Rewarding directors

Professor Paul Kerin considers how boosting non-executive director financial incentives will benefit shareholders and change the future shape of boards.

Boards will inevitably change on many fronts in future – including governance, size, composition and financial incentives. I’ll address each of them in my next few columns, but this column will focus on the one change to current Australian practices that I believe would deliver the single biggest benefit to shareholders: boosting non-executive director (NED) financial incentives.

Economists’ research has produced the following evidence:

1. Share-based incentives improve shareholder value.
2. Cash-based compensation can be structured to improve NED behaviour.
3. Concerns about shares-based incentives are over-rated and manageable.

Giving NEDs share-based incentives through share-based compensation and/or share ownership requirements boosts shareholder value in two ways. First, by improving operating performance (e.g. return on assets), and second, by reducing risk and thereby the cost of equity and debt.

Share-based incentives work by better aligning NEDs’ interests with those of shareholders. They improve NED performance in both of their key roles – monitoring and guiding. NEDs become more prepared to take calculated risks that are likely to increase shareholder value and less prepared to take risks likely to destroy shareholder value.

These benefits are recognised by the market. For example, share prices are marked up when companies announce NED share ownership plans. Even restructuring NED cash payments can create positive incentives. Economists have shown that paying some NED cash payments as meeting fees rather than annual retainers significantly boosts board meeting attendance.

Evidence also shows that concerns about share-based incentives are over-rated. In Australia, a key concern is NED independence. It is true that the evidence shows that high NED share-option incentives increases the risk of fraudulent financial reporting. However, high NED share ownership does not.

A related concern is that share-based incentives may lead to “risk-shifting” – boards taking riskier actions that hurt non-shareholders (such as debt-holders) and, ultimately shareholders. In fact, economists’ evidence demonstrates that share-based incentives actually reduce corporate bond yields because debt investors perceive that NEDs will better monitor and manage risk. Shareholders benefit through a lower cost of capital.

Considerable gains

Sure, boards need to be careful in designing share-based incentives. But the upsides are considerable and boards can guard against the possible downsides through various mechanisms, including vesting periods for share-based compensation and post-retirement holding requirements under share ownership plans. Yet current Australian NED compensation differs substantially from what the evidence suggests it should be. Only about 10-15 per cent of S&P/ASX 200 companies employ share-based NED compensation. Many do have share ownership requirements and at least 80 per cent of NEDs own company shares, although ownership levels are much lower than in the US.

In contrast, over 80 per cent of S&P 1500 companies use share-based compensation. Over 60 per cent of NED compensation is share-based at large-cap US companies (with market capitalisations exceeding $AU6.5 billion); even in small-cap companies, it is almost 50 per cent. Over 80 per cent of large-cap US companies have director share ownership requirements; the median ownership target is around $AU500,000.

Of course, the US isn’t perfect. However, the evidence suggests that by not making sufficient use of share-based incentives, we are leaving substantial gains on the table. While shareholders would generally gain if Australian companies boosted share-based incentives, the incentives should be tailored to a company’s specific circumstances.

There are some impediments to boosting incentives. One is our collective mindset. We all like to think that we will always do our best on a board, regardless of financial incentives. But the evidence shows that we – like everybody else – do respond to incentives. With strong incentives, we do even better, so in light of the evidence, it may be time to review any remaining impediments.