APG Asset Management Issues Remuneration Guidelines

One of the world largest fiduciary asset managers, APG recently issued remuneration guidelines that will be applied to its portfolio of European listed companies. APG believes that the innovation in the new guidelines is twofold. First in that they are based on its practical experience of company engagements and therefore reflect an integrated investment and governance outlook. More specifically, the guidelines place a clear emphasis on value creation. By issuing the guidelines APG is aiming to make its ongoing discussions with companies around pay more effective, thus freeing up time for it to focus on other important corporate governance areas such as board structure, succession and nominations.

As the largest asset manager for pension schemes in the Netherlands, APG Asset Management is invested in over 4,500 listed companies worldwide. Of its total assets under management of 390 billion euros (August 2014) 80% are managed in-house and 60% of that is invested in equities across several investment strategies, mostly through active investment strategies (i.e. not index tracking). Responsible investment is an integral part of its investment process and taking into account governance and sustainability factors in its dialogue with portfolio companies therefore follows as a key feature. APG believes that this contributes to risk-adjusted returns and we see it as an important part of its commitment to its clients—Dutch pension funds including ABP, bpfBOUW and SPW.

It is against this backdrop that APG recently published remuneration guidelines, outlining its thinking on how pay, especially pay awarded to senior employees, should be structured to best serve the interest of sustainable value creation for the long-term. As part of the investment process APG’s portfolio managers have ongoing discussions with many of their portfolio companies on wide-ranging topics including compensation as an element of a company’s long-term value creation story. The guidelines therefore very much capture the investment thinking behind ABP’s corporate governance policy.

In the most basic terms, APG believes that long-term value creation to shareholders is the added economic value over and above the cost of capital. APG believes that pay policies should be set to reflect and support this.

In setting the pay strategy, compensation committees have four areas, or design levers, they can control. The guidelines identify these areas: (a) strategy and risk alignment; (b) shareholder and stakeholder alignment; (c) pay levels; (d) time alignment; and outline some clear preferences including design do’s and don’ts.

The second part of the guidelines deals with performance drivers. The presumption underpinning APG’s thinking is that pay should be linked to a combination of actual current performance measures, as well as measures of financial and non-financial health of the company. Actual and current performance measures can be used to assess value creation, whereas measures of health of a company provide an indication of its ability to sustainably create value in the future.

A company’s intrinsic value is based on its cash flows and its cost of capital, which reflects the financial risk the company is exposed to. Cash flows are driven by both operational returns (on the invested capital) and growth of the business. Therefore, boards are encouraged to link executive pay to both of these measures when assessing performance. Of key importance is finding the right balance between these measures. Too much focus on one while neglecting the others can lead to suboptimal results. Growth in areas where returns are below the cost of capital destroys value, while too much focus on operational returns in isolation can lead to companies underinvesting and foregoing profitable future growth opportunities. Metrics such as Economic Profit (EP), though not without flaws, can capture growth, operational returns, and cost of capital in a single measure.

The ability of a company to continue creating value in the future is ideally assessed by looking at a combination of financial as well as non-financial indicators and indicators of risk that can pose a threat to its balance sheet and operations over time. Therefore APG encourages boards to consider non-financial measures in order to incentivise executives to keep long-term value creation in mind and to prevent short-term interests from jeopardising the sustainability of the company over time. APG expects that at least some metrics will capture non-traditional aspects of (long-term) value creation such as human capital, customers, ethics and environmental and social sustainability considerations that can affect the sustainability of financial performance.

The guidelines list a number of typical measures categorised into performance areas. Knowing that each company faces different business circumstances and that often there could be more than one way of achieving good performance linkage, APG encourages companies to set out their own tailored views and emphasise the most appropriate measures for their situation.

The guidelines have already been sent out to APG’s main European portfolio companies. APG intends for the guidelines to form a framework for discussion and to set a baseline for its engagement and discussions with portfolio companies including voting at shareholder meetings.

Building on its experience in this core market, APG may very well proceed to roll out guidelines to apply to other markets where it is actively investing.