# Response to consultation on draft guidelines on the applicable notional discount rate for variable remuneration

#### Is the example 2 sufficiently clear and helpful to understand the application of the guidelines?

There are in fact two examples not one.We consider that the two examples are confusing.

Furthermore, the present value formula is not general, but applies when the ratio is 100% (and not, for instance, 200%).

The example sets out an example where the EUR 150,000 is deemed to be a “particularly high amount” as set out in CRD Article 94 (m) second paragraph, second sentence.

The amount that is subjected to the long-term deferral incentive is shown as 25% of the EUR 150,000 i.e. EUR 37,500.

It illustrates two sub-examples

a) EUR 37,500 is vested pro-rata over 6 years

b) EUR 37,500 vests at 6 years

Both EBA examples 2 a) and 2 b) are unclear because they are incomplete in the same way that example 1 as set out in response to question 9 is incomplete.

The examples only show the calculation of the values to be included in the calculation of the ratio of variable remuneration to fixed remuneration.

The examples set out by the EBA do NOT explain that the amounts that are not subjected to the discount rate that will be paid in less than 5 years.

In summary, the EBA proposals do not provide a sufficient incentive for the employee.

Q10 Sub-example a)

Assumptions for 2a)

In the sub-example 2a) the EBA makes the following assumptions;

1. 60% of the total revised variable remuneration of EUR 150,000 is considered eligible for deferral i.e. EUR 90,000.

2. A compensation that is “deferred for a six-year period” vesting pro-rata with a further retention period of 2 years for each vested amount of EUR 6,250 is deemed by the EBA to be permissible as per the CRD.

3. The effect is that the EBA considers that the discount rates can use a period of (n) of less than 5 years.

4. The effect is that the employee can sell the deferred compensation that is subject to the discount rate in 3 years (1 year vesting + 2 years retention) and in 4 years (2 year vesting + 2 years retention). Note, if the retention is changed to 0 years, the pro-rata amounts can be paid out after year 1. (We consider this contrary to the Directive’s intention)

5. By utilising the long-term discount rata formula the pro-rata vested amount (EUR 6,250) that can be paid in year 3 is more than could have been paid if no discount rate had been used.

6. The amount that can be paid immediately is 40% of the proposed remuneration of EUR 150,000 that includes the long-term incentive.

The EBA example:

• It indicates that the employee is to receive the variable compensation that is not subjected to the discount rate deferred and pro-rata vesting for 6 years. Yet there is no incentive or benefit for the employee to accept this.

• Advises that the total of the 6 discounted amounts is EUR 21,457.

• Added to the non-discounted amount of EUR 112,500 (that is not shown).

• Is equal to EUR 133,957 and

• Is thus less than the fixed remuneration of EUR 135,000.

• This is equal to a ratio of 99.23%

Thus the proposed remuneration is permissible according to the EBA.

However, it is our opinion that none of the above outcomes are the intention of the European Parliament when enacting the legislation. Also the EBA has an error in its calculation of the formula to calculate the value of the discounted variable remuneration set out on page 20.

Inflation 2% i

Bond yield 2.73% g

Deferral incentive 10% id

Retention incentive 2% ir

r 1.1873

The formula set out on page 20

vrpr 6,250.00

dvr = vrpr x (r^n - 1) / n (r - 1)

(r^n - 1) 1.8013

n (r - 1) 1.1238

dvr = vrpr x (r^n - 1) / n (r - 1) 10,018.02

Amount not subject to discount 112,500.00

Adjusted total 122,518.02

Percentage of Fixed 90.75%

This compares with the amount calculated by the EBA on pages 19 and 20 (for each of the six pro-rata vesting years) of EUR 21,457.

Therefore the EBA formula is incorrect. If it were to be used it calculate the amount to be paid, it would imply that a higher deferred remuneration would be payable.

The correct formula

It should be based on calculating a geometric progression as follows:

vrpr 6,250.00

dvr = vrpr x (1 - 1 / r^n) / (r - 1)

(1 - 1 / r^n) 0.6430

(r - 1) 0.1873

dvr = vrpr x (1 - 1 / r^n) / (r - 1) 21,457.07

Amount not subject to discount 112,500.00

Adjusted total 133,957.07

Percentage of Fixed 99.23%

Fixed pay 133,957.07

Maximum deferral period in years 6

Pro-rata per year 16.67%

r 1.1873

Threshold 25%

Residual (not subject to discount) 75%

Max Total Variable Remuneration (TVR) 150,000.00

Check

TVR x Non-LTDS 75% 112,500.00

Discounted value of TVR 25% 21,457.07

Total 133,957.07

Therefore using the information provided the employee is being provided with a choice

• EUR 133,957 Variable compensation without incentive

• EUR 150,000 Variable revised compensation with incentive

Reconciliation

• EUR 37,500 25% of Variable revised compensation with incentive

• EUR 21,457 Discounted Value

• EUR 112,500 75% of Variable revised compensation with incentive

• EUR 21,457 Discounted Value

• EUR 133,957 Adjusted compensation.

Amount payable immediately

The EBA have read the CRD Article 94 (m) that states that for “particularly high amounts” that 60% should be deferred. Institutions agree with this statement.

However, the EBA has deemed that this statement refers to the total that includes the amount(s) that are subjected to discount rate i.e. the increased long-term incentive.

Thus in the 2a) example, the EBA has applied 60% to EUR 150,000 i.e. EUR 90,000.

The net effect of this interpretation is that 40% of EUR 150,000 would be payable immediately i.e. EUR 60,000.

We note that had no long-term incentive been paid, the maximum variable remuneration would have been 100% of the fixed remuneration of EUR 135,000, not EUR 133,957.

This would have meant that the maximum amount payable immediately would have been EUR 54,000 i.e. 40%.

The consequence of the EBA interpretation is that by including an amount of long-term deferred compensation subject to a discount rate, the consequence is that the employee will receive EUR 6,000 more immediately i.e. EUR 60,000 instead of EUR 54,000.

Institutions opinion is that this is NOT the intention of the CRD or the EU Parliament when the legislation was enacted.

Institutions believe that the percentage amount that is paid immediately in all examples must be based upon the approved percentage of the fixed remuneration.

Thus in the example with a cap of 100%, the maximum amount payable immediately remains unchanged by an increase attributable to use of the long-term incentive process.

Pro-rata vesting of variable compensation not subject to the discount rate

The EBA example on page 18 proposed that “60% of the total variable remuneration, i.e. EUR90 000, would be deferred for six years……. of which EUR 37 500 of this variable remuneration is deferred for a six-year period”. However, the illustration in Figure 2 shows that the entire 60% (EUR 90,000) will vest pro-rata over the six years. Thus the portion not subjected to the discount rate (EUR 52,500) will also be vested and payable pro-rata over the 6 years.

The EBA example does NOT explain why an employee would agree to this, because the employee derives no additional compensation. On the contrary it would be reasonable for the employee to expect for the deferred compensation to vest pro-rata over 3 years.

Thus the EBA proposals in fact reduce the benefit to the employee.

Discount rate for period of less than 5 years

On page 18 the EBA states that “the discount rate can be applied to a maximum of

25% of the total variable remuneration provided it is paid in instruments deferred for a period of at least five years”.

Yet the EBA example shows that amounts will vest pro-rata from year 1 and that following a period of 2 years of retention will be permitted to be disposed of by the employee. The effect is that EUR 6,250 will be available at the end of years 3 and 4 (following 2 years of retention). The EBA has used a value of n of less than 5 years.

In order to more clearly illustrate the EBA proposals, we have reworked the EBA example without the 2 years retention, using the same EUR 37,500 long-term incentive amount, vesting and being paid out pro-rata.

Institutions do NOT agree with the EBA interpretation of the CRD.

Institutions believe that the intention of the CRD is that the minimum period on n in the discount rate should be 5 years.

Thus in the example, the first 5 payments do not comply with the CRD intentions because they use a value of n that is less than 5 years that is in contradiction with Article 94 (g) (iii).

We believe that the minimum value of n to be used in a discount rate is 5 years.

Retention

The example in Figure 2 shows retention of “one year”. This is a typo and should be “two years”.

As explained in the answer to question 5 the EBA proposals with respect to adding 2 years of retention do NOT result in any material increase to the total revised variable remuneration.

The following sets out a comparison of the difference between an approach without retention and with 2 years retention assuming 6 years pro-rata vesting.

• Fixed compensation EUR 133,957.07

• Revised Variable Compensation EUR 148,740.77 (no retention)

• Revised Variable Compensation EUR 150,000.00 (with retention)

• Additional Compensation EUR 1,259.23 (0.85%)

o Additional benefit EUR 14,783.37 (no retention)

o Additional benefit EUR 16,042.93 (with retention)

Comparison of compensations

The EBA example 2 does not explain that there are material impacts for the employee with respect to the different cash flows over the 6 to 8 years (including retention) for variable remuneration

• Not utilising the EBA formula for long-term incentive

• Utilising the EBA formula

The deferred vesting pro-rata per annum for 6 years is as follows

• Deferred not subject to discount EUR 8,624.10 (no retention)

• Deferred subject to discount rate EUR 6,250.00 (no retention)

• Total EUR 14,874.10 (no retention)

From this it is self-evident that the employee is worse off for each of the first 5 years and only receives the additional compensation in the 6th year.

If the employee were to have been provided with the option to pro-rata vest the amount not subject to the discount factor over 3 years, then the EBA proposals are even more of a lack of incentive.

In conclusion the opinion of institutions is that the EBA proposals as set out in example 2a)

• Do not provide an incentive to introduce a pro-rata long term incentive plan

• Are not compliant with the CRD guidance.

Q10 Sub-example b)

The example set out on page 21 is as follows:

• It confirms that the discounted amount is EUR 13,387

• added to the non-discounted amount of EUR 112,500 (that is not shown)

o is equal to EUR 125,887 and

o is thus less than the fixed remuneration of EUR 135,000.

o A ratio of 93.25%

• Thus the proposed remuneration is permissible according to the EBA.

The alternative way to look at this example is as follows:

• Fixed compensation EUR 135,000.00

• Variable Compensation EUR 125,886.54 (no incentive)

• Revised Variable Compensation EUR 148,307.69 (no retention)

• Revised Variable Compensation EUR 150,000.00 (with retention)

• Additional Compensation EUR 1,692.31 (1.14%)

o Additional benefit EUR 22,421.15 (no retention)

o Additional benefit EUR 24,113.46 (with retention)

The point of concern for institutions is that the example does not make it clear that the choice is between;

• EUR 125,886.54 received 100% by year 3

• EUR 112.500.00 received by year 3 (i.e. 89.40%

• EUR 37,500.00 received by year 8

Thus the employee suffers 5 years reduction of EUR 13,386 (i.e. the discount) for the benefit of receiving an additional EUR 24,114. This is an internal rate of return of 12.5%.

It is also noted that since the fixed remuneration in the example is EUR 135,000, the employee in fact is much more likely to prefer EUR 135,000 (40% paid immediately and 60% deferred to vest in 3 years), rather than receive EUR 112,500 as set out in the example instead of the future total compensation of EUR 150,000.

The difference between EUR 135,000 and EUR 150,000 represents EUR 15,000. This is equal to internal rate of return of 2.1% over the additional five year period.

In conclusion this example illustrates why the EBA proposals do not provide any incentive to introduce a long term incentive scheme utilising the proposed formula.

Note 9:

We disagree with this interpretation and consider that only 60% of 100% (or a higher % if approved by shareholders) of the fixed remuneration of EUR 133,957 i.e. EUR 80,374.20 is eligible

Note 10

In fact the EBA proposals would imply that retention is NOT mandatory, in which case amounts would vest and be paid out commencing after year 1. Institutions consider this in contravention of the spirit and intention of the CRD.

#### Is the example 3 sufficiently clear and helpful to understand the application of the guidelines?

The example sets out the EBA interpretation of the CRD with respect to calculate;• The revised variable remuneration

• of which the maximum amount that can be paid in a deferred amount with a minimum of 5 years

The calculation and the example is not as clear as it could be and is shown as only an abbreviated formula.

The formula set out by the EBA includes the fixed value of the threshold of 0.25 (25%) and 0.75 (residual threshold %).

This is incorrect. The two values are variables with maximum and minimum values.

0.25 should be defined as MAX to represent a value between 0 and 0.25 equating to the maximum value of 25% that can be paid in instruments that are deferred for a period of not less than five years, since member states may set a lower maximum percentage.

The value 0.75 should be replaced in the formula with 1-MAX to indicate that value can range between 0.75 and 1.00 equating a maximum value of 100% indicating that no long-term incentive is permitted.

fr x [ (1 + i + g + id + ir) ^ n ] 100,000 x 2.1673

tvr = ---------------------------------------------------- = ----------------------------

1-MAX x [ (1 + i + g + id + ir) ^ n ] + MAX 0.75 x 2.1673 + 0.25

In the example

25% MAX = percentage to be paid in long-term incentive

100,000 fr = fixed remuneration

2.00% i = inflation rate;

2.73% g = interest rate for government bonds EU average;

10.00% id = incentive factor for use of long-term deferral – minimum 5 years

(2.00% for each additional year beyond 5 years)

2.00% ir = incentive factor for additional retention – minimum of 2 years

(1.00% for each additional year beyond 7 years)

5 n = length of the vesting period.

115,559 tvr = total variable remuneration

28,890 MAXamt = tvr x MAX equals the maximum amount to be vested in n years

#### Do you agree with our analysis of the impact of the proposals in this CP? If not, can you provide any evidence or data that would explain why you disagree or might further inform our analysis of the likely impacts of the proposals?

Institutions have reviewed the EBA proposals and set out in detail its response to questions 1 to 11 above.Response

The summary of those responses is that EBA has set out the following:

1) Calculation of the amount subject to long-term deferral

The EBA has interpreted the CRD with respect to the amount that is subject to the calculation of a long-term incentive to be paid in instruments that are deferred for a period of not less than five years as set out in Article 94 (g) (iii) as follows:

The EBA proposes that the maximum amount (a percentage between 0% and a maximum of 25%) that can be deferred is based upon a formula that has as its starting point the approved percentage (100% minimum – 200% maximum) of the fixed remuneration,

Institutions disagree with the conceptual rationale of the EBA proposal.

The EBA formula increases that amount by a discount rate to derive a revised total notional remuneration to which the 25% (or whatever % agreed) is applied to determine the amount of long-term deferred compensation.

Institutions disagree with the conceptual rationale of the EBA proposal that includes a formula for increased compensation that is derived from not just the discount rate.

Because of the way the formula has been designed, a ”stress-test” of the formula reveals that with inflation + 10 government bond rates remaining at current levels an employee would need to accept 20 years deferral to receive 33% additional variable remuneration. The period reduces to 10 years when inflation + 10 year government bond rates were each 20% p.a.

In effect this would result in a situation where 75% of the total revised remuneration would equal 100% of the fixed remuneration. Thus the only additional benefit would be an additional 33% that would be deferred for a minimum of 5 years.

Institutions do NOT believe that the intention of the CRD is to impose such restrictive approaches to additional remuneration for a long term incentive scheme.

2) Calculation of amount paid immediately

If example 2 is applied to all examples, the EBA has interpreted the CRD as permitting the percentage to be paid immediately (40% to 60%) is based upon the total revised remuneration (inclusive of amounts subjected to the discount rate as set out above).

The effect is that if an employee were to elect to have a portion subjected to the long-term incentive, then there would be an increase in the amount paid immediately, offset by equal and opposite reduction in the amounts vesting in future years

Institutions disagree with the conceptual rationale of the EBA proposal.

3) Pro-rata vesting for long-term incentives

The EBA has interpreted the CRD as permitting an employee - who elects to have a portion subjected to the long-term incentive – to receive and dispose of capital instruments pro-rata that could commence in 1 year.

The EBA has used a value of less than 5 for n in the formula.

The effect is that the employee de facto receives an amount more than is permitted if the employee had not opted for the long-term incentive scheme.

Institutions disagree with the conceptual rationale of the EBA proposal. The value of n should be a minimum of 5 years.

Conclusions

Institutions have concluded that:

1. The EBA has misinterpreted;

a. Calculation of the amount subject to long-term deferral

b. Calculation of amount paid immediately

c. Pro-rata vesting for long-term incentives

2. The EBA proposals do not provide any material incentive for long-term deferred compensation and furthermore do NOT provide any incentive to defer immediate cash awards, or vest for longer than the minimum of three years, or add a retention period.

3. The costs of introduction and administration and calculation outweigh the financial increase.

4. It most unlikely that any employee will see the EBA proposals as providing any benefit.

5. It is most unlikely that any bank will ever implement the EBA proposals.

In addition institutions believe that the EBA has not conducted a sufficient thorough assessment of the drivers of long-term deferral incentive scheme taking into account all relevant factors including inflation rate and risk, which includes length of deferral.

Institutions do not believe that the proposed EBA guidelines on the discount rate specifically consider how to incentivise the use of instruments which are deferred for a period of not less than five years;

It is the opinion of institutions that the EBA proposals do:

• NOT comply with the objectives of the CRD to provide an incentive to defer variable compensation for five years or more.

• NOT comply with the spirit or letter of the CRD that is focussed only on the 25% (or lower percentage if mandated by a member state).

• NOT differentiate between the riskiness of each institution or the capital instruments.

• NOT enable institutions to implement remuneration policies aligned with the long-term growth and strategy.

• NOT enable institutions to differentiate the calculation of the increased variable remuneration for employees that might be included in the scheme.

In conclusion, if the EBA proposals are adopted as proposed institutions do not expect to avail themselves of the facility to increase variable compensation using the proposed formula and methodology set out by the EBA.

The BBA has prepared a paper setting out an alternative model that it believes should be considered. A separate submission has been made to the EBA with a spread-sheet that supports the comments made in this response.