Report of the Board in relation to remuneration policy and practice
For the year ended 31 December 2006
Dear Shareholder
I am delighted to introduce this, our fifth, HBOS Remuneration Committee Report for which we will be seeking approval from shareholders at our Annual General Meeting. It is my final report as Chair of the Committee. Karen Jones, a fellow Non-executive Director, will take over as Chair immediately following the Annual General Meeting in April 2007.
We introduced our current remuneration policy for our most senior colleagues (now about 215 in all) at the start of 2002, immediately following the establishment of HBOS plc. Our remuneration principles have changed little since then and, in broad terms, are as follows:
- we have a median salary policy and manage actual salaries broadly up to this position;
- we set clear and tough targets under our short term incentive (‘STI’) schemes - and we inform shareholders of our performance against those targets and the resulting STI outcomes;
- we operate a “nowt for nowt” long term incentive (‘LTI’) scheme: if we do no better than matching our competitor average in terms of returns for shareholders, our top 215 colleagues get no LTI; and
- we ensure that we have a clear correlation between overall reward and corporate performance, both in the short and the long term.
We believe that we are at the forefront, among our competitors, of operating in such a robust and transparent remuneration environment.
Following the five full calendar years that our remuneration policy has been in place, I can report that:
- during that period, and following regular reviews by the Committee, we have maintained the key characteristics of our policy and have not seen a need for fundamental change;
- we have gained strong support for our policy and practice from shareholders generally, as recently evidenced by support from almost 99% of shareholders who voted on the 2004 and 2005 Remuneration Committee Reports;
- we have maintained regular and open dialogue with our major shareholders and their representative bodies and have enjoyed welcome support and advice from them on remuneration matters; and
- we have examined how well incentive awards made in previous years have aligned with both shareholders’ interests and the Group’s performance and have concluded that alignment is strong.
Specifically, on that latter point we have looked back over the first five full calendar years of HBOS (2002-2006) in order to assess the correlation between corporate performance and incentive outcomes.
Under the STI arrangements, we have used consistent measures - profitability, earnings per share (‘EPS’) and return on equity (‘ROE’). Over the five year period these have risen, on average, by about 17.3% p.a., about 16.1% p.a. and about 6.7% p.a., respectively. Even though we have delivered double digit profit growth each year, our STI payments have, on average, been only about one third of the way from the target levels towards the maximum levels.
Our consistent delivery of operational performance also shows through in our strong relative total shareholder return (‘TSR’) performance and in the rewards which our shareholders - and also our colleagues - enjoy as a result. Specifically, under the LTI arrangements, we have again used a consistent measure - TSR - and over the five year period, we have, on average, outperformed our competitors annually by about 5% – and HBOS’s absolute TSR over that period has been about 69%. In terms of incentive outcomes, we have made payments, on average, at about 90% of maximum levels. Overall, over this period, shareholders have enjoyed about £11bn of added value over and above the cumulative annual growth delivered by our weighted average comparator group; our LTI payments to colleagues have represented approximately 1.5% of this gain.
Every year since 2002, all incentive outcomes earned by Executive Directors have, at their choice, been taken in HBOS shares, rather than in cash.
In 2005, we conducted a wide ranging review of remuneration policy for our most senior colleagues and, as explained in last year’s report, we decided to:
- cease, from Pensions ‘A-Day’ in April 2006, service-related pension accrual for those whose pension pots then exceeded the £1.5m Lifetime Allowance. We replaced that remuneration element with a simple but generally lower value annual taxable cash allowance of 25% of salary;
- maintain the LTI scheme for our most senior colleagues, in its current form. It pays nothing for average performance and pays linearly increasing amounts as we add more value for shareholders relative to that created by our competitors - with about 1.5% of that relative added value going to participants and 98.5% going to shareholders generally; and
- maintain the structure of the existing STI scheme and introduce, from January 2006, a second element to the STI scheme for our 50 most senior colleagues who collectively, are the principal drivers of not only divisional operating but also Group operating and Group shareholder performance.
One year later, it is apparent that many competitors have increased incentive opportunities quite significantly and appear to have made relatively strong STI payments for relatively average performance. Furthermore, the changes we have made in response to the Pensions ‘A-Day’ legislation, which bring greater transparency and performance orientation to the HBOS reward proposition, have been followed, so far, by very few others.
We must be competitive on our reward offerings. So, to retain our best colleagues and to recruit and retain the best from elsewhere, we propose further changes from 2007 - but on a basis which continues to align colleague and shareholder interests.
Firstly, as established readers of our reports will know, we actively encourage colleague shareholding, most significantly through our ‘sharekicker’ facility. This allows colleagues to invest their STI outcomes in HBOS shares and to get 50% more after three years if they stay with us. We intend to sustain that scheme for the vast majority of colleagues.
But, from 2007, for our most senior 215 colleagues, sharekicker will become much more performance-linked. Like our existing LTI, it will work on a “nowt for nowt” principle. So, if we do not grow EPS, in real terms, over the three year sharekicker period, senior colleagues will just get their own invested money back with no enhancement. Our rigorous “nowt for nowt” approach in relation to mediocre performance flows through into an equally rigorous approach when we perform well. So, if we deliver real EPS growth of 12% p.a. or more over three years, colleagues will get a 200% return on their sharekicker investment.
Secondly, for Executive Directors (and subject to shareholder approval at our Annual General Meeting), we will increase conditional share grants under our existing LTI from 100% to 133.33% of salary.
The changes we are making recreate the opportunity for colleagues to receive competitive incentive outcomes but only if they create additional value for shareholders through real EPS growth and relative TSR growth. We construct all our incentives so that all our colleagues have a very clear performance:reward link - and one that is increasingly performance focused and longer term in nature, as colleague seniority increases.
The changes mean that our suite of incentive schemes for 2007 for our top 215 colleagues will be:
Core STI (1 year)
Purpose: To motivate achievement of divisional operating objectives over one year.
Performance measures and drivers: Will vary by level of seniority and function. May include divisional sales, costs, profitability, risk management delivery and/or customer service delivery.
Extended STI (2 years) (top 50 colleagues only)
Purpose: To motivate consistent achievement of Group operating objectives over more than one year.
Performance measures and drivers: Group profitability, operating expenses and EPS.
LTI - TSR (3 years)
Purpose: To incentivise relative and absolute overall share performance. To align shareholder and senior colleague interests.
Performance measures and drivers: Relative TSR with secondary absolute TSR.
LTI - EPS (3 years)
Purpose: To incentivise consistent improvement in real EPS and to encourage colleagues to invest core STI and extended STI outcomes in shares.
Performance measures and drivers: Real EPS growth.
In the full report which follows, we have produced transparent and extensive technical details, as we have done for the past four years.
We welcome questions and feedback from all shareholders on both the content and the transparency of the report.
We believe our remuneration policy is right for our shareholders and right for our colleagues - and we encourage all shareholders to support this report at the Company’s forthcoming (2007) Annual General Meeting.
Sir Brian Ivory
Chair
Remuneration Committee
27 February 2007
