Chapter 5: Variable pay - VdW

1 Chapter 5: Variable pay The real purpose of any Variable pay, incentive or bonus scheme must be clear. The organisation must have a clear idea as to its value. The motive for Variable pay should be retention or some similar aim. It is not the ideal tool to increase business performance, because people are inclined to start viewing Variable pay as a right and to balk at accepting less in a subsequent year. The value-add of Variable pay schemes must be assessed and people must be sensitised to the business case for the scheme. Care must be taken not to create perverse incentives. Variable pay should motivate and engage employees. There may be different approaches to Variable pay. The organisation's approach to this issue should be made clear in the reward strategy, whether bonuses can be paid out or some pay is at risk.

2 A slope of between 15 and 30% represents the safe range of funding methods to determine bonus pools. Most short-term incentive schemes have a slope of about 20%, which would mean paying out 20c in the rand of profit. If the slope is higher than this, management will have to be able to justify it. The slope of the scheme will probably vary according to how human or monetary capital intensive the organisation is. For most organisations, the ratio of human to monetary capital is about 50:50. Short-term incentives The purpose of short-term incentives (STIs) is to: (a) attract and retain participants as part of a market competitive package. (b) reward participants directly for individual, team and organisation performance achieved over a monthly, quarterly or annual time frame.

3 (c) support the achievements of the tactical and strategic objectives of the organisation by influencing the behaviour of the participants. 1. Design principles The design principles for STIs include the following: (a) Alignment. Payments under the plan should reinforce the tactical and strategic objectives of the organisation. The plan should firstly be aligned internally, with the daily activities of the participants as reflected in performance management practice. Secondly, it should be aligned externally, with the expectations of stakeholders and with the environment. Thirdly, it should be aligned with efficacy, or the ability of the person being offered the incentive to influence the outcome and the difficulty of the goal. (b) A performance culture. Payments under the plan should be significantly geared to individual, team and organisational performance, with no payments made for unacceptable levels of performance, and exceptional payments made only in the case of genuinely stretching achievements.

4 (c) Participants in the STI should be able to influence the business process. (d) Affordability. Payments from the plan should not expose the organisation to undue market and liquidity risk. (e) Simplicity. Schemes should avoid complexity where possible. (f) Communication. Participants should understand the workings of the plan, what they need to do to optimise their payments, and have access to regular reports which give feedback on the metrics that drive payment. (g) Instrumentality. Participants must believe that if they perform as agreed, they will be accordingly rewarded. (h) Good governance. Targets and parameters should be set in advance of the applicable financial year. Disclosure of targets, achievements against those targets and payments should be disclosed to the appropriate governance bodies management, executive committees, the remuneration committee, the board or shareholder or stakeholderss as determined by disclosure best practice.

5 (i) As far as possible, STIs should promote high performance with high integrity. 2. Eligibility STI schemes should clearly state the eligibility of participants each year in the scheme, including the amount of payment due for performance against agreed targets. (a) Executive directors and all employees of organisations are usually eligible for participation in STI plans, provided they are able to influence the business objectives that the STI is intended to influence. (b) It is generally not viewed as appropriate for non-executive directors to participate in STIs. (c) Contractors may participate in STIs if the nature of their role is similar to that of conventional employees (they are able to influence business results directly). (d) The scale of eligibility should be set carefully.

6 (e) Affordability must be carefully considered when deciding on eligibility. How much of every incremental rand will be paid over to employees? (f) Pay at risk up to a specified minimum can be part of Variable pay. Employees would then be at risk of losing a Variable part of their standard package if performance targets are missed. This must be made clear in the remuneration philosophy, if pay at risk is used, and the policy document must state how Variable pay works. This feature must be documented for audit purposes. Funding methods to determine the bonus pool When a self-funding method is used, payment is determined by an agreed financial driver exceeding a set threshold. The size of the bonus pool for the organisation is set as follows: (a) Continuous funding: A portion (the sharing percentage) of the excess over threshold is used to determine a bonus pool; or (b) On-target bonus with stretch and super-stretch targets: An agreed portion of the financial driver is assigned to the pool on the basis of achieving the threshold or target (on-target bonus).

7 With stretch targets to follow with linear apportionment between these target levels. 3. The bonus pool is allocated to subsidiaries or divisions of the organisation on the basis of their performance on the basis of the financial driver. Subsidiary or divisional modifiers may also be used to influence this allocation. The bonus pool (organisation, subsidiary or divisional) is disbursed to participants based on the distribution method. Where a self funding method is not used and the scheme is pre- funded by allocating funds to the bonus pool, the funding is a bonus funding. Distribution methods to allocate payments Distribution could be based on participant influence or could be automatic. See the alternative approaches in Annexure B. Administrative rules A set of guiding principles for the STI should be approved by the Remuneration Committee and be available for inspection by all participants.

8 The rules should be clear, unambiguous and provide for every event where rules about the scheme, the payment and participation are involved. A letter should be issued in advance of each year to each participant setting the targets and parameters for their participation in the scheme that year. The letter should state: (a) the amount of payment for performance against set targets;. (b) the measures used to assess performance;. (c) the targets appropriate to the scheme, including gatekeepers, thresholds, targets and stretch targets;. (d) caps, where appropriate; and (e) deferral or banking requirements, where appropriate. Reporting and disclosure The following information must be disclosed individually for executive directors: 4. (a) The amount paid or accrued in terms of the STI in the course of the reporting period.

9 The following disclosure is recommended for executive directors: (a) The threshold, on-target and stretch level of the STI. (b) The performance measures, their weighting, threshold, target and stretch levels for executive STIs Long-term incentives The purpose of long-term incentives (LTIs) is to: (a) attract and retain participants as part of a market competitive package;. (b) reward participants for medium- to long-term organisation performance or outperformance; and (c) align management with shareholder or stakeholder interests Long-term incentive instruments may include: (a) share options (b) share appreciation rights (c) restricted shares (d) forfeitable shares (e) performance shares (f) deferred bonus plans (g) outperformance plans (h) cash settled plans linked to the share price (i) cash settled plans not linked to the share price (j) combination schemes.

10 More detail on these instruments is provided in Annexure C. 5. A multidisciplinary team will have to be involved in setting up LTI. schemes and the 1% rule should be followed when it comes to actual settlement. Scheme documentation The following documentation should be prepared when adopting a new scheme, depending on the organisation's stakeholders: (a) Salient features of scheme (b) Rules of the scheme (c) Grant letter (d) Board paper and resolution (e) Institutional investor presentation (f) Shareholder resolution (g) Employee presentation (h) Other communication with employees. Adoption process The following process should be followed when adopting a new scheme: (a) Design (b) Approval (c) Implementation. (a) The design phase should include: a review of local best practice a review of global best practice 6.