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Chapter 5: Variable pay

The real purpose of any variable pay, incentive or bonus scheme

must be clear. The organisation must have a clear idea as to its

value. The motive for variable pay should be retention or some

similar aim. It is not the ideal tool to increase business

performance, because people are inclined to start viewing variable

pay as a right and to balk at accepting less in a subsequent year.

The value-add of variable pay schemes must be assessed and

people must be sensitised to the business case for the scheme.

Care must be taken not to create perverse incentives. Variable pay

should motivate and engage employees.

There may be different approaches to variable pay. The

organisation’s approach to this issue should be made clear in the

reward strategy, whether bonuses can be paid out or some pay is at

risk.

A slope of between 15 and 30% represents the safe range of

funding methods to determine bonus pools. Most short-term

incentive schemes have a slope of about 20%, which would mean

paying out 20c in the rand of profit. If the slope is higher than this,

management will have to be able to justify it. The slope of the

scheme will probably vary according to how human or monetary

capital intensive the organisation is. For most organisations, the

ratio of human to monetary capital is about 50:50.

5.1. Short-term incentives

The purpose of short-term incentives (STIs) is to:

(a) attract and retain participants as part of a market competitive

package.

(b) reward participants directly for individual, team and organisation performance achieved over a monthly, quarterly

or annual time frame.

(c) support the achievements of the tactical and strategic

objectives of the organisation by influencing the behaviour of

the participants.

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5.1.1. Design principles

The design principles for STIs include the following:

(a) Alignment. Payments under the plan should reinforce the tactical and strategic objectives of the organisation. The plan

should firstly be aligned internally, with the daily activities of

the participants as reflected in performance management

practice. Secondly, it should be aligned externally, with the

expectations of stakeholders and with the environment.

Thirdly, it should be aligned with efficacy, or the ability of the

person being offered the incentive to influence the outcome

and the difficulty of the goal.

(b) A performance culture. Payments under the plan should be

significantly geared to individual, team and organisational

performance, with no payments made for unacceptable levels

of performance, and exceptional payments made only in the

case of genuinely stretching achievements.

(c) Participants in the STI should be able to influence the business

process.

(d) Affordability. Payments from the plan should not expose the

organisation to undue market and liquidity risk.

(e) Simplicity. Schemes should avoid complexity where possible.

(f) Communication. Participants should understand the workings of

the plan, what they need to do to optimise their payments, and

have access to regular reports which give feedback on the

metrics that drive payment.

(g) Instrumentality. Participants must believe that if they perform

as agreed, they will be accordingly rewarded.

(h) Good governance. Targets and parameters should be set in

advance of the applicable financial year. Disclosure of targets,

achievements against those targets and payments should be

disclosed to the appropriate governance bodies – management,

executive committees, the remuneration committee, the board

or shareholder or stakeholderss as determined by disclosure best practice.

(i) As far as possible, STIs should promote high performance with

high integrity.

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5.1.2. Eligibility

STI schemes should clearly state the eligibility of participants each

year in the scheme, including the amount of payment due for

performance against agreed targets.

(a) Executive directors and all employees of organisations are

usually eligible for participation in STI plans, provided they are

able to influence the business objectives that the STI is

intended to influence.

(b) It is generally not viewed as appropriate for non-executive

directors to participate in STIs.

(c) Contractors may participate in STIs if the nature of their role is

similar to that of conventional employees (they are able to

influence business results directly).

(d) The scale of eligibility should be set carefully.

(e) Affordability must be carefully considered when deciding on

eligibility. How much of every incremental rand will be paid

over to employees?

(f) Pay at risk up to a specified minimum can be part of variable

pay. Employees would then be at risk of losing a variable part

of their standard package if performance targets are missed.

This must be made clear in the remuneration philosophy, if pay

at risk is used, and the policy document must state how

variable pay works. This feature must be documented for audit

purposes.

5.1.3. Funding methods to determine the bonus pool

When a self-funding method is used, payment is determined by an

agreed financial driver exceeding a set threshold. The size of the

bonus pool for the organisation is set as follows:

(a) Continuous funding: A portion (the sharing percentage) of the

excess over threshold is used to determine a bonus pool; or

(b) On-target bonus with stretch and super-stretch targets: An

agreed portion of the financial driver is assigned to the pool on the basis of achieving the threshold or target (on-target bonus)

with stretch targets to follow with linear apportionment

between these target levels.

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The bonus pool is allocated to subsidiaries or divisions of the

organisation on the basis of their performance on the basis of the

financial driver. Subsidiary or divisional modifiers may also be used

to influence this allocation.

The bonus pool (organisation, subsidiary or divisional) is disbursed

to participants based on the distribution method.

Where a self funding method is not used and the scheme is pre-

funded by allocating funds to the bonus pool, the funding is a bonus

funding.

5.1.5. Distribution methods to allocate payments

Distribution could be based on participant influence or could be automatic. See the alternative approaches in Annexure B

5.1.6. Administrative rules

A set of guiding principles for the STI should be approved by the

Remuneration Committee and be available for inspection by all

participants.

The rules should be clear, unambiguous and provide for every event

where rules about the scheme, the payment and participation are involved.

A letter should be issued in advance of each year to each participant

setting the targets and parameters for their participation in the

scheme that year. The letter should state:

(a) the amount of payment for performance against set targets;

(b) the measures used to assess performance;

(c) the targets appropriate to the scheme, including gatekeepers,

thresholds, targets and stretch targets;

(d) caps, where appropriate; and

(e) deferral or banking requirements, where appropriate.

5.1. Reporting and disclosure

The following information must be disclosed individually for

executive directors:

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(a) The amount paid or accrued in terms of the STI in the course of

the reporting period.

The following disclosure is recommended for executive directors:

(a) The threshold, on-target and stretch level of the STI.

(b) The performance measures, their weighting, threshold, target

and stretch levels for executive STIs

5.2. Long-term incentives

The purpose of long-term incentives (LTIs) is to:

(a) attract and retain participants as part of a market competitive

package;

(b) reward participants for medium- to long-term organisation

performance or outperformance; and

(c) align management with shareholder or stakeholder interests

Long-term incentive instruments may include:

(a) share options

(b) share appreciation rights

(c) restricted shares

(d) forfeitable shares

(e) performance shares

(f) deferred bonus plans

(g) outperformance plans

(h) cash settled plans linked to the share price

(i) cash settled plans not linked to the share price

(j) combination schemes.

More detail on these instruments is provided in Annexure C.

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A multidisciplinary team will have to be involved in setting up LTI

schemes and the 1% rule should be followed when it comes to

actual settlement.

5.2.1. Scheme documentation

The following documentation should be prepared when adopting a

new scheme, depending on the organisation’s stakeholders:

(a) Salient features of scheme

(b) Rules of the scheme

(c) Grant letter

(d) Board paper and resolution

(e) Institutional investor presentation

(f) Shareholder resolution

(g) Employee presentation

(h) Other communication with employees.

5.2.2. Adoption process

The following process should be followed when adopting a new

scheme:

(a) Design

(b) Approval

(c) Implementation.

(a) The design phase should include:

a review of local best practice

a review of global best practice

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consultation with participants and Remuneration Committee

members

consideration of taxation matters

consideration of accounting matters

consideration of statutory matters – for example the

Companies Act and the JSE Listings Requirements.

financial modelling of the cost to company (on an accounting,

cash-flow and dilution basis) and benefit to participants of

initial and subsequent grants

drafting of a recommendation paper, documenting the above

matters

drafting of the rules, salient features, resolutions and grant

letter.

(b) The approval phase should include the following for listed

companies:

Executive committee approval

Remuneration committee approval

JSE approval

Board approval

Shareholder approval.

(c) The implementation process should include:

preparation of presentation material to use in communication

of the new scheme to participants.

implementing a communication process, which may use a

road-show with live presentation, conference calls, web-casts,

intranet documents or other appropriate methods.

determining the actual number of instruments issued for the

initial grant, within the parameters of the approved scheme.

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obtaining Remuneration Committee approval for the initial

grant.

issuing grant letters to the participants.

collating the acceptance notices of the participants.

issuing subsequent grants on an annual or six-month cycle,

following the steps above.

providing interim feedback on progress against performance

measures for all outstanding grants.

providing confirmation of results of performance vesting tests, and notices of if, and how many instruments have vested.

executing exercise instructions when received from

participants.

settlement of exercised options or share appreciation rights

and vested performance shares by paying out cash or

procuring shares.

the correct withholding of PAYE on accrual of instruments.

calculating the accounting charge that has arisen from

unvested equity settled grants, and all outstanding cash-

settled grants.

providing regular reports on the current and future market

risk and liquidity risk of the organisation because of long-term

incentive exposures.

5.2.3. Administrative rules

The formal rules of the scheme should include sections covering:

(a) the purpose of the scheme

(b) overall organisation limits

(c) individual limits

(d) the eligibility for participation

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(e) the time when grants may be made

(f) the grant process

(g) parameters to be specified in the grant letter

(h) performance conditions (if any)

(i) vesting, exercise (if required) and accrual of the instrument

(j) settlement

(k) lapse

(l) termination of employment

(m) change in capital structure of the organisation

(n) change of control of the organisation.

5.2.4. Performance conditions

Institutional investors now require performance vesting conditions to apply to all forms of long-term incentive schemes. They will

require these conditions in order to vote for approval of new

schemes, or will put pressure on companies to comply with this

requirement in the course of normal shareholder relations and

interactions.

Typical Performance Measures for Share Schemes are:

(o) Absolute Real Growth in Headline Earnings per Share. From

2% to 5% in SA Schemes, typically used for Listed Company Share Appreciation Rights. From 5% to 15% used for Listed

Company Performance Shares.

(p) Relative Total Shareholder Return (Share Price increase +

Dividend Yield). Compared against a Peer Group (eg. INDI

25). Compared against Lower Quartile, Median, and Upper

Quartile. Typically used for Performance Shares.

(q) Return on Capital Employed. Typically used for a portion of

Listed Company Performance Share Scheme grants.

(r) Non-financial Drivers. Typically used for State Owned Enterprises Performance Shares.

5.2.5. Taxation

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The taxation implications of the introduction of new schemes should

be carefully assessed during the design phase.

(a) The taxation rules in all relevant jurisdictions should be monitored and reviewed in case of changes and new

developments.

(b) The impact of the following should be assessed for all entities

involved in the share scheme, including trusts and special

purpose vehicles (SPVs):

Employee tax

Company tax

Capital gains tax

Withholding tax

Secondary tax on companies or dividend tax.

This assessment is complex and depends on the details of the scheme, the rules and related agreements and the structures put in

place to implement the Scheme. In particular, in South Africa, the

implications of Section 8C of the Tax Act should be considered, and

the PAYE withholding requirements should be carefully monitored,

as this aspect is a common source of costly errors.

A formal tax opinion should be sought as part of the design process,

and a review of the taxation position of the scheme, and statutory

compliance should be conducted as part of the internal and external

audit process.

5.2.6. Accounting

The accounting implications of the introduction of new schemes

should be carefully assessed during the design phase.

(a) The international accounting standards and any standards

required for companies with offshore reporting requirements

(such as US GAAP) should be monitored and reviewed in case of changes and new developments.

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(b) The impact of the following should be assessed for all entities

involved in the share scheme, including the parent company,

employer companies, trusts and SPVs:

The treatment of equity-settled share based payments (IFRS 2 and FAS 123)

The treatment of cash-settled share-based payments (IFRS

2 and FAS 123)

The treatment of cash-settled long-term incentives not

linked to the share price (IAS 19)

The treatment of hedge positions related to the scheme (IAS 39).

This assessment is complex and depends on the details of the

scheme, the rules and related agreements and the structures

put in place to implement the scheme. A formal accounting

opinion should be sought as part of the design process, and a

review of the accounting implications of the scheme and

statutory compliance should be conducted as part of the

internal and external audit process.

5.2.7. Exercise and employee settlement election

(a) After an option or share appreciation right has vested, and a

participant wishes to exercise the instrument, they should

provide a written communication (electronic communications

may be deemed to be written) to the scheme administrator on

a prescribed form indicating:

their identity, preferably stating a unique employee number

the original date of grant of the instruments

the number of instruments to exercise

their settlement election, in the case of equity-settled

instruments.

(b) In the case of equity-settled instruments, for exercised options or share appreciation rights, and vested conditional shares and

matched shares, the participant should indicate their settlement

elections as follows:

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Sell the shares in the market for cash.

Sell sufficient shares in the market for cash to settle the

PAYE.

Deliver all the shares to the participant, and the participant

will settle the PAYE obligation by deduction from their

monthly remuneration, or remittance to the company from

their own resources

(c) To retain the equity settled nature of the scheme for accounting

purposes, it is important that this instruction relating to the

total number of shares to be delivered in settlement is received

from the participant, and not from the company.

5.2.8. Settlement

The following aspects of the settlement process should be carefully

specified and implemented to ensure optimal taxation and

accounting treatment, and market risk and liquidity risk

management:

(a) Settlement by issue of new shares from the parent company

(b) Subscription for new shares at market value using a

contribution from the employer company

(c) Purchase of shares in the market using a contribution from the

employer company

(d) Usage of hedge positions (see the following section) in

settlement of scheme benefits

(e) Cash-settlement by the employer company.

5.2.9. Risk management

The following aspects of risk management as relating to long-term

incentives should be considered:

(a) Statutory risk

(b) Market and liquidity risk

(c) Reputational risk.

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These risks should be managed as follows:

(a) Statutory and reputation risk should be managed by periodic

internal and external audits of the share scheme processes and review of local and international best practice to ensure

compliance with law, the scheme rules, accounting and

taxation, and important stakeholders.

(b) To manage market and liquidity risk, the following should be

performed:

Risk reporting of the cash exposure of group entities over a

planning horizon for cash-settlement or cash purchase of shares in the market required for scheme operations. This

should be done on the basis of agreed confidence intervals,

current share prices and market condition, the current

intrinsic values of all share scheme obligations and the

volatilities of all related instruments.

Hedging share scheme exposures, as instructed by the Risk

Committee, and implemented by the treasury.

5.2.10. Quantification of awards

It is important to quantify LTI awards for the purposes of:

(a) Assessment and benchmarking of appropriate award levels

(b) Reporting the probable and possible costs and dilution to

shareholder or stakeholders

(c) Determining the appropriate leverage of awards

(d) Determining the IFRS 2 accounting charges

(e) Determining the market and liquidity risk of schemes.

The following cost parameters should be assessed for the scheme

instruments, for individual awards, total annual awards to all

participants, and all outstanding awards:

(a) The Face value of an instrument or award is related to the

share price of all shares related to the award. For example, for an Option or Share Appreciation Right, the Face Value of the

instrument is equal to the share price times the number of

Options or Share Appreciation Rights awarded.

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(b) The Expected value of an instrument or award is related to

the present value of the instrument, taking into account the

probability of all future cash-flows related to the award.

Specialised valuation formulae and models such as the Black-

Scholes formula, the binomial tree model and Monte Carlo models are used for this purpose.

For the purposes of computing the IFRS 2 Expected Value of

the award, only the market conditions and the probability of

employee forfeiture are considered. The IFRS 2 Expected

Value is amortised over the vesting period to yield the IFRS 2

Accounting Charge.

(c) For the purposes of computing the Participant Expected Value of the award, the market and non-market conditions are

considered. The probability of employee forfeiture is not

considered for this purpose.

(d) The Intrinsic Value is the value of an award at a reporting

date, considering only the market and non-market conditions

at that point, ignoring the probability of these changing until

the settlement of the award.

(e) The Settlement value is the actual value of the award

delivered to a Participant, valued on the day that it accrues to

the Participant, or at the actual cost incurred by the employer

company in settlement of the award.

5.2.11. Leverage of LTI instruments

The leverage of LTI instruments is computed as the ratio of face

value to expected value.

The leverage of a scheme determines its focus on retention or

reward:

(a) Forfeitable shares, co-investment and deferred bonus plans –

high retention value.

(b) Share appreciation rights, share purchase schemes and

performance shares reward performance.

(c) Premium priced or indexed share appreciation rights or

performance shares with high hurdles reward out-performance.

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(d) Leverage increases from retention schemes to out-performance

schemes.

5.2.12. Disclosure and reporting

In terms of current South African regulations, the following aspects of long term incentives have to be disclosed individually for the

directors of the company:

(a) The settlement value of awards delivered or exercised during

the reporting period

The following aspects of equity-settled long-term incentives have to

be reported individually for the directors of the company, and in

aggregate for all participants:

(a) All outstanding grants, categorised by number, date of grant,

date of lapse and strike price where relevant.

(b) Awards granted, exercised, lapsed and forfeited during the

reporting period.

In terms of IFRS 2 the following disclosure is required:

(a) The IFRS 2 expected value of awards granted, exercised,

lapsed and forfeited during the period.

(b) The main assumptions underlying their valuation.

(c) The type of model utilised for the valuation require disclosure.

In addition, in line with emerging good practice, the following

disclosure is recommended:

(a) The face value and expected value to the participant of all LTIs

(equity-settled and cash-settled) granted in the reporting

period, for the directors and in aggregate, for all participants.

(b) All outstanding awards, including equity-settled and cash-

settled awards, categorised by number, date of grant, date of

vesting, date of lapse and strike price, where relevant.

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Annexure B

Alternative approaches to short-term incentives

STIs have a funding and a distribution component. It is possible

(desirable) that the funding and the distribution of funds should be

driven by the same driver(s). The driver of the STI is influenced by

the extent that the participants have influence over it. For instance,

if the participants do not have influence over the driver(s), the STI is classified as a bonus. If the participants have influence over the

driver(s), it is called an incentive. When the funding and influence

interact, all STIs are grouped into four categories.

< >

Budgeted incentive plan: The

plan is funded through funds

provided against the Income

statement. The distribution of

the funds takes place through

contracted targets/objectives

with participants or group(s) of

participants.

Self-funded incentive plan: The

plan is so designed that it starts

to fund the bonus pool once pre-

contracted targets have been

achieved. The distribution of the

funds takes place through

contracted targets/objectives

with the participants or group(s) of participants.

Budgeted bonus plan: The plan is funded through funds provided

against the income statement.

Distribution is not done against

pre-defined criteria, but is

normally within management’s

discretion or a formula decided

after the fact.

Self-funded bonus plan: The plan is so designed that it starts to

fund the plan once pre-

contracted targets have been

achieved. Distribution is not

done against pre-defined criteria

but normally within

management’s discretion or a

formula decided after the fact.

< Influence over funding >

<

In

fluence o

ver

dis

trib

ution

>

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Annexure C

Share options

These were historically the most commonly used plan.

The participant is permitted to acquire a company share at a

preset strike price, usually the market value of the share when

the option was granted – an “at-the money” option.

May be exercised after vesting (3-5 years) but before lapse (5-

10 years).

Usually settled by the company issuing new shares.

Share appreciation rights

These are the new generation “options”.

The participant receives a benefit equal to the increase in the

share price from a grant to exercise.

Settled in equity or cash.

May be exercised after vesting (3-5 years) but before lapse (5-

10 years).

May be subject to performance vesting conditions.

Can be more tax-effective and better for dilution than

conventional options.

Restricted shares

Restricted shares are (free) company shares granted to an

individual subject to their remaining in the employ of the

company until a specified date, usually three to five years from

the grant date.

The participant receives dividends and voting rights on the share

at grant, but may forfeit the share if they resign or are dismissed

for disciplinary reasons before the vesting date.

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Performance shares

Performance shares are conditional (free) shares delivered to the

participant at a defined future date (usually three years after

grant) which vest subject to performance conditions.

For listed companies these performance conditions are usually

related to financial drivers (shareholder returns, return on capital

and profit growth).

For state-owned enterprises, these can be non-financial

measures linked to capacity building, empowerment,

environmental impact and operational efficiency.

Forfeitable shares

Free shares are granted up front, but may be forfeited if

employment requirements and other conditions are not met.

Qualify for dividends and voting rights immediately.

May be used to implement restricted share schemes and

performance share schemes.

Deferred bonus plans

The participant is permitted (optional deferral) or compelled

(compulsory deferral) to invest a portion of the annual bonus in

company shares or assets under management (investment

managers).

Up to half the annual bonus is usually subject to deferral.

In the case of optional deferral, 0,5 to 1 matching shares are

awarded per pledged share after three to five years if the

participant is still in the company’s employ and the pledged

shares are retained.

In the case of compulsory deferral, the initial annual bonus is

increased with compulsory deferral and co-investment for two to

three years.

Out-performance plans

Certain companies implement more leveraged plans, where the

participant has a chance of higher value being delivered than

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other plans, but extraordinary performance is required. In the

case of normal performance, little or no value is delivered by the

plan.

Premium priced options or share appreciation rights, or performance shares, deferred bonus plans and co-investment

plans where a large number of shares vest on the basis of very

stretching performance conditions fall into this category.

Co-investment and purchase schemes

Similar to deferred bonus plans.

Funds may come from other resources than the bonus.

In leveraged plans, funds can be loaned from company or a third

party.

The loans may be interest bearing or interest free (in the case of

the company loan).

Investments can be in shares or in more leveraged instruments –

for example convertible shares or preference shares.

Common in private equity deals.

Matching shares or conversions reward tenure and performance.

Cash-settled schemes linked to the share price

These schemes usually replicate the economic affect of share

appreciation rights or performance share schemes (cash-settled

share appreciation rights or cash settled LTI schemes).

They do not require JSE or shareholder approval.

It is, however, viewed as good practice to voluntarily comply

with the substance of shared-based scheme statutory

requirements.

They fall within the scope of IFRS 2 for accounting purposes, but

are accounted for as a liability rather than a reserve, and the liability must be marked to market on the basis of market

conditions (for example the share price) at reporting date. The

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accounting treatment is thus more volatile than that of equity-

settled schemes.

Cash-settled schemes not linked to the share price

These schemes usually involve a future cash payment, over a one to three year future period, based on current and future

performance, and continued employment over that period.

They are often linked to deferral or matching of the short-term

bonus, and take the form of a bonus banking scheme.

The deferred bonus may bear interest at money market rates.

The deferred bonus may be linked to a future percentage of a financial driver such as operating profit.

They do not require JSE or shareholder approval.

It is, however, viewed as good practice to voluntarily comply

with the substance of shared-based scheme statutory

requirements.

They do not fall within the scope of IFRS 2 for accounting purposes, but should be recognised as an employee benefit

under IAS 19.

Combination schemes

Over and above the above “pure” LTIs, combinations of the

characteristics above could be used. Of importance is to note that

the IFRS 2 and IAS 19 apply to the elements that are included in

the combination LTI scheme.