It is generally conceded that inappropriate incentives and remuneration structures led to unwelcome behavior in the banking industry: this increased risk and contributed to the crisis. Regulators across Europe and Asia-Pacific are now focusing closely on this topic in relation to investment management firms, reflecting the political imperative to control excess and reduce risk. Firms will have to respond. But it will be important to preserve flexibility.

General anger, specific concern

Remuneration is one of the more politically sensitive issues to emerge as a priority from the financial crisis. When times are good, there appears to be little general concern over levels of remuneration in the financial sector. But when things go wrong, causing loss and damage to millions of people, there is an inevitable focus on the contrast between performance and reward. The sense that senior executives, in particular, have 'got away with it', and in many cases received massive rewards for failure, has been a powerful stimulus to political action.

While this kind of reaction is primarily an expression of generalized and unsophisticated anger, more considered analyses have also led to concern about remuneration arrangements in financial services. There is an increasingly widespread view among political leaders, regulators and supervisors that, in the period leading up to the crisis, remuneration structures created damaging and destabilizing incentives. At the least, they stimulated excessive short-termism at the expense of the long-term sustainability of business models; at worst, they created pressure to make profit at any price, if necessary through behavior which was improper or bordering on illegal.

The apparently endless succession of miss-selling scandals now hitting the industry provides a stark demonstration that remuneration policies and incentives resulted in serious misbehavior. Many – though not yet all – leaders within the financial services industry itself are coming to feel with hindsight that the concerns now being expressed are justified. As regulators focus on prudential management, conduct of business and financial stability, they are also – for the first time – directly addressing the issue of remuneration.1


For investment managers in Europe, this focus on remuneration will mainly be felt through the new Alternative Investment Fund Managers Directive (AIFMD), which places remuneration policy firmly within a framework of promoting sound and effective risk management. The European Securities and Markets Authority (ESMA) published draft guidelines on the remuneration elements of the Directive in June 2012, followed by final guidelines in February 2013. AIFMD must now be implemented at national level by 22 July 2013.

The regulations implementing AIFMD will require investment management firms to make changes to the structure and governance of remuneration, and will introduce a new disclosure regime. In-scope firms will be required to have remuneration policies that 'promote effective risk management' and which align risks with their broad investment objectives. The remuneration requirements will primarily apply to employees whose role has a material impact on the risk profile of the firm or the funds under management ('identified staff').

There will be specific requirements in relation to the funding and delivery of variable remuneration. A portion of the variable remuneration for identified staff must be deferred for between 3-5 years (unless the lifecycle of the fund is shorter). At least half of all variable remuneration must be in the form of equity instruments linked to the performance of the funds managed. Variable remuneration should be determined by performance of the funds, of the business unit and of the individual combined. There will also be controls on guarantees, severance pay and personal hedging strategies.

In addition, there will be new regulations on remuneration committees, on internal controls and on reporting and disclosure.

ESMA has introduced various anti-avoidance measures to ensure that the regulations capture the intended firms, individuals and forms of remuneration. The provisions also introduce the concept of clawback provisions (or 'malus') for remuneration in the case of under-performance. These concepts will be familiar to many in, for example, the banking sector, where they have become a feature of remuneration packages since the crisis. However, it remains unclear how they will work in practice in other industries and for a wide population of staff.


In Australia, the Future of Financial Advice (FOFA) reforms will introduce a ban on 'conflicted remuneration', including commissions, in the retail investment products market. Broadly speaking, licensees and authorized representatives will not be allowed to give or receive payments or non-monetary benefits if these could reasonably be expected to influence financial product recommendations or financial product advice provided to retail clients. As a result, all payments dependent on the total number or value of financial products of a particular type will be presumed to be conflicted, although it will be open to advisers to prove that they are not. These reforms are designed to encourage financial advisers to become more client-focused, with more of their fees being paid directly by the client rather than indirectly through product commissions.

In Japan, there are currently no specific regulations governing executive remuneration. However, the Japan Financial Services. Authority retains the power to require changes to any remuneration system in a financial institution which it feels is creating excessive risk. There is also an obligation to disclose details of high salaries, requiring financial institutions to disclose both the number of highly remunerated individuals and the amounts involved.

Implications for investment managers

The thrust of the increasing regulatory oversight of remuneration in investment management is to limit risk and ensure that it is consistent with an organization's explicit risk appetite and risk management policy. Organizations therefore need to develop remuneration frameworks which connect performance and reward with the strategy, priorities and value drivers of the organization, and which incorporate effective risk management.

In turn, this depends on creating a culture of appropriate behavior and values and on expressing organizational priorities clearly and consistently – embedded using structure, process and training and passed on over time through stories of successes, failures, doing the right thing and doing things right – reinforced through incentives. These arrangements need to be underpinned by robust governance arrangements including appropriate control functions.

Embracing regulatory initiatives early on – seeking the opportunities rather than focusing on the challenges – can allow the organization to respond and act quickly ahead of the competition.

Getting the balance right

The remuneration policies of financial institutions are likely to remain high on the political agenda for the near future. As we have seen, the need to address issues from systemic risks to investor protection and to improve transparency, corporate governance and tax compliance will add to the pressure for tougher regulatory action in this area.

However, it is important to remember that incentive structures which involve a high proportion of variable remuneration, in the form of commission or bonuses, ultimately reflect a desire to improve the flexibility of cost structures, and tie remuneration more closely to performance: where remuneration is largely fixed and rigid, the ability to match costs to revenues and profits is severely curtailed. In the new era of low returns and increased cost pressure, flexible resourcing and remuneration models will be more important than ever in the investment management industry. The challenge for new regulation will be to restrict excessive and perverse incentives while allowing the industry the necessary flexibility to grow and to serve customers effectively.


1 The discussion which follows draws on the latest edition of KPMG's series Evolving Investment Management Regulation: Light at the End of the Tunnel? June 2013.

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