Why is the structuring of directors’ remuneration important and what are the implications of failing to structure remuneration appropriately?

A director’s remuneration is a remuneration package consisting of elements which maximises through the integrated delivery of salary, share option schemes and short and long term performance rewards. A reward for the delivery of business results is connected with the reward for value flowing to shareholders. The incentive arrangements are structured in such a way that rewards cannot be maximised through inappropriate short term risk-taking. Its important to have such a remuneration package because it keeps directors motivated to act in the best interest of the shareholders. Failure to have this could lead to agency problems between the managers and the shareholders.

To begin with, it’s important to define agency theory. Agency theory is a relationship between the principal and the agent. A principal (shareholder) is a person who delegates the authority to make decisions to the other party where as an agent is the person who is given the authority to make decisions on behalf of the principal (Drever et al, 2007). It is based on this theory which has got some agency problems such as risk aversion, dividend retention and horizon disparity. A bonus incentive is an effective solution to solving this problems and that’s where director’s remuneration package comes in. A long term incentive integrated into director’s remuneration package would help avoid horizon disparity problems because directors would then reflect the long-term value of the company and will make investments and decisions that are best for the long term of the company. An example of this incentive was illustrated in Ralph Norris’s (CBA CEO) remuneration package which would motivate him to stay with his company for a long period of time. On the other hand, a short term incentive can be linked to accounting earnings such as profits and dividends for a particular period which would allow directors to engage in activities in order to maximise profits and dividends for the company and also achieve their short term incentive. Therefore, the structuring of directors remuneration is important because it clarifies the platform on which the director’s rewards are based on. Another reason structuring is important is for disclosure purposes. When a company has received media attention, especially when it is specifically named in the press, in relation to the remuneration packages of its executives and directors, it is likely to react by publicly providing its own information about the topic being publicised (Liu and Taylor, 2008).To comply with the appropriate disclosure of information through the annual reports, companies will need to structure their remuneration packages effectively well because they are communicating this information to stakeholders such as investors and the public.

There are some implications of failing to structure remuneration appropriately. Firstly, if the remuneration package isn’t well constructed and isn’t clear about what performance rewards are based on which part of the package, then this would become less transparent to other shareholders and investors meaning it would be less decision useful (decision usefulness theory). If a company has a poor structure of director’s remuneration package, then most likely it may affect many investors’ decision or change their opinion of that company. This could also lead to bad image of the company because of its inability to disclose proper and useful information to its stakeholders. Also, as laws and society values are changing, a shift from voluntary disclosures to mandatory disclosure of remuneration package leaves the company with no choice but to disclose the information and in this case, the company cannot afford to disclose inaccurate information. Secondly, in Forster’s (2010) article, it was mentioned that board of directors and especially non-executive directors must assume responsibility for the remuneration packages. In times of crisis, most companies will be placed under increased financial distress because of slashed dividends, job cuts and lower profits and questions will be raised as to why pay packet’s of senior executives is increasing (Williams, 2009). This can act as noisy signal of the agent’s efforts, and therefore, the non-executive directors would need to explain that certain bonuses included in the remuneration package was based upon past performance of directors and not on present situation. Therefore, this type of information should be well structured in the remuneration package when disclosing it in the annual reports. This would allow users to make informed decisions or form an opinion of the company. Failure to do so will have an impact on the company as a whole.

In conclusion, its important to have a director’s remuneration package because it would encourage directors to perform in the best interest of the shareholders and not just only that, the company would also need to disclose the remuneration information to the public. It’s important to structure the director’s remuneration in appropriate manner so that its easy to understand and decision useful for outside investors. However, on the other hand, there are some consequences of failing to structure the remuneration package appropriately. Poor and unclear remuneration information would confuse investors and therefore would neglect the two main qualitative characteristics of decision usefulness theory which is reliability and comparability. Its vital for companies to consider the importance of director’s remuneration package because it is a great way of motivating director’s performance and reducing agency problems.