Dear Shareholder
I am delighted to introduce this, our third, HBOS Remuneration Committee Report for which we will be seeking approval from shareholders at our Annual General Meeting.

Just over a year ago, in late 2003 and early 2004, we met with over 20 of our major shareholders, collectively representing about one third of the total HBOS equity, together with their representative bodies. These meetings assisted us with a number of issues on reward policy and practice: much of that was reflected in last year’s report – for which we received support from 96.75% of shareholders who voted - and was implemented during 2004.

This year, we have again had discussions with our major shareholders and their representative bodies on both reward policy and reward practice. This report gives comprehensive details based on the policy we set out a year ago, along with changes we have made in the interim, and changes we plan for the future.

The disclosure regulations mean that the focus of this report is on Directors and, to a lesser extent, their most senior colleagues. In reality, the Committee’s focus extends to all our 71,000 colleagues in the HBOS Group: we believe that it is important that we have consistent remuneration principles across the Group regardless of business area and seniority.

More specifically, as was the case a year ago:-

• our salaries are managed around median levels in the financial services sector;
• our annual incentives have stretching performance targets consistent with those in our operating plan; are generally team based; and focus on issues for which each team has prime accountability. Annual incentives are a material part of reward - and all colleagues know that there is a distinct possibility of zero payments, as well as the possibility of high rewards where targets are significantly exceeded;
• our longer term incentives allow most of our colleagues to enjoy a “share in success” of HBOS; and, for our most senior colleagues, the long term arrangements are strongly driven by the Group’s relative performance against key comparator companies. These latter rewards are paid only if the Group’s performance is better than the average of the key comparator companies;
• wherever possible, our annual and longer term incentives are denominated in shares rather than in cash - so that colleagues are also shareholders. The Committee has also set out clear requirements for all Directors, and other senior colleagues, to own shares in the Group;
• our benefits offering is positioned at the market median and gives colleagues flexibility over their choice of benefits; and we have an extensive colleague product offering – so that colleagues are also customers.

This reward philosophy has applied in HBOS since inception, did not change during 2004 and will continue to apply in 2005 and, subject to review, in 2006. During 2005, we will review our longer term incentives, not least to honour commitments we made to our major shareholders three years ago. And we will also review our pension policy in the light of the legislative changes which are being introduced from April 2006.

Whilst the vast majority of our shareholders who expressed a view were supportive of our reward policy and practice, and the extent of the disclosures in last year’s report, it was clear that some shareholders were keen to see more extensive disclosure in the summary financial statement. Whilst all shareholders are entitled to see a copy of this full report, we recognise that many shareholders prefer to see a summarised document. We have thus extended the disclosure in the Annual Review & Summary Financial Statement so that it includes more specific reward details.

In similar vein, we think that it is useful to summarise in this letter the key changes during the year, although more detail is contained within the full report:-

Salary increases in 2004
Whilst we need to maintain competitive salary positions for our most senior colleagues, we have sought not to be at the market forefront on increases in senior salaries. In 2004, Executive Directors’ salaries increased, on average, by 6.8%; and the Chairman’s fee increased by 4.8%;

Introduction of special short term incentive in 2004
We enhanced short term incentive targets and maxima by one half for our most senior colleagues, firstly, to recognise that our standard targets and maxima were significantly behind the market position; secondly, to focus such colleagues on the importance of delivering substantial improvements in earnings per share, return on equity and profit before tax; thirdly, to ensure that such improvements were not achieved at the expense of risk management; and fourthly, to make sure that each of our most senior colleagues had an element of short term incentive driven from Group performance. In 2004, those stretching targets for those Group measures were generally achieved;

Removal of Abbey National from comparator group for long term incentive plan
We retrospectively removed Abbey National from our comparator group effective from the end of June 2004, immediately before bid activity started (which culminated in Abbey National being acquired by Banco Santander Central Hispano in November 2004); and replaced them with Alliance & Leicester, Bradford & Bingley and Northern Rock effective from the start of July 2004;

Retirement of Mike Ellis
Mike Ellis, our former Group Finance Director, retired at the end of the year on contractual terms. There was no termination payment and no pension enhancement;

Appointment of Mark Tucker
Mark Tucker, our new Group Finance Director, was hired on terms broadly equivalent to those which applied to Mike Ellis. However, we have not included Mark Tucker in final salary pension arrangements. We have, for 2004 only, doubled his long term incentive arrangements – which will pay out only if, and to the extent that, HBOS outperforms its comparator group - and will pay nothing for “average” (or poorer) performance; and we have backdated his short term incentive arrangements to the start of 2004;

Maturity of special long term incentive plan for Andy Hornby
The performance period for the special long term incentive arrangement, effective from January 2002, for Andy Hornby, Chief Executive Retail, finished at the end of 2004 and performance criteria in each of the years 2002, 2003 and 2004 were satisfied. Specifically, that division increased profit before tax and exceptional items, using a like for like comparison, over the three year period by more than 60%. The arrangement gives Andy Hornby the opportunity to receive up to 260,000 shares in April 2005. Full details of the maturity will appear in the 2005 Annual Report & Accounts;

Revisions to short term incentive plan for 2005 and beyond
For Executive Directors and about a further 200 of our most senior colleagues, we have increased target and maximum short term incentive payment opportunities, where it was clear that our practice had fallen significantly behind the market position - for example, for Executive Directors, the target incentive, if taken in shares, has been increased from 60% to 75% of salary; but we are not repeating, in 2005, the special short term incentive scheme which applied in 2004; and

Introduction of free shares in 2005 and beyond
During 2005, HBOS will replace its share option plan with a free share plan - of equivalent expected value - under the Share Incentive Plan legislation. That legislation, in broad terms, requires all UK employees to be included in the scheme, up to the free share limit of £3,000 p.a.

In the full report which follows, we have produced transparent and extensive technical details, as we have done for the past two years.

We welcome questions and feedback from all shareholders on both the report content and the report transparency.

We believe our reward policy is right for our colleagues and right for our shareholders – and we encourage all shareholders to support this Report at the Company’s forthcoming (2005) Annual General Meeting.

Brian Ivory
Chairman
Remuneration Committee
1 March 2005