The Investment Association has this afternoon published its much anticipated update to the ‘Principles of Remuneration’.

The Principles have been refreshed and simplified. The overall tone is positive, with companies encouraged to view the Principles as guidance and not ‘rules’. There is greater flexibility in a number of areas, alongside acknowledgement that proposals will be assessed by investors on a ‘case-by-case’ basis. Equally, the role of shareholder engagement and effective disclosure remains critical.

Our five key takeaways from the new Principles are:

1) Amenable to ‘hybrid’ long-term incentive structures

As anticipated, new guidance has been included on ‘hybrid’ long-term incentive structures (e.g. typically where a Performance Share Plan is combined with Restricted Shares). While the guidance is clear that some companies “may opt for” a hybrid structure, it will be important to ensure a compelling rationale and supporting narrative, as the Principles state: “Shareholders recognise that hybrid schemes are sometimes used by companies that have a significant US footprint and/or compete for global talent. Shareholders expect committees to explain why the hybrid model is preferred over a single structure.”

The IA expect the Restricted Shares element to follow the relevant guidance for Restricted Share proposals, most notably on the ‘haircut’ to award sizes, the underpin, and time horizons. Interestingly, the guidance on the ‘haircut’ has been slightly softened from “should be at least 50%” to “typically a discount of 50%, however, depending on the company's circumstances and the performance measures used in the previous plan a different discount rate may be considered appropriate”. On expected time horizons, the guidance states that the “vesting period for a hybrid scheme is expected to be at least five years”. The IA has confirmed to us that this should read “vesting and holding” period in line with the standard PSP/RSP sections of the guidance.

Impact: There is nothing unexpected in this change to the guidance, which is encouraging for the growing number of companies wishing to explore a hybrid structure. The guidance is helpful in focusing on the need for a compelling rationale and the importance of appropriately discounting award quantum to reflect the greater certainty of vesting from the RSP element.

2) Greater flexibility on bonus deferral

Previously, the Principles included a relatively prescriptive provision that “deferring a portion of the entire bonus into shares is expected for bonus opportunity of greater than 100% of salary”. Under the updated Principles, deferral has been re-positioned as just “one way” in which shareholder alignment might be achieved, and states that:

“A deferral policy which is aligned with the risk profile and time horizon of the business is expected by shareholders. If an executive director has met the shareholding guideline, shareholders may support a reduction in the level of deferral for the relevant director, provided that the committee still has sufficient ability to exercise malus and clawback provisions.”

This provides much greater flexibility on the level of deferral, and opens up the opportunity to link the deferral requirement to the level of the executive’s shareholding (an approach taken by around 20% of new FTSE 350 Remuneration Policies during the 2024 AGM season).

This theme is also mirrored in the guidance around other typical provisions designed to create long-term shareholder alignment (e.g. shareholding guidelines), which now states that: “If the committee considers that one element is not appropriate for the company, it is expected to explain how the equivalent goal is achieved through other mechanisms”.

Impact: The updated guidance is likely to add further momentum to the emerging market trend to link bonus deferral to shareholding guidelines, which in our view is a sensible means of simplifying the package without compromising shareholder alignment.

3) Discretion – acknowledging a role for positive discretion

The Principles continue to recognise the key role of discretion in ensuring that incentive outcomes can take into account broader performance context. However, the Principles have been updated to present a more balanced perspective of how it may be used.

Previously, the Principles focused only on the example of reducing pay-outs in the event of a ‘negative event’, with no mention of discretion being used to adjust outcomes positively. Under the updated Principles it is recognised that discretion could be used to “avoid rewarding or penalising executives for factors beyond their control or influence” and that:

“Shareholders recognise that discretion should be applied in a balanced and consistent manner, and that it can have both positive and negative implications for executive remuneration. Positive discretion can be used to reward exceptional achievements or contributions that are not captured by the predefined performance measures or targets, while negative discretion can be used to adjust remuneration outcomes downwards if they do not reflect the underlying performance of the company or the individual, or if there are significant adverse events.”

The importance of exercising discretion “diligently”, supporting decisions with high quality disclosure, and ensuring that incentive plans allow the use of discretion have all been retained in the new guidance. One addition is that companies are now also “encouraged to consult with shareholders and other material stakeholders as appropriate, especially in cases where the exercise of discretion may have a material impact on the remuneration outcomes or the perception of the company's governance and reputation”.

Impact: This is a significant change in tone from the IA. Although discretion provisions are capable of being exercised ‘both ways’, investor scepticism around positive discretion has meant that in practice it is rarely used (c.95% of discretion use in the 2024 AGM season was to reduce outcomes). Although this more balanced view provides welcome flexibility for committees, we would expect many shareholders to expect a high compelling rationale to support any positive discretion.

4) Dilution – additional flexibility, including removal of the 5% limit

The Principles continue to require that the number of new shares issued (or treasury shares re-issued) should not exceed 10% of the issued ordinary share capital in any rolling 10-year period.

However, the previous requirement that awards under ‘executive’ share plans should be limited to 5% of share capital has now been removed. In addition, the new guidance provides additional flexibility for ‘high growth’ companies to exceed the main 10% limit:

“Exceptional cases may arise for high growth companies that have recently listed on the stock exchange and need to incentivise their key employees with share-based rewards. In such cases, committees may seek shareholder approval for higher dilution limits. Committees will have to disclose the rationale and expected timeline for aligning with the standard dilution limits.”

Impact: For smaller companies in particular, this change will provide helpful flexibility in operating their executive share plans.

5) Quantum – transparency on benchmarking

The Principles continue to urge caution on the use of benchmarking (“The use of benchmarking on its own to justify increases in remuneration is not appropriate, as it can lead to a ratchet effect in the market.”).

Where benchmarking is used, the guidance on disclosure has been expanded, as shown below. This clearly acknowledges a key theme of the ongoing ‘Big Tent’ debate around the competitiveness of pay in a global market context, encouraging companies to address these issues in their disclosure.

“If the remuneration of peers and peer groups are used to justify positioning, shareholders expect that the identity and constituents of these should be disclosed, and an explanation provided as to why their selection are appropriate. If the company is deriving significant revenues from particular markets such as the US or is competing for talent globally, the committee is encouraged to set out the impact of attracting global talent on the positioning of remuneration.”

More generally on the subject of quantum, there is a general ‘softening’ of the language. For example, previous phrases such as “matter of concern”, “excess rent extraction” and an expectation that committees “show restraint” have all been removed. The tone of the new guidance is to focus more on how quantum is “appropriate for the company’s circumstances” and linked to performance.

Impact: This is a further positive development which may help the market to develop a more rational and less emotionally charged framework for discussing pay levels, for the benefit of all stakeholders. Greater transparency on benchmarking has been an emerging theme in this AGM season and could play a key part in evidencing that benchmark data is used in a robust and relevant way.

Concluding remarks

The updated Principles should be seen as positive step for the UK market. While they bring potentially greater flexibility in a number of areas identified above, the importance of a robust and balanced approach, combined with effective shareholder engagement and disclosure, will remain critical.

It will also be important to stay abreast of how the major voting agencies respond when they update their policies during the months ahead.

Appendix – other notable changes

• Non-financial bonus measures. The reference to “not rewarding executives for ‘business as usual’ performance” has been removed. However, new guidance on the relative outcomes of financial and non-financial metrics has been included: “Shareholders expect that good performance against non-financial/strategic metrics would normally translate into financial performance of the company. Therefore, in circumstances where bonus is payable for non-financial performance only, shareholders would like to understand the committee's rationale in support of such payments, including details on how the achievement of the non-financial metrics were evidenced and how pay outcomes are justified”.
• ESG outcomes in the LTIP. Building on the above, the LTIP section now includes the following statement around ESG vesting outcomes: “The pay-out of LTI awards based on ESG criteria needs to provide demonstrable performance outcomes achieved and be commensurate with the level of value creation and risk mitigation achieved by the performance against these targets”.
• NED time commitment disclosure. New requirement to “clearly disclose the time commitment which NEDs are expected to fulfil, and their fee should be commensurate to this commitment.”
• Shares which can be counted towards shareholding guidelines. The new guidance clarifies that unvested Restricted Share awards subject to an underpin should not be counted. The IA has also confirmed to us that unvested deferred bonus shares (on a net of tax basis) should still count.
• Strengthened wording on impact of share buybacks on EPS measurement for LTIPs: “Committees are also cautioned that share buybacks can impact earnings per share (EPS), and shareholders expect their impact be excluded from the calculation of performance.”
• Guidance on other long-term structures updated. The guidance on VCPs has been expanded, generally to urge caution on the potential risks. Guidance on Matching plans, Option plans and ‘Performance on grant’ plans has been removed.
• LTIP mitigation for retirees removed. The guidance that awards to good leavers who ‘retire’ should be subject to mitigation if they subsequently take up an executive role has been removed.
• Tax guidance removed. The guidance stating “Remuneration Committees should not seek to make changes to any element of executive remuneration to compensate participants for changes in their personal tax status” has been removed.