The Advisors' Blog

– Steven Hall, Steven Hall & Partners

The “newest old thing” these days is designing compensation plans that do not encourage excessive risk taking. “Experts” have identified risk as the hottest emerging issue for compensation committees, stating that “we” do not yet know how to create the proper relationship between pay and risk.

I fully agree that the word “risk” has never been used more in compensation committee meetings than in the last six months, but that doesn’t mean the concept is new. In fact, responsible directors have considered the risks and potential impact, good and bad, of every pay decision for decades.

While not explicitly termed “risk assessment” each time a salary increase is considered, or a short- or long-term incentive plan is adopted or modified, management and boards consider the risks associated with their actions, or lack of action. But in the old days, the considered risk was how decisions would impact the company, its operating results and stockholders. Now boards are confronted with the added risk of how regulators, legislators and the public will view their decisions, today and tomorrow, with the added benefit of 20-20 hindsight.

Debate continues as to 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 plan achievement.

Ironically, Wall Street has been down this road before. About twenty years ago, Wall Street recognized the high risk to shareholders if executives were paid solely in cash for short-term results achieved in a manner detrimental to the long-term success of the firm. Sound familiar? In response, Wall Street firms began to pay part of annual bonuses in shares subject to future price fluctuations. Therefore, if an individual earned an annual bonus through actions that were not in the best interests of customers, those customers would leave and, as the business suffered, so would the stock price on shares held by executives.

Additionally, such deferred payouts served as a retention tool, as well as creating significant ownership and shareholder alignment. It is clear from the losses realized by executives at Bear Stearns and Lehman Brothers that there was significant “skin in the game,” a fact that should have counterbalanced any desire to take risky positions only to generate short-term payments. Sometimes businesses make bad decisions, and pay has nothing to do with it. Given the investment these employees had in their firms, it is difficult to believe how compensation plans alone created a high risk culture.

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. Are they based on a thorough review process by the full board that defines the pay for performance range from minimally acceptable to exceptional?

– Consideration of unintended consequences. Could the pay program create an incentive for behavior that rewards executives, while detrimental to the company and its shareholders? Has the probability of a black swan been considered?

– Will the compensation program address the often unmentioned 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? If not, why not? Unfortunately, to complicate the issue, there are examples of “old” best practices that are now viewed negatively.

– Is the program sufficiently flexible to permit the compensation committee to recognize and adjust for special situations that, left ignored, could either create undeserved windfalls or penalize executives unfairly?

The events of the last two years have been tragic from a business and stockholder viewpoint. The fact that many employees of impacted companies were recipients of very large pay packages prior to the market collapse certainly provides blame-seekers with a terrific target. Unfortunately, with the benefit of hindsight, the cause of the downfall is not compensation-related, but rather, poor business decisions driven by risky business strategies. Decisions to take on increasing levels of risk were pushed by investors and analysts focused on short-term growth, earnings and stock gains with little concern for the risk profile necessary to achieve the desired performance.

But, one must consider the fates of management and boards who resisted the push. Their lack of relative performance would certainly have doomed their tenure given market demands for ever higher earnings and stock price. Lest we forget, although it is true that the last several years saw high investor gains mirrored by huge pay packages, we also saw dramatically shorter tenures, particularly at the most senior levels as boards quickly replaced “non-performers.”

There are undoubtedly many reforms to be considered as boards work to rebuild shareholder confidence, and assuring that pay programs continue to support business strategy is certainly one of them. But it is foolish 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.