2 June 2009

In brief: Last week, the Australian Prudential Regulation Authority released proposed extensions of its prudential standards to cover remuneration, and a draft prudential practice guide on remuneration policies for financial institutions. Allens Executive Partner Paul Quinn looks at the new guidelines.

How does it affect you?

  • Australian Prudential Regulation Authority (APRA)-regulated entities must have a remuneration policy that aligns remuneration and risk management. They must also have a board remuneration committee comprising of non-executive directors.
  • Comments on the drafts must be submitted to APRA by 24 July 2009. It is expected that the final standards and associated prudential practice guide will be released in September 2009, to be effective from 1 January 2010.
  • APRA-regulated entities will need to ensure that they have a remuneration committee and remuneration policy that comply with the new standards. APRA has indicated that should entities fail to comply, then it has several supervisory options, including the power to impose additional capital requirements.

APRA standards and guidelines

APRA has proposed an extension to existing governance standards to cover remuneration. It has also issued a draft prudential practice guide on remuneration.

The proposed extensions will require APRA-regulated institutions to:

  • have in place a remuneration policy that includes alignment of remuneration arrangements with the long-term financial soundness of the regulated institution and its risk management framework, and explains who is covered by the policy, and
  • establish a board remuneration committee comprising entirely of independent directors with the requisite skills and knowledge to perform its functions, which, at a minimum, are to review the remuneration policy periodically and make recommendations to the board.

The Prudential Practice Guide on Remuneration is to assist boards to comply with the new governance standard and covers issues such as:

  • the use of deferred remuneration;
  • guidance on the links between incentive and risk and on the use of equity in incentive arrangements;
  • the need to link incentive remuneration to both forward- and backward-looking risk measures; and
  • the balance between fixed and variable components.

The proposed extension of the standards is to cover gaps identified by the Principles of Sound Compensation Practices, issued by the Financial Stability Forum and endorsed by the leaders of the G20 in April. Of particular concern was that remuneration incentives did not have adequate regard to longer term risks. This amplified the excessive risk taking that destabilised the global financial system. Hence the focus on aligning remuneration policies with risk management.

Remuneration policy

The board of a regulated institution must establish a written remuneration policy designed to encourage behaviour that supports long-term financial soundness and the risk management framework of the institution. The design of individuals' performance-based remuneration arrangements must allow for adjustments to reflect the risks arising from the business activities, the controls in place to mitigate those risks, the time necessary for the outcomes of those businesses to be reliably measured and the capital allocated to the business activities.

These elements must be fed into the measures of performance and the mix of forms remuneration (such as fixed and variable components), cash and equity related benefits (and the timing of when the individual becomes eligible to receive the payments). It envisages that a board can reduce or eliminate payments of performance-based remuneration where necessary to protect the financial soundness of the institution, or where adverse outcomes over time lessen the original assessment of the performance.

The policy must, at a minimum, cover the following persons:

  • each responsible person (excluding responsible auditors and non-executive directors);
  • risk management, compliance, internal audit and financial control personnel; and
  • all other employees or agents for whom a significant proportion of total remuneration is variable and determined by performance measures.

This would cover not only employees of the regulating institution but also employees of subsidiaries or other related companies, and even consultants, contractors or agents if they fulfil one of the roles described above.

It also provides that risk and financial control personnel are remunerated in a manner that is independent of the business areas they oversee.

It prohibits those who receive equity or equity linked deferred remuneration from hedging their economic exposure ie, those persons should be subject to downside risk.

The remuneration policy must form part of the regulated institution's risk management system and be provided to APRA on request.

Board remuneration committee

Unless otherwise approved in writing by APRA, a regulated institution must have a board remuneration committee with at least three independent directors. It will be responsible for conducting regular reviews of remuneration policy and assessing its effectiveness and compliance with the requirements of the Prudential Standards. The committee will make recommendations to the board. Members of the board remuneration committee must collectively possess appropriate expertise to perform their function. However, it is acknowledged that they may supplement their knowledge and expertise through appointing independent experts on remuneration and risk issues. Those experts must be selected and instructed by the committee directly.

The board remuneration committee must have free and unfettered access to risk and financial control personnel and to other parties (internal and external) to advise on the operation and effectiveness of the remuneration policy. The board remuneration committee must also be available to meet with APRA on request.

Prudential Practice Guide

The draft Guide gives further guidance on complying with the new extended standards. This includes discussion on adjusting remuneration for risk, measuring performance and other considerations for executive remuneration.

Remuneration and risk

APRA'S new Prudential Standards clearly focus on the need for remuneration policies to take account of risk. This is one of the key lessons from the Global Financial Crisis. Remuneration policies that focus on short-term profits without adequate regard to risk motivate excessive risk taking. APRA has adopted a sensible principles-based approach to give institutions the ability to incorporate the new standards and guidelines within risk management policies that are appropriate for the relevant institution. APRA sees these new requirements as being closely aligned with the ASX Corporate Governance Principles and Recommendations and the Guidelines for Listed Company Boards released in February 2009 by the Australian Institute of Company Directors. These are supported by APRA.

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