Following the release of APRA's final version of CPG 511, Regulated Entities should begin to review and revise their remuneration arrangements sooner rather than later.
In response to Prudential Standard CPS 511 Remuneration (CPS 511) being released on 27 August 2021, the Australian Prudential Regulation Authority (APRA) has recently published a final version of its Prudential Practice Guide CPG 511 Remuneration (CPG 511).
CPG 511 provides APRA-regulated entities (including banks, insurers and superannuation licensees) (Regulated Entities) with guidance on navigating heightened requirements under CPS 511 with respect to remuneration and accountability, and communicates APRA's expectations in this regard.
Despite the first CPS 511 requirements not taking effect until early 2023, Regulated Entities should begin to review and update their remuneration practices as APRA increases its supervisory oversight on the implementation of CPS 511 requirements. Having regard to these requirements, it is likely that Regulated Entities will need to plan ahead for compliance with the new regime - this is particularly so given the volume and pace of financial services regulatory reform in general.
On 18 October 2021, APRA released the final version of CPG 511 which seeks to provide guidance to entities covered by CPS 511. Broadly, CPS 511 requires Regulated Entities to establish and maintain:
- stronger incentives for individuals to prudently manage
- appropriate consequences for poor risk outcomes; and
- increased oversight, transparency and accountability on remuneration.
CPG 511 assists Regulated Entities in meeting these requirements by providing guidance and examples of better practice to enhance Board oversight, maintain a compliant remuneration framework, improve the use of non-financial measures in remuneration design, and ensure there are suitable consequences for risk issues or misconduct.
Who is affected?
CPS 511 applies to all APRA-regulated entities but imposes more onerous requirements on significant financial institutions (SFIs) who satisfy the following asset thresholds:
- Authorised deposit-taking institutions (ADIs)
with total assets in excess of $20 billion;
- General and life insurers with total assets in excess of $10
- Private health insurers with total assets in excess of $3
- Registrable superannuation entity (RSE) licensees with total assets in excess of $30 billion.
CPG 511 states APRA can also determine that an entity is an SFI based on the complexity of its operations or remuneration practices, or its membership within a corporate group.
APRA has also determined foreign branches will not be classified as SFIs in most circumstances and will only be required to comply with specific SFI requirements if their assets exceed the thresholds outlined above. This is welcome news for foreign entities whose SFI obligations will generally be confined to their Australian branches (where applicable). For those foreign entities who fall outside this regulatory relief from SFI obligations, it will be important to pay particular attention to the new regulatory requirements.
How are you affected?
CPS 511 requires Boards to play a more active role in determining remuneration outcomes across the organisation and for key individuals. Boards of SFIs must establish a Board Remuneration Committee (RemCo) to oversee the design, operation and monitoring of the remuneration framework. CPG 511 suggests that a prudent Board would ensure the RemCo is comprised of appropriately qualified members who possess a clear understanding of risk management. Despite not being required to establish a RemCo, Boards of non-SFIs must implement arrangements to comply with the requirements of CPS 511 and ensure there is sufficient oversight of the remuneration framework and key remuneration decisions.
CPG 511 says that APRA expects Boards to be actively involved in the review of key remuneration decisions in order to provide comprehensive and independent scrutiny. This role is intensified in unusual or exceptional circumstances, such as when there is a material adverse risk or conduct outcome and/or the Regulated Entity is undergoing a period of financial stress.
CPG 511 also outlines the expectation for Boards to use their discretion in a timely and informed manner. This may include pre-emptively reducing variable remuneration during a period of stress rather than reacting once risk issues are made public.
APRA says Boards should also ensure that management reporting on remuneration is detailed, sufficient and meaningful. Performance and risk assessments on key individuals should be formally documented and input should be sought directly from senior risk management personnel. Verbal discussions, generalised attestations as evidence of performance or risk assessments, and high level summaries of major incidents are insufficient. For many Regulated Entities, this will require a recalibration of the way in which remuneration is dealt with at the Board level and throughout the organisation.
Regulated Entities must maintain appropriate remuneration frameworks that set out key policies and processes necessary to comply with CPS 511 requirements. Remuneration policies must govern the entire entity but special requirements are imposed for senior managers, executive directors, risk and financial control personnel and material risk takers (Specified Roles) whose variable remuneration must be approved by the Board or relevant oversight function.
Third party service providers remain a focus as APRA reaffirms the requirement for Regulated Entities to mitigate material remuneration conflicts that may result from compensation arrangements with third parties, such as investment managers and brokers. CPG 511 states that changes to a third party service contract should not occur where a Regulated Entity has already put in place effective strategies to mitigate the risk of requiring change to such contracts. Examples of appropriate risk mitigation measures that have been provided by APRA include:
- seeking assurances from third parties;
- reviewing business written by third parties with greater
- subjecting third parties to greater controls, such as tighter approval criteria, increased reviews, and more detailed and frequent monitoring.
Regulated Entities are also required to design remuneration with regard to performance and risk under CPS 511. CPG 511 says that when designing remuneration arrangements, a prudent entity would carefully review the balance between fixed and variable remuneration so incentives for performance and risk management are appropriately balanced. More complex remuneration arrangements are expected to be subject to greater oversight and risk controls.
So that financial performance is not the sole driver of remuneration outcomes, CPS 511 requires that SFIs give material weight to non-financial measures when determining performance-related variable remuneration. The process for defining how material weighting is applied should be clearly defined and not be completely discretionary or opaque. CPG 511 also expresses APRA's expectation that non-SFIs will consider whether and how to incorporate non-financial measures into remuneration. These matters were the subject of considerable debate during the Hayne Royal Commission and it will be interesting to observe the extent to which Regulated Entities have already made a head start on this aspect of the new remuneration requirements.
Under CPS 511, SFIs must also apply minimum deferral periods to variable remuneration earnt by Specified Roles, provided that deferred variable remuneration is $50,000 or more in a financial year. These periods are intended to reflect the length of time required for risk and conduct issues to materialise, thereby providing SFIs with the opportunity to adjust short-term awards where long-term risks persist. CPG 511 suggests that SFIs may consider longer deferral periods and expand deferral arrangements to other roles not already covered by CPS 511. Non-SFIs are also encouraged to apply deferral periods despite not being required to do so.
Risk and conduct adjustments
Regulated Entities must implement mechanisms to allow for adjustments to variable remuneration. These mechanisms include in-period adjustments, malus1 and clawback2 which are capable of reducing all or part of variable remuneration for serious risk issues and misconduct, including conduct dating back several years. CPG 511 advises that these features should be incorporated into contractual arrangements and policy to give a legal basis for downward adjustments.
Where a downward adjustment has been applied to variable remuneration, CPG 511 says that it would be inconsistent for entities to make offsetting increases to other forms of remuneration. Downward adjustments should also be made on a timely basis and may be required at the executive level to reflect a line of accountability where lower level employees have had their variable remuneration reduced.
To better ensure downward adjustments are proportionate to the severity of the risk and conduct outcome as required by CPS 511 requirements, CPG 511 suggests a 'severity scale' be developed to guide decision-making and maintain consistency across adjustments through the use of case studies and precedents. This will not come as a surprise to Regulated Entities, and again, some will find they have already taken steps towards adopting something akin to a 'severity scale' in the context of adjusting variable remuneration.
SFIs are required to undertake annual compliance reviews of their remuneration framework by conducting a self-assessment against CPS 511 requirements. CPG 511 suggests prudent non-SFIs will also consider reviewing their remuneration framework when applicable. A more comprehensive review must also be completed by SFIs every three years and includes benchmarking their remuneration framework against better practice. CPG 511 advises that such reviews could be carried out by expert external providers, otherwise Boards should seek assurances that internal reviewers are sufficiently independent. The key here is to ensure true independence for the comprehensive review and not simply seek out confirmatory views from the Regulated Entity's external providers under a tick-box approach.
Alignment with the Financial Accountability Regime
Following consultation on a draft version of CPG 511 earlier this year (Draft CPG 511), APRA has sought to align CPG 511 with the Federal Government's proposed Financial Accountability Regime (FAR). FAR, which is yet to be finalised, will require APRA-regulated entities to establish minimum requirements for the deferral and reduction of variable remuneration to target poor accountability outcomes. CPG 511 provides further guidance on deferral and vesting requirements under CPS 511 to create better alignment with FAR, and APRA has previously indicated that it may make additional amendments to CPS 511 when FAR is finalised. Given the history of recent financial services regulatory reform and what we know about FAR to date, it is almost inevitable that CPS 511 will require some tweaking to accommodate the FAR proposals (which themselves have a long gestation period ahead).
APRA has also addressed submissions made on Draft CPG 511 that buyouts, where a new employer reimburses an individual for their forfeited variable remuneration at an existing employer, should not be subject to deferral requirements. APRA has rejected such carve outs on the basis they are inconsistent with the draft FAR regime.
What timeframes apply to you?
Under the staged implementation approach, CPS 511 requirements will first apply to ADI SFIs from 1 January 2023, followed by insurance and RSE licensees SFIs from 1 July 2023 and non-SFIs from 1 January 2024.
In response to queries raised during consultation on Draft CPG 511, APRA has clarified that CPS 511 requirements do not apply to variable remuneration if the opportunity to earn the variable remuneration arose prior to the commencement dates. This flexibility is also extended to employees that joined a Regulated Entity after the commencement date but before its end of financial year. Practically, this means an ADI SFI with a financial year ending 30 June must have implemented its CPS 511 requirements for all employees from 1 July 2023.
APRA expects all Regulated Entities to have a strong focus on the implementation of CPS 511 requirements and will be undertaking greater supervision to ensure adequate preparations are being made ahead of commencement. Regulated Entities should expect further remuneration obligations in the future as APRA plans to release draft reporting and disclosure requirements for consultation in 2022. These are expected to be finalised in 2023.
In light of this, we recommend Regulated Entities begin to review and revise their remuneration arrangements in line with CPS 511 requirements as it is anticipated these changes will be resource and time intensive for most organisations.
Boards of Regulated Entities that are already complying with CPS 511 requirements should continue to communicate their clear expectations to management, employees and service providers to achieve better remuneration outcomes across the organisation, whilst recognising that no matter how much work has been done in this space, there is a regulatory expectation that the entity's remuneration arrangements will be the subject of ongoing proactive review.
1 Malus refers to an adjustment to deferred variable remuneration before it has vested.
2 Clawback refers to the recovery of variable remuneration once it has been paid or vested.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
|Chambers Asia Pacific Awards 2016 Winner
Client Service Award
|Employer of Choice for Gender Equality