Tuesday November 25, 2014

Risk-Adjusted Compensation

Compensation committees should consider risk-adjusted compensation for executives to better align pay with performance and risk mitigation.

“If I hit, you pay.”
Operating efficiency indicators that were in vogue before the financial crisis – such as profit, revenue, productivity, costs and volume metrics – and some market measures, such as share price and total shareholder return, by and large, continue to be used by many compensation committees and consultants.  These measures are short-term and do not properly incorporate the explicit risks, costs and time to materialize of managements’ actions.  Metrics like these are analogous to steroids – all gain and no pain.  Management is driven to “max out” based on these types of metrics, offering compensation committees limited discretion, up front or at the back end.  “If I hit, you pay” becomes the operative norm.

Compensation Metrics Need a Re-haul
Compensation drives behavior, and it is the compensation committee’s responsibility to take all reasonable steps to ensure that management is not taking imprudent risks by virtue of their pay structure, and to require – if not insist – that any retained compensation consultant recommends a “risk-adjusted compensation” regime that reflects true costs and risks for management compensation, for the specific company within its industry.  The compensation committee however, has an obligation to employ its own judgment, skill and experience in approving and recommending this regime to the board.

The Dodd-Frank Legacy: “Risk-Adjusted Compensation”
It is important to note, however, that risk-adjusted compensation is not attempting to control the amount of executive compensation – only to ensure that the compensation be sufficiently aligned with actual performance and appropriate risk mitigation.

Approaches to Align Executive Compensation with Risk
There are two main time frames and four types of approaches to align compensation with risk: before and after compensation accrues or is awarded; and quantitative, qualitative, explicit and implicit approaches.  The compensation committee should be familiar with timing and approaches, as well as their interactions.

Combining the two time frames and four approaches gives us four adjustments to align executive compensation with risk and achievement:

  1. Quantitative Risk Adjustments Before Compensation Accrues or is Awarded
  2. Qualitative Risk Adjustments Before Compensation Accrues or is Awarded
  3. Explicit Risk Adjustments Based on Actual Results
  4. Implicit Compensation Adjustments

Compensation Committees Need to Drive These Reforms
These approaches are emerging practices for addressing risk and compensation in the aftermath of the global financial crisis.

To expect that management, compensation consultants or industry associations, alone or even in combination, will advance or implement the above reforms is ambitious, and perhaps misguided.  Management’s interests may often be contrary to the practices recommended above.  Compensation consultants may prefer simplistic metrics, that are not risk-adjusted, that can be used and explained, and that can be rolled out firm-wide.

The drivers of the above reforms will have to be compensation committee chairs and committee members themselves, who understand the need for such approaches and commit to mastering these emerging standards.

To implement such reforms, compensation committees should employ their experience and judgment; retain independent, qualified compensation consultants; and insist upon tailored, risk-adjusted compensation advice and reporting.

Institutional shareholders and proxy advisors would also be wise to consider this sort of explicit linking of risk and compensation, when voting upon or assessing pay-for-performance linkages and compensation regimes, as risk-adjusted compensation may prove to have a higher alignment with shareholder value creation than more simplistic, non risk-adjusted performance measures.

Dr. Richard W. Leblanc is a corporate governance expert and advisor to leading boards and committees.  He can be reached at http://www.boardexpert.com.

The views and opinions expressed in the article do not necessarily reflect the views of the NACD.

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