Report of the Board in relation to remuneration policy and practice
continued
1. What this report covers
This report to shareholders:
- sets out our remuneration policy;
- explains the policy under which our Chairman, our Executive Directors, the next two most senior groups of colleagues and our Non-executive Directors were remunerated for the year ended 31 December 2006; and
- sets out tables of information showing individual details of the salary, incentive, share and pension interests of all the Directors for the year ended 31 December 2006.
2. Role and membership of the committee and compliance issues
The Remuneration Committee (the ‘Committee’) is a committee of the Board. Your Board believes that a properly constituted and effective Remuneration Committee is key to ensuring that Executive Directors’ and other colleagues’ remuneration is aligned with shareholders’ interests and that it motivates Executive Directors and other colleagues to enhance the absolute performance and the relative competitiveness of the Group. The full Terms of Reference of the Remuneration Committee can be found at www.hbosplc.com/abouthbos/remuneration_committee.asp.
The members of the Committee during 2006 were all independent Non-executive Directors, as shown below:
Sir Brian Ivory (Chair)
Sir Ron Garrick
Karen Jones (joined 1 July 2006)
Coline McConville
At the invitation of the Chair of the Committee, the Group’s Chairman and the Chief Executive attend Committee meetings to provide background and context on matters relating to the remuneration of the other Executive Directors and other colleagues in the Group, but do not attend when their own remuneration or contractual terms are discussed. No Director is involved in determining his or her own remuneration or contractual terms.
During 2006, the Committee met on 7 occasions and the attendance of Committee members is as shown below:
Sir Brian Ivory (Chair) – 7 meetings
Sir Ron Garrick – 7 meetings
Karen Jones – 3 meetings (of a possible 3)
Coline McConville – 7 meetings
This frequency of meetings enables the Committee regularly to review, for Executive Directors and other senior colleagues, overall reward and the components thereof, in relation to the absolute performance and the relative competitiveness of the Group.
The performance of the Committee is evaluated as part of the overall evaluation of the performance of the Board as a whole and of each Non-executive Director, as set out in the Corporate Governance Report on pages 93 to 98.
Full details of the Group’s approach to Corporate Governance, including compliance with the Combined Code, are also included in that report.
The Board has approved this report. A resolution will be put to shareholders at the Annual General Meeting inviting them to consider and approve this report, as required by the Companies Act 1985.
The report complies with the requirements of all relevant regulations under the Companies Act 1985 and the Combined Code.
Section 10 of this report has been audited by KPMG Audit Plc, with the exception of Section 10.3.1 (Shares), Notes 5 and 10 to Table 6a within Section 10.3.3 (TSR performance), Section 10.3.7 (Interest in Shares under Trusts) and Section 10.3.9 (Statutory Performance Graph), which do not fall to be audited.
3. Advisors to the committee
During 2006, David Fisher, Director, Group HR, acted as Secretary to the Committee and provided advice to it. Ian Goodwin, previously Secretary to the Committee, continued to provide advice to it. Harry Baines, Company Secretary, also provided advice to the Committee. In addition, the Committee sought independent external advice on remuneration matters. The Committee does not retain a lead advisor but uses organisations best suited to undertake specific projects from time to time. During 2006, the Committee took advice, directly or indirectly, from:
- Watson Wyatt Limited, in relation to pension issues; a partner from this organisation acts as Trustee Actuary to the Group’s final salary pension scheme;
- Mercer Human Resource Consulting, in relation to pension issues; this organisation also acts as Corporate Actuary to the Group;
- Hay Group, in relation to remuneration issues; this organisation also advises the Group on a range of remuneration issues;
- New Bridge Street Consultants LLP, in relation to various policy and remuneration issues and in relation to the preparation of this report; and
- Linklaters, in relation to various legal issues and in relation to the preparation of this report; this organisation also provides legal advice to the Group on remuneration and on a wide range of other issues.
In the opinion of the Committee, there were no conflicts of interest during 2006 in relation to these organisations advising the Group, the pension scheme trustees and the Committee.
4. Service contracts
The Chairman of the Group is covered by a contract which extends to 30 June 2008. If the contract is terminated by the Group prior to the expiry of the term, contractual compensation equivalent to the fees payable during the balance of the term (subject to a maximum compensation equivalent to one year’s fees) may, in certain circumstances, be payable.
All the Executive Directors have rolling contracts which can be terminated by the Group on one year’s notice or by the Director on six months’ notice. If any contract is terminated by the Group prior to the expiry of the term, contractual compensation up to the equivalent of one year’s basic salary may, in certain circumstances, be payable. There is no contractual compensation entitlement for any of the Directors beyond this. Executive Directors are expected to make reasonable efforts to mitigate any loss arising from early termination of their contracts.
There are no provisions in service contracts which provide for enhanced terms on a change of control of the Group.
It is the Committee’s policy to design contracts for any newly recruited Executive Directors in a comparable form to the contracts of existing Executive Directors.
Non-executive Directors are appointed by letter for an initial term of three years. They will usually serve a second three year term. Where the Board is satisfied that it is in the interests of the Group and its shareholders, a Non-executive Director may be asked to serve a third three year term.
Notwithstanding these three yearly terms, appointments of Non-executive Directors can be terminated at any time on one month’s written notice given either by the individual Director or by the Group.
5. External appointments
The Group recognises that Executive Directors may be invited to become non-executive directors of other companies and that such appointments can broaden their knowledge and experience, to the benefit of the Group. Provided that it does not impact materially on their executive duties, Executive Directors are generally encouraged to accept one such appointment. They may retain any resulting fee. In certain circumstances, two such appointments may be permitted. The fees payable in respect of any second appointments are donated to charity.
6. Share ownership
The Group believes that share ownership by colleagues throughout the Group enhances their alignment with shareholders’ interests. Therefore colleagues in the Group are able to acquire shares as a result of:
- the free share plan (up to £3,000 p.a.);
- the sharesave plan (based on contributions of up to £3,000 p.a.);
- the sharebuy plan (based on contributions of up to £1,500 p.a. or 10% of salary, whichever is the lesser) (this is being introduced in 2007);
- the short term incentive plan for all other than the most senior 215. Colleagues can opt to take the whole or part of their incentive in shares rather than in cash. Those who take their incentive in shares, retain them for three years and remain with the Group for that period (or rank as qualifying leavers) receive a guaranteed 50% enhancement of such shareholding (this facility is termed ‘sharekicker’);
- the long term incentive plan linked to the core and extended short term incentive plans. For the most senior 215, colleagues can opt to take the whole or part of their incentive in shares rather than in cash. Those who take their incentive in shares, retain them for three years and remain with the Group for that period (or rank as qualifying leavers) may receive no enhancement or may receive up to a 200% enhancement of such shareholding depending on the real growth in the Group’s EPS over the three year period. There is a real “at risk” element to this component (this is being introduced from the start of 2007);
- the long term incentive plan linked to TSR performance. For the most senior 215, share grants of varying percentages of salaries are made and colleagues may receive none of the grant or may receive up to 200% of the grant depending on the Group’s annualised TSR compared to the annual weighted average TSR of a basket of comparator companies. There is also a real “at risk” element to this component; and
- personal purchase using the Group’s, or other, sharedealing facilities.
These arrangements assist colleagues throughout the Group to acquire shares. They form a key element of the Group’s sustained and, we believe, differentiating commitment to encouraging share ownership by as many colleagues as possible.
The Group requires all of its Directors (including the Chairman and the Non-executive Directors), together with other senior colleagues, to acquire and retain significant numbers of shares relative to base salaries or fees. In the case of each Director the value of the shareholding is required to be at least 100% of base salary or base fee, based on average personal shareholdings, within three years of appointment. All such colleagues satisfied these requirements in 2006. It is pleasing to report that the average holding of Executive Directors who had been in post for at least three years at the end of 2006 was about six times the minimum requirement – a strong vote of confidence in the Group’s future prospects.
7. Remuneration policy for Executive Directors and other senior colleagues
To deliver its objective of creating real increases in shareholder value relative to the finance sector, the Group needs to attract and retain the most capable and committed people and create the right employment conditions and reward opportunities for them.
The remuneration policy for Executive Directors and their most senior colleagues is aligned with this objective. Accordingly, the focus of remuneration policy is not simply on salary but is increasingly weighted towards incentive plans that are aligned with the delivery of both shorter term operating plans and longer term increases in shareholder value.
The practical delivery of this policy is achieved through a number of objectives which have remained largely stable since 2002. However, in 2006, the Group modified both its short term incentive plan and its pension policy (as explained in last year’s report) and, in 2007, the Group intends (subject, in respect of one element, to shareholder approval at our Annual General Meeting) to make further changes to incentive plans, most significantly by introducing a second long term incentive plan. The resulting objectives for 2007 will therefore be as follows:
- salary policy will be set at around market median for the financial services sector though, in practice, salaries are managed broadly up to this position;
- the short term incentive plans will be based on the delivery of operating plans; and
- the long term incentive plans will be focused on both the creation of relative additional shareholder value and the creation of real growth in EPS. Participants in these plans will not receive any payments under them unless either:
- the Group’s relative TSR is above that of the finance sector as measured using the weighted average TSR of a comparator group of companies. This long term plan is highly geared so that average performance (or worse) generates no reward but outstanding performance generates a high level of reward; or
- the Group’s growth in EPS is above that of the growth in the Retail Prices Index. This long term plan is also highly geared so that no real performance improvement (or worse) generates no reward but outstanding performance generates a high level of reward.
The Committee has appropriate procedures in place to ensure that these policies are followed in practice.
The changes we are making to our remuneration structures are set out in Sections 7.3 and 7.4. There are no further plans at present to make any changes to this remuneration policy for 2007 and beyond.
In broad terms, for 2007 and beyond, for every £100 of target reward for Executive Directors, about £30 is fixed and £70 is performance contingent. Sustained exceptional performance can result in a further £100 of reward. Of the performance element of reward, between 13.5% and 22% is based solely on annual performance with the rest based on longer term performance.
For remuneration purposes, roles in HBOS fall into one of ten categories, Levels 1-9 and the Executive Directors.
This report covers colleagues who fall into Level 8 and above, about 50 colleagues in all, but with emphasis on Executive Directors. The report
also covers the Chairman and the Non-executive Directors. The Appendix gives broad details of remuneration arrangements for colleagues in
Levels 1-7.
7.1 Salary
Salary benchmarks are reviewed annually, taking account of information from independent sources on salary rates for comparable jobs in the finance sector and in other selected major listed companies. Actual salaries are normally reviewed annually in May but can be reviewed at any time. There is no automatic or guaranteed annual salary increase.
The benchmarking process is both extensive and rigorous. It is designed to ensure that actual salaries are managed up to broadly the median salary policy adopted by the Committee. Specifically, the Committee considers data sourced from Hay Group and New Bridge Street Consultants LLP; as well as data sourced from annual reports and accounts of other relevant companies. These include selected companies from the ‘FTSE 20’ – comprising an equal number of companies, by market capitalisation, bigger than and smaller than HBOS – together with other major banks, insurance companies and retailers.
Base salaries of the Executive Directors after the most recent review with effect from 1 May 2006 and at 31 December 2006, were:
Peter Cummings £570,000, Jo Dawson £455,000, Benny Higgins £625,000, Andy Hornby £870,000 (from 1 August 2006), Phil Hodkinson £615,000, Colin Matthew £575,000. The significant salary increase for Andy Hornby was largely attributable to his promotion to Chief Executive with effect from 1 August 2006.
Until the date of his leaving on 31 July 2006 Sir James Crosby’s base salary was £875,000.
At 31 December 2006, the average salary for those in Level 9 was £290,000; the upper quartile was £315,000 and the lower quartile was £260,000; and for those in Level 8 the average was £219,000; the upper quartile was £241,000 and the lower quartile was £187,000.
7.2 Incentive plan philosophy
The purpose of the incentive plans is to provide a direct link between each individual’s remuneration and three components of performance, namely their own, that of the business they work in and that of the total Group, both over the shorter and the longer term.
All Executive Directors and a substantial majority of other senior colleagues with HBOS-wide portfolios participate in incentive plans which are Group-wide. Performance targets and levels of participation differ in order to align overall individual remuneration with the Group’s policy objectives outlined earlier. Different, market specific, arrangements exist for a small number of senior colleagues within the Group.
Payment of incentives, for Executive Directors and certain other individuals, is subject to the approval of the Committee. Except in certain exceptional circumstances in respect of initial periods of employment, it is the Committee’s policy that no Executive Director should have a contractual right to an incentive.
Incentive arrangements to apply during 2007 are set out below.
7.3 Shorter term incentive plans
The shorter term incentive plans for Executive Directors and colleagues in Level 9 and Level 8 have two key elements.
| Category | Incentive for 2007 as a % of annual salary | |
| Target | Maximum | |
| Executive Directors | 60 | 90 |
| Level 9 | 50 | 75 |
| Level 8 | 40 | 60 |
Any incentive outcome from the 2007 plan is crystallised for participants in March 2008 but then may be invested in shares for three years until March 2011 (see Section 7.4).
For Executive Directors and certain senior colleagues, payment of target incentive will require the achievement of targets which include EPS, profitability and operating expenses. For others, payment of target incentive will require the achievement of divisional or functional operating plan targets which might include sales, costs, profitability, risk management and/or customer service components.
| Category | Incentive for 2007-2008 as a % of annual salary | |||||||
| Target | Maximum | |||||||
| 2007 | 2008 | 2007-08* | Total | 2007 | 2008 | 2007-08* | Total | |
| Executive Directors | 10 | 10 | 10 | 30 | 15 | 15 | 15 | 45 |
| Level 9 | 8.33 | 8.33 | 8.33 | 25 | 12.5 | 12.5 | 12.5 | 37.5 |
| Level 8 | 6.67 | 6.67 | 6.67 | 20 | 10 | 10 | 10 | 30 |
*Payable only if 2007 and 2008 targets/maxima are attained.
Any incentive outcome from the 2007-08 plan is crystallised for participants in March 2009 but then may be invested in shares for three years until March 2012 (see Section 7.4).
The incentive levels for both the first and second elements of the plan are generally similar to, but marginally higher than, those which applied in 2006 and 2006-07. The Committee is proposing to increase certain incentive levels for these plan elements to address, in part, a clear shortfall in HBOS’s competitive remuneration position in the financial services sector.
There is a separate additional core short term incentive plan for one Executive Director, Peter Cummings, to recognise and respond to market practice in his divisional specialism. The levels of the incentive payments under this additional plan are dependent on the extent to which Peter Cummings achieves his divisional operating plans. The additional incentive opportunity was a target incentive of 50% of salary (and a maximum of 75% of salary) for 2006 and will be a target incentive of 100% of salary (and a maximum of 200% of salary) for 2007, payable in a mixture of cash and shares.
7.4 Longer term incentive plans
The longer term incentive plans for Executive Directors and colleagues in Level 9 and Level 8 have two key elements.
| Category | Conditional share grant as a % of salary |
| Executive Directors | 133.33 |
| Level 9 | 100 |
| Level 8 | 66.67 |
The number of shares ultimately released to participants under the plan is dependent on the Group’s annualised TSR (defined as the gross overall return on ordinary shares of HBOS after all adjustments for capital actions and reinvestment of dividends or other income) over three year periods, compared to the annualised weighted average TSR of a basket of comparator companies (Alliance & Leicester; Aviva; Barclays; Bradford & Bingley; Legal & General; Lloyds TSB; Northern Rock; Prudential; Royal Bank of Scotland; and Royal & Sun Alliance) over equivalent periods.
| Group’s relative TSR performance | Amount released as a % of share grant |
| 0% p.a. (or below) | 0 |
| +3% p.a. | 100 |
| +6% p.a. (or above) | 200 |
Intermediate positions will be determined by interpolation.
If the relative TSR performance does not exceed 0% p.a. after three years, the conditional share grant lapses. There is no retest in this or any other circumstance.
The Committee believes that TSR is an appropriate performance measure because it is a robust and transparent measure of the creation of shareholder value; that a relative measure is more competitively appropriate than an absolute one; and that a weighted average group made up of the biggest domestic banking and insurance companies is the most valid comparator and gives a more effective performance test than a traditional ranking-based league table.
Calculations of TSR performance are performed independently of the Group by New Bridge Street Consultants LLP for the purposes of determining outcomes under the plan.
Provided that the weighted average TSR of the comparator companies is at least 0% p.a., HBOS shareholders will have to enjoy an additional return equivalent to at least £8bn over 2007-2009 for share grant participants in 2007 to enjoy maximum releases early in 2010. The estimated face value of conditional share grants for 2007 is about £22.4m in respect of about 205 participants. Maximum releases would amount to about £44.8m plus share growth plus dividends.
| Group’s real EPS performance | Amount added as a % of amount invested |
| 0% p.a. (or below) | 0 |
| +6% p.a. | 100 |
| +12% p.a. (or above) | 200 |
Intermediate positions will be determined by interpolation.
If the real EPS performance does not exceed 0% p.a. after three years, the investment opportunity lapses. There is no retest in this or any other circumstance.
The Committee believes that EPS is an appropriate performance measure because it is a robust and transparent measure and regarded as the best rounded long term absolute measure of financial performance.
This second element of the longer term incentive plans replaces ‘sharekicker’ for Executive Directors and colleagues in Levels 9 and 8 (as set out for Executive Directors in Section 10.3.2). Colleagues with existing sharekicker entitlements from March 2005 and/or March 2006 will be given the opportunity to transfer these interests into this new incentive plan in March 2007 but only linked to the performance of prospective (and not retrospective) real growth in EPS.
Executive Directors and colleagues in Level 9 and Level 8 have never been granted executive share options by HBOS and will not be granted executive share options in 2007. There are no plans to grant executive share options to these individuals in future years.
The Executive Directors and other senior colleagues may participate in the free share plan and in the sharesave plan. The Executive Directors and other senior colleagues will also be able to participate in the sharebuy plan being introduced for all eligible UK colleagues in 2007. These are all standard HMRC approved schemes available to nearly all colleagues, with no performance conditions.
These overall long term incentive levels are higher than those which applied in 2006. The Committee is proposing to increase the overall potential incentive levels to address, in part, a clear shortfall in HBOS’s competitive remuneration position in the financial services sector.
7.5 Benefits
Each senior colleague is provided with benefits, which principally comprise a company car (or cash in lieu), pension arrangements or allowances, paid leave, healthcare cover and preferential terms for some Group products.
Individuals are generally included in membership of HMRC approved final salary pension arrangements and, for certain individuals who joined the Group after 1989, for membership of separate final salary pension arrangements. These arrangements, taken together, provide a personal pension benefit based on salary only. The arrangements also provide a lump sum life assurance benefit of four times salary and pension benefits for spouses/dependants and qualifying children.
The final salary pension arrangements are closed to new entrants. All recruits since October 2002 have been, and future recruits will be, included in HMRC approved money purchase pension arrangements or separate arrangements of equivalent value. These arrangements also provide a lump sum life assurance benefit of four times salary.
All tax-approved benefits are subject to HMRC limits. Pension entitlement is based on salary only.
In April 2006 service related pension accrual under final salary pension arrangements ceased for those whose pension interest then exceeded the Lifetime Allowance of £1.5m. In broad terms, this is equivalent to a maximum pension of £75,000 p.a., or such higher amount as had accrued by April 2006. Similar cessations applied under money purchase pension arrangements. Affected colleagues receive an annual non-pensionable cash allowance of 25% of salary, payable monthly, in lieu of such service related pension accrual or money purchase pension contributions. This cash allowance will not count as salary for the purposes of the incentive schemes.
Similar cessations will take effect in April 2007 (and in each subsequent April) as more colleagues’ pension interests exceed the Lifetime Allowance applicable at that time.
8. Remuneration policy for the Chairman
The remuneration policy for the Chairman recognises that, whilst the Chairman was independent of the organisation when he joined it, he is not now regarded as independent. The Chairman plays an active role in influencing the strategic direction of the Group and ensuring overall performance delivery. Therefore we believe that it is entirely appropriate that the Chairman’s reward arrangements are based on a mixture of a base fee and performance-related long term incentive.
The base fee of the Chairman after the most recent review with effect from 1 July 2006, and at 31 December 2006, was £680,000.
In addition, as has been the case in HBOS since 2002, the Chairman is included in a long term incentive plan equivalent to that described in the first part of Section 7.4. He receives an annual conditional grant based on 100% of his fee which is otherwise subject to the same performance conditions as apply to Executive Directors.
The Committee established the long term incentive plan for the Chairman through a separately constituted scheme, for two reasons. Firstly, so that shareholders could vote on this scheme quite separately from any vote on the scheme applying to Executive Directors. Secondly, for legal reasons, because the Chairman is not an employee of the Group and cannot therefore be included in the share-based long term incentive plan described in the first part of Section 7.4 as that plan is available to employees only. In practice, however, the scheme which applies for the Chairman is a mirror image of the scheme applying to Executive Directors, save that the annual conditional grant is based on, and will remain at, 100% of his fee.
There is no other incentive plan and there are no benefits (car or cash in lieu, pension, paid leave, healthcare) for the Chairman. The Chairman is reimbursed for a proportion of his office expenses.
The Committee does not seek precisely to calibrate the Chairman’s reward to a particular time commitment: in practice the Chairman has always been available as required by the Group and, in broad terms, spends about half his working time on HBOS business.
9. Remuneration policy for Non-executive Directors
Remuneration for Non-executive Directors consists solely of fees. There are no short term incentive plans or long term incentive plans or benefits (car or cash in lieu, pension, paid leave, healthcare) for Non-executive Directors.
The current base Board membership fee for each Non-executive Director after the most recent review, effective from 1 May 2006, is £57,750. In addition, fees are paid for services on committees and for directorships of subsidiaries and joint ventures.
Fees are set based on comparisons with other Non-executive Director fees and time commitments in comparable companies.
