Three good reasons why non-institutions should consider regulatory remuneration requirements when drafting their remuneration policies
By Dr. Alexander Insam; Dr. Theofanis Tacou, LL.M.; and Dr. Moritz Kaus
The current version of the Remuneration Ordinance for Institutions (Institutsvergütungsverordnung or IVV 3.0) contains minimum supervisory requirements for the remuneration systems of German financial institutions. The ordinance regulates the way employees are remunerated according to position and performance and restricts the free movement of banks in favor of bank stability and the stability of the financial market. This includes the restriction of harmful incentives to take disproportionately high risks. Banks are thus forced to design remuneration systems that comply with the rules laid down in IVV 3.0. In practice, affected banks are confronted with substantial challenges. They must invest a considerable amount of time in the development and optimization of their remuneration processes. Although a remuneration system’s complexity depends on the size, nature and complexity of a bank’s activities, all institutions that fall within section 1 paragraph 1b and section 53 paragraph 1 of the German Banking Act (Kreditwesengesetz or KWG) are affected, as well as all members of their management bodies and staff. As a result, the scope of application is extensive. The ordinance makes a distinction between major institutions and non-major institutions. In essence, for a company to be classified as a major institution, the balance sheet total for the last three completed financial years needs to reach or exceed an average of €15 billion, unless the institution provides a risk analysis and proves it is not a major institution (section 25n paragraph 1 of the KWG). There are also other specific cases in which an institution must be classified as a major institution. Though the IVV 3.0 contains special requirements for major institutions, even non-major institutions face the problem that their remuneration systems must comply with the general requirements of IVV 3.0.
However, from the point of view of institutions, these extensive and labor-intensive requirements also have their positive facets. A comprehensively regulated remuneration system increases internal acceptance among employees and provides a clear mission statement, leading to greater transparency and traceability on the subject of remuneration. The benefits of this system reach beyond employees. Managers of these institutions are also provided with comprehensive guidelines regarding the remuneration of employees, which enables them to react to special situations in a clearly defined manner. Ultimately, this leads to greater comparability. From a performance management perspective, target agreements can have an especially positive impact for employers, given that employees need to reach their ambitious targets to obtain bonus compensation. The regulating authority intends to prevent agreements involving payments that are not sustainable for companies, thereby helping employers set sustainable goals and secure strong employee performance over a longer period.
Remuneration policy options for non-institutions
These positive facets of the IVV 3.0 regulations may also prove fruitful for non-institutional sectors – that is to say, for corporations. Especially considering the government’s draft of the act implementing the Second Shareholder Rights Directive (Gesetz zur Umsetzung der zweiten Aktionärsrechterichtlinie, ARUG II), which stipulates that a “clear and comprehensible” system of remuneration for members of the board of managing directors must be adopted in listed companies (section 87a of the AktG-E), it is clear that the importance of this issue outside the banking sector is bound to increase. The legislature is increasingly focusing its attention on other sectors. Thus, remuneration policy is an issue that corporations should already be addressing. Recognizing the benefits of individual elements of a remuneration system should give companies a competitive advantage.
Specific regulations regarding remuneration
Three aspects of the IVV 3.0 – namely, the regulations regarding target agreements, severance payments and remuneration strategy – are particularly highly relevant for corporations and therefore have bearing beyond the financial sector.
Most companies claim a “pay for performance” philosophy. Target agreements are therefore often (but not exclusively) made with top executives to set incentives for higher performance. Executive compensation plans define how top executives are paid. The importance of group targets and individual performance relative to an employee’s variable compensation depends on his or her management level. This means the remuneration of managers and executives depends more on a bank’s overall outcomes. The IVV 3.0 regulates the procedure for variable remuneration. In general, the remuneration parameters shall be defined in such a way that target achievement levels can be clearly delineated. Section 19 of the IVV 3.0 makes special demands on significant institutions. According to section 19 paragraphs 1 and 3, variable remuneration of risk-takers must be connected to all risks and the success of the bank as a whole, as well as the organizational unit and the individual employee (BaFin interpretation aid, p. 52). The process of setting target parameters should function as a cascade, starting at the organizational level and descending to each specific risk-taker and nontariff employee. The fixed part should carry more weight in remuneration agreements with control functions, and the variable part should not be highly dependent on business goals. Market-oriented business goals (such as income and return on equity) are thus generally inadmissible. Core objectives are the control unit’s objectives, such as core capital ratio. Conduct that runs contrary to ethics or duties may not be balanced out with positive performance contributions, but instead must reduce the variable remuneration amount (section 19 paragraph 2 of the IVV 3.0). These clear guidelines are intended to prevent risk assumption by workers and ensure bank stability.
For noninstitutions such as corporations, similar systems would carry the advantage of providing incentives for better performance while simultaneously discouraging employees from taking extraordinary risks for the company. Clarification concerning the admissibility of individual target parameters regarding variable remuneration for support and control units prevent target agreements from being handled without proper supervision. Moreover, under such a system, each employee is aware of the specific level of performance he or she is responsible to reach. At the same time, public confidence in companies using such systems would increase, as risky behavior would not be rewarded with financial gain.
Pursuant to section 5 paragraph 6 sentence 1 of the IVV 3.0, severance payments are also to be regarded as variable remuneration. However, sen-tence 5 contains simplifications for the privileged forms listed there with regard to the applicability of sections 7 and 20 of the IVV 3.0 (reservation of the performance capacity of the institution; ex-post risk adjustment) and section 25a paragraph 5 of the KWG (bonus upper limit). Section 2 paragraph 5 of the IVV 3.0 defines severance payments as remuneration received by an employee in connection with premature termination of employment, agency or a service relationship. Since the IVV 3.0 regulations provide guidelines for a written framework, institutions must regulate maximum payment amounts and criteria for determining such payments in their internal guidelines. Severance payments may not constitute an unreasonably high reward, but instead must generally be regarded as compensation for an employee in the event of premature termination of an employment relationship. In addition, severance payments must take into account the previous performance of the person concerned. In particular, negative profit contributions and misconduct must also be taken into account (BaFin interpretation aid, p. 17). BaFin’s interpretation aids, which specify specific groups of cases in which severance payments should not be made, provide further orientation for process optimization.
Since employment termination occurs in every company, this aspect of the ordinance could also be fruitful for non-institutions. The implementation of a system that clarifies internal specifications for severance payments would have a positive impact. HR managers would have the advantage of being able to conduct exit interviews more quickly and efficiently, since transparency would already clarify the severance payments that can be expected. This would also minimize the risk of long-term litigation. In addition, the risk of developing a negative public reputation could be reduced, especially where severance payments for executives is concerned. Many corporate cases have fueled heated public discussions as to whether low performers received too much money. If corporations gain more public trust regarding their severance payments for executives, this could increase their share prices and thus lead to a win-win situation for employers and shareholders.
Written remuneration policy
The implementation and monitoring of remuneration strategies can also be advantageous for non-institutions, as these steps ensure the issue is dealt with on a regular basis. Clear documentation of a mission statement helps to ensure acceptance of a company’s chosen remuneration system. A regular annual review including an adjustment of remuneration systems, as provided for in section 12 of the IVV 3.0, also helps organizations stay up-to-date and to react promptly to changes. The time spent writing a remuneration policy is well-invested, as it helps prevent misunderstandings within a company while simultaneously strengthening public trust and employer branding.
The IVV 3.0 and its regulations confront banks with major challenges. The enormous organizational effort of compliance ties up resources and makes daily business more difficult. Nevertheless, the binding requirements also have positive facets. The development of clear guidelines leads to greater acceptance of the remuneration system applied within a company. This acceptance within a company’s workforce is growing in importance, especially as Generations Y and Z make their way into the labor market. These generations are confidently demanding more transparency and participation. In this light, company-wide sustainable remuneration strategies help companies become more attractive employers.
In addition, executives and managers may also benefit from a clear remuneration strategy and policy. First, such a strategy enables them to more easily assess if their performance is in line with their bonus payments. Secondly, such a policy can help regain public trust and justify bonuses as sustainable and well-deserved.