A chain reaction: the link between diversity and remuneration in financial services
The UK financial services regulators are increasingly focussed on the role diversity and inclusion plays in supporting better decision-making, better outcomes for firms and customers, and enhanced risk management. One key question being asked by regulators is whether linking remuneration to diversity and inclusion metrics as part of non-financial performance assessment could be an effective way to drive progress.
The focus on D&I
The last decade has seen an unrelenting focus on culture within financial services. The link between poor culture, poor decision-making and conduct failings was laid bare by the 2008 global financial crisis. Focus has now shifted to the role other non-financial performance drivers play in supporting a better culture, including ESG and diversity and inclusion.
July 2021 Discussion Paper
In July 2021, the FCA, PRA and Bank of England published a joint Discussion Paper (DP) on their plans to monitor, track and improve diversity and inclusion in regulated firms. The DP sets out a wide range of policy options across various topics, including the question:
What are your views on linking remuneration to diversity and inclusion metrics as part of non-financial performance assessment? Do you think this could be an effective way of driving progress?
In the DP, the regulators make clear that linking progress on diversity and inclusion to remuneration could be “a key tool for driving accountability in firms and incentivise progress”. They are considering whether to develop guidance on how metrics linked to diversity and inclusion can be used as part of non-financial criteria when setting variable remuneration awards, and whether to make explicit in their rules that a firm’s remuneration policy should ensure that all types of remuneration (fixed and variable) do not give rise to discriminatory practices.
The role of the Remuneration Committee Chair
The FCA has made clear that the Remuneration Committee Chair is “crucial” to ensuring a firm’s remuneration policy supports and connects remuneration outcomes to the firm’s strategic priorities, purpose and values. These views were echoed in the recent DP, where the regulators stated that Remuneration Committee Chairs should be responsible for ensuring committees adequately consider diversity and inclusion.
The FCA already expects Remuneration Committee Chairs of regulated firms to summarise in their remuneration policy statements how they have assured themselves that the firm’s overall remuneration policies drive behaviours that reduce potential harm. This has included how firm’s remuneration policies promote equality of opportunity and ensure diversity and inclusion is embedded within a firm’s approach to rewarding individuals.
Recently, the FCA has gone further and wrote to the Chairs of Remuneration Committees in Summer 2021 - this time expressly encouraging them to review pay data in light of diversity and inclusion and to address any disparities. In this recent letter, the FCA made clear that it expects to see more firms using non-financial measures to support ESG factors and expressly calls for non-financial performance metrics, including diversity and inclusion, to be linked to remuneration.
Will linking D&I with remuneration drive progress in D&I?
Many organisations, not just financial services firms, are already using non-financial metrics in their performance and remuneration assessments. Investors, shareholders, the media and other stakeholders are increasingly holding companies to account for pay-outs which, while meeting agreed financial or business targets, are considered to be out of line with ESG, including D&I objectives. But, whilst doing so can demonstrate to the market that business leaders are taking D&I seriously and be a positive driver for change, there could be unintended consequences that firms should be mindful of:
- One of the key issues with any kind of reporting or measurement against metrics in this area is the data relied on. Without sound and robust data, decisions may be made which are not truly representative or proportionate to the workforce. Firms across the sector will approach their diversity data collation differently and obtaining information from individuals relating to their personal characteristics is not straightforward given the reliance on individuals to voluntarily disclose information. Firms should refrain from prematurely linking their remuneration with diversity and inclusion metrics before carefully considering the data they collect and control.
- With various charters, benchmarking tools, governance expectations and regulatory initiatives on D&I, the expectations for firms are evolving and developing – many of these being aspirational and longer-term objectives for businesses to achieve. Firms should refrain from linking their remuneration practices to non-financial metrics in a way which could be too restrictive and leave little room for flexibility and adjustment in the short to medium term.
- Firms should be mindful of how their approach to linking remuneration with diversity and inclusion could be perceived and the messaging around the approach. Even with the best intentions, some may question whether remuneration can truly help to improve diversity in a sustainable way – will behaviours default back to how they were once the financial incentive is removed? If, for example, long term D&I targets are set over a 10 year period, how do those translate into short and medium term remuneration targets over a one to three year period? There is always a risk with such measures that they are set in a way that is not stretching enough or so stretching that the value of the award is discounted by management? The alternative is long term shareholding. Professor Alex Edmans, of London Business School, considers that requiring management to hold shares for a long period will achieve more progress than specific ESG metrics, including D&I metrics. That’s on the premise that for long term success, management have to be focussed on such factors. As PRA Senior Managers are subject to a three – seven year deferral period, that should go some way to helping achieve that.