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EY Pay Perspective 2017 Executive and Board Remuneration Report: Turbulent times in executive remuneration

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EY Pay Perspective2017 Executive and Board Remuneration Report: Turbulent times in executive remuneration

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Executive summaryPage 3

Contents

012016: influences on remuneration

Page 4

03Short-term variable pay

Pages 6—7

05Fixed remuneration

Page 9

2017: a year to focus on performance

Page 10

04Long-term variable pay

Page 8

02

Page 5

Remuneration mix and structures

06

22

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Some companies are reconsidering executive remuneration design. For example, moving away from the market prevalent approach of fixed remuneration, short-term incentive (STI) and long-term incentive (LTI). Others are changing performance measures in their existing structures.

We start with a different perspective.

To decide what structure is most suitable, we believe it is critical to consider how value is created in your company and decide where and how you should link your remuneration structures to value creation. Defining this link to performance will inform the selection of the best remuneration structure for your business. For this report, we analysed the remuneration structures and payments for the top 100 companies¹ in the ASX200, to test our views on how executive pay should reflect performance. Our results are below.

Although some companies are considering how to use the components of remuneration in different ways, the majority of the top 100 use a construct of fixed remuneration, STI and LTI. Our findings have therefore been presented within these categories.

Executive summaryThere is an obvious intuitive appeal in saying that an effective link between pay and performance for executives is important. In our 2017 Executive and Board Remuneration Report: Turbulent times in executive remuneration, we look at how the pay and performance link is playing out in Australia as companies face a backdrop of increased political uncertainty, challenging performance and vocal shareholders.

3EY Pay Perspective | 2017 Executive and Board Remuneration Report

Remuneration mix is skewed towards variable pay, albeit to a lesser extent than in some other countries (e.g. the US and UK). Approximately 10% of companies have adopted an ‘alternative’ structure, and the speed of change has been slow.

STI design is clearly performance focussed. But it may not be entirely effective in aligning outcomes with overall performance. Across the market, STI payments do not fluctuate significantly year-on-year. Financial performance was lower in 2016 than 2015, while STI payments (as a percentage of target) were higher.

The top 100 companies are at different stages of their strategy and business cycle and in a wide range of industries, but approximately 70% of the market operate an LTI with similar performance measures and vehicles (relative TSR and performance rights respectively).

Fixed remuneration does tend to reflect many factors - including experience, as we continue to see new incumbent CEOs receiving less pay than their predecessors.

What we foundRemuneration mix should be skewed towards variable pay at the executive level. Across the market, there should be variation in the structures used to deliver executive remuneration. Designing your executive remuneration approach around your value drivers and your view of critical performance is the key ingredient.

Our view

It is equally important to have a link to performance in both: 1) the STI design2) STI payment outcomesPayments should consider both overall and individual performance.

The LTI design, incorporating performance measures and vehicles should be company specific and relevant, implying there should be variation in the market.

Fixed remuneration should reflect company complexity, the individual’s experience and role requirements.

¹The top 100 refers to the largest 100 companies in the ASX 200 by 12 month average market capitalisation. All analysis refers to the top 100, unless stated otherwise.

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01 2016: influences on remuneration2016 saw turbulent times in executive remuneration, driven by the following factors:

4

External views While there were divergent views between investors around remuneration structures and measures, the AGM season aired some common concerns, primarily around whether executive remuneration outcomes reflected whole of company performance.The broader community expressed concerns over the amount paid to some executives.

Internal pressures2016 saw new political and ongoing economic uncertainty. Against this backdrop, some companies had difficulty setting performance targets, experienced a lack of variability in remuneration outcomes and questioned the effectiveness of the STI to deliver the right messages.

Talent market Remuneration was used actively as a tool to attract (and help retain) the right talent and to reinforce the company’s desired behaviours and culture.

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Consistent with our expectations, the market continues to have a heavier weighting on variable remuneration than fixed remuneration (figure 1).

The way that variable remuneration is delivered, and your performance emphasis, should be customised to your business value drivers. As outlined in figure 2, companies may consider changes within existing prevalent structures or may consider entirely different structures.

Figure 2: ‘alternative’ remuneration structures

For some companies, the market prevalent approach will continue to work, potentially with further customisation of specific design elements (e.g. performance measures or performance periods). For other companies, an alternative framework could be considered if it suits the business circumstances and strategy.

Approximately 10% of companies have adopted a different structure, and the speed of change has been slow. Common approaches are the provision of some fixed remuneration in equity or a combination plan that

amalgamates the STI and LTI into a single plan. We do see some variation in the period over which remuneration is delivered (e.g. the average time to receive variable remuneration in the retail sector is 2 years, compared to 2.7 years in the finance sector). However the variation is not to the extent we would expect.

We expect the slow pace of change to continue in 2017, as companies continue to consider revised structures. We do not expect this will result in a radical shift in practices in the near future.

02 Remuneration mix and structures“Your performance emphasis should be customised to your business drivers”

BUH

CFO

CEO

Average fixed remuneration as a % of total remuneration

Average variable remuneration as a % of total remuneration

31%

38%

40%

69%

62%

60%

Figure 1: target remuneration mix continues to be weighted to variable remuneration for all roles²

EY view

Remuneration mix should be skewed towards variable pay at the executive level.

Across the market, there should be variation in the structures used to deliver executive remuneration. Designing your executive remuneration approach around your value drivers and your view of critical performance is the key ingredient.

Fixed remuneration + LTI

Fixed remuneration + combined variable

remuneration incentive

Medium to long-term strategic focus

Fixed remuneration + STI

Fixed remuneration + STI

Short term tactical focus, emove performance

based LTI

-term performance focus

LTI with company

milestone measuresLTI without relative

TSR

Short and long-term incentive plan: Prevalent structureMajority of ASX 200 listed companies retain this approach

LTI (equity) with TSR and another

STI (cash) (likely with deferral

into equity)

Fixed remuneration (cash)

ormay be delivered partly in

equity

R

(with STI partly delivered in deferred equity)

(both elements delivered partly in equity)

5EY Pay Perspective | 2017 Executive and Board Remuneration Report

² Chief Executive Officer (“CEO”) Chief Financial Officer (“CFO”) Business Unit Head (“BUH”)

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STI design

STI frameworks are linked to performance, with most companies operating a scorecard which measures both financial and non-financial measures.

While a scorecard presents a balanced view of performance, the discrete measurement of multiple components is more likely to result in payments consistently around target level. The “whole of company” performance overlay is important to determine where adjustments may need to be made to payments derived from the underlying scorecard.

Short-term performance measures tend to be consistent across the market, most commonly, profitability (figure 3) and strategy-based measures (figure 4). The three most prevalent measures in 2016 are presented in the relevant figures.

Figure 4: strategy-based measures are the most prevalent non-financial measure

Figure 5: rights and shares continue to be the primary STI deferral vehicle

The majority (69%) of companies are retaining ongoing exposure to company and share price performance through the use of STI deferral. The most common vehicles for deferral continue to be rights and shares (figure 5).

03 Short-term variable pay“There is an opportunity for companies to strengthen the link between performance and payment outcomes”

Figure 3: profit/earnings is the most prevalent financial measure

94%

88%

2016 2015

Profit/earnings

Expenses/cost management 35%

33%

26%

34%

Return

2016 2015

70%

58%

People/values/culture/behaviour

Business plans/strategy/growth

Safety/health/environment/sustainability

65%58%

58%

52%

2015

48%

48%

38%

8%8%

8%3%

41%

RightsSharesOtherCash

2016

EY view

It is equally important to have a link to performance in both:

1) the STI design

2) STI payment outcomes

Payments should consider both overall and individual performance.

More focus should be placed on the whole of company assessment of performance.

Good decision-making in determining incentive outcomes requires performance information to be drawn from a range of perspectives and considered on a timely basis.

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Figure 6: STI payment ranges are narrowing

STI payments as a percentage of target opportunity

7EY Pay Perspective | 2017 Executive and Board Remuneration Report

There is an opportunity for companies to strengthen the link between performance and payments. To strengthen this link, management and the Remuneration Committee have different roles to play:

³Sixty-five percent (65%) of top 100 companies experienced lower TSR in 2016, 56% experienced lower EPS growth and 55% experienced lower Operating Income growth. 4CEO STI payments for any company in the ASX100 at 1 December, over the past five years.

STI payments

At an aggregate market level, the focus on performance that is present in STI design is not reflected in the level of STI payments. Financial performance in 2016 was lower for most companies than 2015³. Consequently, we expected lower (or potentially a broader range) of STI payments as a percentage of target.

The market data, at an aggregate level, does not indicate a strong downward movement or a broadening of payments (figure 6)4. The payment range narrowed in 2016, with payments:

Test and validate information from management, including considering whole of company performance.Analyse the implications for payments when results are conflicting (e.g. under achievement of financial performance and over achievement of non-financial performance could still result in target payments for some companies).

Ensure clear messages are given to executives around the level of performance expected to receive payments and, once payments have been determined, how performance has been considered in the determination of outcomes.

Undertake clear external communication and drive the shareholder engagement process.

The Remuneration Committee may:

Increasing at the:

10th percentile 25th percentile 50th percentile

However, while the aggregate market may not exhibit significant volatility, we do see some volatility at an individual company level. For example, 25% of companies did not make an STI payment at some point over the last 5 years.

Decreasing at the:

90th percentile75th percentile

Management may:

Ensure the information provided to the Remuneration Committee is ongoing and considers all remuneration elements at the same time, rather than discrete decision making regarding individual remuneration elements.

Undertake a critical assessment of performance at the end of the period. Information should be provided to the Remuneration Committee incorporating both the view of performance within the plan design plus the whole-of-company performance as seen by shareholders (i.e. financial, operations, risk, culture and reputation which are potentially not included in the plan design).

180%

140%

100%

60%

20%

2012 2013 2014 2015 20160%

25th percentile10th percentile 50th percentile 75th percentile 90th percentile

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The majority of companies continue to use relative TSR as a performance measure (potentially combined with a second measure) (figure 7) and performance rights as the plan delivery vehicle (figure 8). This uniformity of measures and vehicles infers there is a similar long-term strategy across the majority of companies – which is in contrast to our understanding of the variation in business strategies across the market.

TSR can reflect a different performance focus, depending on the comparator group selected and the way performance is measured. We suggest companies are clear on the purpose of their TSR measure before selecting a measurement approach, for example:

Figure 7: TSR is the most prevalent performance measure

94%

85%

2016 2015

TSR

EPS 45%

39%

42%

27%

Return

Figure 8: performance rights are the most prevalent plan vehicle

92%

81%

2016 2015

Performance Rights

Share options 14%

5%

17%

4%

Phantom/Cash

Other

Performance shares

5%

2%

12%

4%

EY view

LTI design, incorporating performance measures and vehicles should reflect company needs.

The significant use of features such as performance rights and relative TSR suggest LTI design is undertaken without sufficient consideration of its alignment to business strategy or the aims of the plan.

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Relative TSR measured against broad, multi-industry comparators

Relative TSR measured against select industry comparators (“peers”)

Absolute TSR

Exam

ple

perf

orm

ance

mea

sure

Broad comparisonShareholders can allocate their investment funds across a broad group of industries/companies. We want to be a preferred investment choice across that group.

Industry comparisonWe will outperform relevant peers (typically those in “our industry”) – when investors put money into our industry, we want them to invest in us.

Outcomes achievementWe want to deliver positive shareholder returns regardless of market dynamics, to reflect our shareholder’s expectations.

Impl

ied

stra

tegy

04 Long-term variable pay“Uniformity of measures and vehicles…is in contrast to our understanding of the variation in business strategies across the market”

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EY view

Fixed remuneration should reflect company complexity, the individual’s experience and role requirements.

05 Fixed remuneration“Remuneration increases continue to be constrained”

9EY Pay Perspective | 2017 Executive and Board Remuneration Report

Fixed remuneration does reflect company complexity and individual experience. In 2016, we saw a flat market for fixed remuneration (figure 9) as new incumbent CEOs continued to be paid less than predecessors. Further, increases across the market remained conservative (figure 10). For fixed remuneration, increases were 3% or less across CEO, CFO and BUH roles (individuals in the same role year-on-year).

Figure 10: median remuneration increases continue to be constrained (percentage increase in target remuneration for same incumbent roles)

Element CEOFixed remuneration

Total remuneration

2.3% 3.0% 2.6%

1.4% 4.7% 1.7%

CFO BUH

Figure 9: median fixed remuneration remained relatively stable across all roles

6,222 6,128

2,169 2,417 2,2512,486

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2015 2016 2015 2016 2015 2016

($'000s)

Fixed remuneration Variable remuneration

CEO CFO BUH

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Remuneration Committees will make hard decisions about how, and how much, remuneration is paid

Remuneration Committee membership is not for the faint-hearted, with executive remuneration becoming a high profile statement of a company’s acceptable level of performance, for the company overall and its individual executives. Over the coming year we expect more Remuneration Committees to exercise informed judgement over STI payments.

Refreshed engagement with investors

We believe a new perspective on interacting with shareholders is required. We believe the right way forward is to adopt a mindset which recognises shareholders as both customers and owners and to drive a proactive communication approach that focuses on:• A clear explanation of how the company creates shareholder value and how

the remuneration approach supports this• An explanation of what key remuneration decisions were made and why• Simple and easy to understand Remuneration Reports

An emerging focus on assessing remuneration in the context of the purpose and culture of the company

A company’s remuneration framework and, in particular, incentives have a substantial influence reinforcing company purpose and behaviours. We expect companies to assess critically the current and potential consequences of the remuneration framework, both on performance and culture.

More ‘alternative approaches’, but not the majority

Companies will re-think structures and/or performance measures. There will be enhanced consultation on and communication of, any changes. We believe the rate of change, particularly in terms of changing structures and measures will be gradual.

06 2017: a year to focus on performance

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AdelaideCraig Whiteman Tel: +61 8 8417 1770 [email protected] BrisbaneShannon James Tel: + 61 7 3011 3182 [email protected]

MelbourneJoanne Avasti Tel: +61 3 9288 8212 [email protected]

Bruno Cecchini Tel: +61 3 9288 8423 [email protected]

Hillel Nagel Tel: +61 3 8650 7227 [email protected]

Mark Phillips Tel: +61 3 9288 8007 [email protected]

PerthTanya Ross-Jones Tel: +61 8 9429 2249 [email protected] Connors Tel: +61 2 9248 4318 [email protected]

Chris Galway Tel: +61 2 8295 6476 [email protected]

Mike Hogan Tel: +61 2 8295 6853 [email protected]

David Werner Tel: +61 2 8295 6721 [email protected]

EY contacts

11EY Pay Perspective | 2017 Executive and Board Remuneration Report

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