The Magazine of Corporate Responsibility

Pay for Risk-Appropriate Performance

by Bruce R. Ellig

Among the December 2009 proxy rule changes approved by the SEC was a requirement that companies discuss and analyze risks that are reasonably likely to have adverse effect on the company’s reputation and/or sustainability.  This means companies must not only identify the risks facing them but also determine the probability and severity if realized and how that relates to the company’s compensation policies and programs.

Board RoomBut it is virtually impossible for a company to succeed without taking risk.  Success is not guaranteed.  And it is reasonable that CEOs and other executives should be rewarded for succeeding in spite of the risk.  But companies and more specifically the boards of directors have to know the severity and probability of risk.  What boards are learning is that it is not a smart business decision to take on a risk that could destroy the company even if the probability is low.  Paying excessively to executives to take on this risk makes it even worse.

SEVERITY & PROBABILITY OF RISK

A starting point would be to categorize severity of risk as: low (or none), reasonable or severe.  A severe risk would cause major damage to the company possibly sending it into bankruptcy, and/or rippling through the economy with disastrous results.   Reasonable risk is what companies are expected to include in their plans, whereas low risk targets would result in under-performing companies.

The probability of occurrence could similarly fall into three categories: low or (none), moderate and high.  Combining the severity of risk with the probability of occurrence results in nine combinations.

Severe risk with:

  • High probability
  • Moderate probability
  • Low probability

All severe risk situations, regardless of probability should be avoided.  Some have argued that the securitization of loans was a low probability situation.  But we saw how that turned out.

Reasonable risk with:

  • High probability
  • Moderate probability
  • Low probability

Reasonable risk situations are what companies should be considering and a major factor in designing the pay-for-performance plans.

Low risk with:

  • High probability
  • Moderate probability
  • Low probability

Low risk situations should focus the emphasis on the salary plan not the incentive program.

EXECUTIVE PAY

With the backdrop of probability and severity of risk, it is possible to examine executive pay in terms of: low, reasonable and excessive.  The one receiving the most attention is of course excessive pay.  Given the five pay elements: salary, employee benefits, executive benefits, (or perquisites), short-term and long-term incentives, an overly generous payment of any could be excessive but the most likely candidates are the incentive plans, both short and long-term.

EXCESSIVE PAY

There are three scenarios for excessive pay.  It can be tied to severe risk, reasonable risk and little if any risk.  The first scenario is when the pay is appropriate given the level of risk, but the plan should never be designed to reward achievement that can severely damage the company, if not send it into bankruptcy.  One does not have to look further than the subordinated mortgage debacle.

The reasonable risk situation is when the pay is greater than justified in relation to the risk.  This is probably the most common situation.  And incentive payment of any amount is probably excessive when there is little if any risk.

REASONABLE PAY

The objective of any well-designed pay plan is reasonable pay for achieving reasonable performance targets based on an assessment and probability of risk.

Pay-for-performance should be focused on stretch targets but not high-risk targets.  No pay plan should be structured to pay for successfully meeting performance targets that could drive the company into bankruptcy.  However, if there is low to no risk, payments should be moderate.

LOW PAY

If performance is low, it is expected that pay will be low.  If not, it can be argued that pay is not reasonable maybe even excessive.  In fact, there probably should be no pay under the annual and long-term incentive plans.  The only pay should be in salary.

However, the low-paying scenario may also describe a situation where the executive has met the performance expectations but because of a poorly designed plan, the person is underpaid.  This is hypothetically possible but hard to find in the for-profit sector.

Low pay may also be the result of a draconian clawback because of an after-the-fact determination of the appropriate amount of pay for continued performance.  Careful analysis of risk before finalizing the pay plan should minimize such a draconian action.

BOARD OF DIRECTOR & COMPENSATION COMMITTEE RESPONSIBILITIES

When companies become too big for the owner to continue to control day-to-day operations, the owner looks to bring in professional managers to take on the responsibility.  To think like owners, these managers are given cash and stock incentives.  It is reasonable to expect the cash to meet current needs and the stock to be an asset for later needs.  Stock plans were created in the 19th century to make professional managers think like owners.  Acquired stock was not to be sold until leaving the company, preferably at retirement age.

But today many boards and their compensation committees have lost their way.  They permit executives to cash out stock options and stock awards, thereby breaking the link with the shareholders.  And to make matters worse some companies have approved incentive plans that pay out lavishly in the presence of major risks, thereby threatening the sustainability of the company.

Bruce Ellig is the author of more than 100 articles and seven books including his most recent, the updated and revised edition of The Complete Guide to Executive Compensation. Much of the material in this paper has been taken from this book.  Ellig served as worldwide head of HR for Pfizer Inc. for the last 11 years of his 35 years with the company.

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