The “newest old thing” these days is designing compensation plans that do not encourage excessive risk taking. The word “risk” has never been used more in compensation committee meetings than this year, but the concept is hardly new. While not always explicitly termed “risk assessment,” for decades management and boards have considered the risks of their actions, or inaction, each time a salary increase is considered, or a short- or long-term incentive plan either is adopted or modified.
However, one thing has changed. Boards had considered the risk of pay decisions on the company, its operating results, and stockholders. Now boards must also confront the risk of how regulators, legislators, and the public will view their decisions. The debate still rages whether Wall Street and its regulators had the proper controls to manage risk. However, it was aggressive business plans, approved by directors, which led to the highly leveraged positions fatal to some firms. Compensation programs implemented to support such business plans were not the drivers of risk, but rather were designed to incent achievement of such plans.
Ironically, Wall Street has been down this road before. Twenty years ago, firms recognized the high risk to shareholders if executives were paid solely in cash for short-term results and began to pay part of annual bonuses in stock. These compensation plans, which were designed to promote alignment between management and shareholders, as well as employee retention, worked as intended. From their personal losses, it is clear executives at Bear Stearns and Lehman Brothers had significant “skin in the game,” which should have offset any incentive to take risky positions to generate short-term payments. It is hard to believe that their compensation plans alone created a high-risk culture.
Sometimes businesses make bad decisions, and pay has nothing to do with it. Let’s be clear: Risk assessment should be an important part of every pay-related decision made by compensation committees. Specifically, assessment should focus on:
- Whether performance goals are fair and reasonable in light of past performance, market conditions, and the competition.
- Consideration of unintended consequences. Does the pay program incentivize behavior that rewards executives but is detrimental to the company and its shareholders?
- Has the probability of a Black Swan been considered?
- Does the compensation program explicitly address the risk that the firm may not be able to attract, retain, and motivate executives essential to the firm’s success?
- Are currently accepted “best practices” considered in the design?
- Does the compensation committee have the flexibility to adjust for special situations that may create windfalls or unfair penalties?
In the face of a tragic market collapse, the fact that many senior executives received large pay packages before their firms’ demise provided blame-seekers with a terrific target. But the crisis seems to have been caused by poor business decisions, driven by risky business strategies, not by compensation practices. Investors and analysts, who were focused on short-term growth, earnings, and stock gains, pushed management and boards to take on increasing levels of risk. Management and boards who resisted were doomed to short tenures as “non-performers” were quickly replaced.
There are undoubtedly many reforms to be considered as boards work to rebuild shareholder confidence, and assuring pay programs continue to support business strategy is certainly one of them. But it is naive to believe that a new, elaborate exercise that considers pay and related risk is a new approach that will magically avoid past mistakes. This process has been firmly entrenched in the work of compensation committees for many years. The real need is for recognition that engaged board oversight of rigorous business planning, including risk assessment, will serve to avoid the mistakes of the past far better than a more complex compensation process.
Steven E. Hall is a founding partner and managing director of Steven Hall & Partners. Visit www.shallpartners.com.