Be a Ringmaster of Risk

Consider human resource strategy as risk management.

By Wayne F. Cascio Apr 1, 2012
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April CoverKai-Fu Lee joined Microsoft in 1998 and was in charge of creating and running operations in China. Responsible for development of the MSN Internet search program, Lee had knowledge of trade secrets. In 2000, Microsoft officials moved to protect the company by requiring Lee to sign a noncompete agreement. Nevertheless, Lee quit in July 2005 upon notifying Microsoft that he was moving to Google to lead the search engine's expansion into China. That prompted Microsoft to sue Google and Lee, contending that Lee's duties at Google would violate the agreement. Google hit back with its own lawsuit, contending that Microsoft's clause was "an illegal restraint of trade" since it violated laws in California, where Google is based, that protect workers' right to change jobs. In December 2005, the parties resolved the issues in a private agreement. In 2009, however, Lee reportedly left Google to work on his own venture in China.

In knowledge-based companies, the most valuable assets are not buildings or hardware; they are people. People make up a company's stock of human capital. As the above anecdote makes clear, the risk of losing key players is substantial enough that some companies try to lock in their services through legal constraints. Others may use restricted stock that vests over time. Still others, such as the SAS Institute, focus on creating great cultures and fun places to work that make it difficult for employees to leave. Each strategy is designed to mitigate human capital risk.

As defined by The Conference Board, human capital risk is "the uncertainty arising from changes in a wide range of workforce and people-management issues that affect a company's ability to meet its strategic and operating objectives." As S. Varadarajan, executive vice president for Tata Teleservices Ltd. in Delhi, noted in a 2011 research report by The Conference Board, "We have to manage human capital risk. In our business, human capital is our only asset, our only raw material and our only product."

Indeed, Ernst & Young identifies human capital risk as a key business risk. Its 2008 survey of Fortune 1000 executives reported that the top five HR risks are:

  • Talent management and succession planning.
  • Ethics and tone at the top.
  • Regulatory compliance.
  • Pay and performance alignment.
  • Employee training and development.

More broadly, in a 2011 survey of more than 100 directors at large public companies, financial consulting firm BDO found that boards of directors now count risk management as their top concern. That concern is well-placed, as some recent events have demonstrated clearly.

Risks of Employee Turnover

Consider a recent newspaper headline: "Most Companies Lose Top Talent." According to a Manpower Group survey, 75 percent of chief HR officers reported that their employers voluntarily lost at least some of their most high-performing employees in 2011-12. Is this a cause for concern? Certainly. The Conference Board reports that loss of key talent remains one of the highest-ranked HR risks. The risk escalates among members of talent pools that have a major impact on sustainable strategic goals.

Furthermore, a 2008 study shows that companies that lay off 10 percent of their workers in any given year can expect to experience a 50 percent spike in voluntary turnover the following year, from 10 percent to 15 percent. Conversely, competitors are often in a position to take advantage of these situations by poaching the discarded A-level players. Companies may also benefit, however, by the departure of people whose skills are no longer needed or are redundant.

Most HR professionals strive to minimize turnover, yet they must decide whether they are optimizing risk by doing so. Here's a typical analysis:

Start by measuring your turnover and benchmarking against industry competitors. Report the turnover rates and benchmarks to the executive team. Then calculate the costs of separating, replacing and training employees to show the dollars saved—the costs avoided—as a result of a low employee turnover rate.

To help determine where to focus such retention efforts, HR professionals in many companies identify pivotal talent pools—groups of employees whose ability to achieve strategic objectives would be impacted significantly by changes in the quantity or quality of talent.

HR professionals at Boeing, for instance, once focused on engineers only as key designers of airplanes and their components. Yet the 787 Dreamliner requires that Boeing's non-U.S. suppliers of key components do much more of the design and quality control than before. Boeing's engineers need to avoid coordination gaffes with their counterparts from other countries. 

Investments in HR programs that will help current engineers manage global teams effectively are a win-win for both parties. Going forward, Boeing officials have identified a pivotal talent pool and changed the recruiting strategy to focus on aeronautical engineers who have the interpersonal skills to manage global teams, point out John W. Boudreau and Peter M. Ramstad in Beyond HR (Harvard Business School Publishing, 2007).

When would reducing employee turnover have the largest effects on the organization? In Short Introduction to Strategic Human Resource Management (Cambridge University Press, July 2012), Boudreau and I find that reducing turnover benefits organizations when:

  • Turnover costs are high and reducing turnover can save those costs.
  • Those leaving are much more valuable than their replacements.
  • There is great uncertainty about availability or quality of the replacements.
  • Increasing turnover has the largest positive effect on the organization when:
  • Turnover costs are low and reducing turnover saves little.
  • Those leaving are much less valuable than their replacements.
  • There is certainty about the availability or quality of the replacements.

McDonald's has followed this high-turnover philosophy. The value of high turnover among front-line employees remains a basic principle at its restaurants, where those employees receive low pay and are easy to train and where managers face some certainty about having enough replacement candidates.

However, when researchers from Lancaster University Management School studied employee segments at 400 McDonald's restaurants in the United Kingdom in 2009, they found that customer satisfaction levels were 20 percent higher in restaurants with some employees older than 60. 

David Fairhurst, McDonald's chief people officer in the United Kingdom, said improved customer satisfaction from restaurants with a mix of old and young staff generates higher profits for the company.

While McDonald's would like to increase its number of older workers, that is difficult because they do not represent a high proportion of job applicants. HR analytics provided the insight that the turnover of front-line employees was not equally pivotal at McDonald's among those older than 60 and younger than 30.

—Wayne F. Cascio


The global financial crisis is one such example. In an ongoing series of articles, the publication Knowledge@Wharton has explored the underlying causes of the crisis. If one word characterizes that crisis, it would be "risk." Indeed, keen observers of the financial meltdown have concluded that it was less a failure of capital than a failure of people—people who took extraordinary risks, fueled by individual incentive plans that handsomely rewarded that behavior, as Wharton Professor Peter Cappelli and I wrote in an article published in the January 2009 issue of HR Magazine. Going forward, thefocus on risk will serve as a constant reminder of what happened during the global financial crisis.

The tragic events associated with the 2010 explosion of the Deepwater Horizon drilling rig in the Gulf of Mexico serve as another example. The tragedy left 11 workers dead and the worst oil spill in U.S. history. In January 2011, a national commission concluded that "The explosive loss of the Macondo well could have been prevented" and that "The immediate causes of the Macondo well blowout can be traced to a series of identifiable mistakes made by BP, Halliburton and Transocean that reveal such systematic failures in risk management that they place in doubt the safety culture of the entire industry."

In fact, a number of unattended HR issues regarding culture and leadership may well have contributed to the explosion and subsequent oil spill.

To their credit, BP leaders took serious steps following the spill to change the company's culture to emphasize safety. They established a safety division and, in the fourth quarter of 2010, based 100 percent of managers' incentive pay on safety, compliance, operational risk management, and whether managers exhibit and reinforce behaviors consistent with these goals.

Three Definitions of Risk

Now consider these scenarios in terms of three definitions in the lexicon of business risk:

Uncertainty—The degree to which we are unsure about whether an outcome will occur and its consequences, good or bad.

Risk—An undesirable outcome and its consequences.

Opportunity—A desirable outcome and its consequences.

As the examples above have shown, talent represents a major business risk to be managed. The Conference Board report identified 27 types of human capital risk.

With respect to each of these potential risks, consider asking the following questions:

  • Is it relevant to your organization?
  • Might it have a material impact on your organization?
  • If relevant and material, is it an enduring risk?
  • If relevant, material and enduring, is it addressable?

The objective of this approach is clear: Focus on addressing risks where they matter most. Having identified the kinds of human capital risks that do matter most, here are seven alternatives for dealing with them from a 2010 report by the Corporate Research Forum.

Tolerate the risk, taking no steps to address the issue.

Eliminate the risk; the possible outcome is unacceptable. For instance, you might not hire people with job-related personal or background characteristics that make them too risky, such as airline pilots with poor vision.

Minimize the likelihood of an outcome occurring and minimize its impact through training or backup systems.

Diversify the risk across areas such as management training programs that include rotations through various functional areas of a business.

Identify the human capital risks that matter most. Weigh the alternatives.

Concentrate risks into one area or theme. You might, for example, organize a dedicated enterprise risk management department.

Hedge. Assume additional risks to reduce exposure should the risk in question arise. You could offer probationary periods or "job tryouts" to new hires, for instance.

Transfer risk to an external party. Some HR leaders do this by outsourcing functions or purchasing insurance.

Don't Miss Out on Opportunity

Many businesspeople define risk as a bad outcome in the future. In HR, these bad outcomes might include violating employment laws, burning out employees or losing key talent. Considering only the negative ramifications of risk constitutes a serious danger: If you allow this perspective to dominate the way leaders approach your HR strategy, you might miss opportunities such as saving benefits dollars through the temporary use of contingent workers, reducing health care costs through wellness initiatives, or using compensation tools to influence employees' decisions to stay or leave.

Examples of Human Capital Risk

Strategic

  • Poor alignment of HR strategy and activities
  • with business strategy
  • Globalization and offshoring
  • Intellectual property loss or violation
  • Inability to compete for critical talent
  • Loss of critical knowledge through attrition
  • Managing talent through mergers and acquisitions
  • Outsourcing and vendor management
  • Compliance and regulatory issues

Behavioral

  • Unethical behavior
  • Low employee engagement
  • Inadequate or declining productivity
  • Behaviors and practices that undermine diversity and inclusion
  • Employee wellness and the impacts on
  • individual and company performance
  • Unionization and labor relations
  • Organizational culture that does not support desired
  • behaviors or encourages undesirable ones

Skills Gaps

  • Shortage of critical skills within the company's workforce
  • Shortage of critical skills in the external workforce
  • Gap between talent capabilities and business goals
  • Succession planning and leadership pipeline and the
  • impact on business performance and continuity
  • Overuse or underuse of external talent to fill key roles

Staffing

  • Ineffective selection processes that result in poor hiring
  • Excessive turnover or failure to retain critical talent
  • Use of contingent workers

Compensation and Incentives

  • Alignment of pay and performance
  • Excessive risk-taking
  • Executive compensation
  • Excessive labor costs

Source: Adapted from Managing Human Capital Risk, The Conference Board, 2011. Category headings assigned by Wayne Cascio.


Consider one such example: In the current climate of uncertainty surrounding business—regarding tax and regulatory policies as well as the direction of the domestic and global economies—many business leaders are sitting on mountains of cash and not hiring more employees, despite their overall profitability. In the face of this economic uncertainty, some are freezing pay, cutting or eliminating bonuses, and not restoring matching contributions to company-sponsored savings plans. Is this shortsighted frugality? Is it a strategy for optimizing and managing risk? Might these employers pay a steep price when the economy rebounds and many of their best employees leave to find better employment deals?

The fact is, we can't be so risk averse that we're never willing to venture into an area where we're not certain of the outcome. We need to put the organization in a position to benefit from the outcome of uncertain events. In many cases, this requires HR professionals to take measured risks, to innovate, and to try new programs or new ways. To the innovator, people are a source of competitive advantage; to the cost cutter, people are an expense to be minimized. To illustrate the difference in the philosophy and values that underlie the management practices that follow from these approaches, consider how Steve Jobs, the late chief executive of Apple Inc., thought about managing in difficult economic times—namely, in 2008 at the onset of the Great Recession:

"We've had one of these before, when the dot-com bubble burst. What I told our company was that we were just going to invest our way through the downturn, that we weren't going to lay off people, that we'd taken a tremendous amount of effort to get them into Apple in the first place—the last thing we were going to do is lay them off," Jobs told a Fortune reporter. "And we were going to keep funding. In fact, we were going to up our R&D budget so that we would be ahead of our competitors when the downturn was over. And that's exactly what we did. And it worked. And that's exactly what we'll do this time."

Work it did, for in November 2001, just before the dot-com crash ended, Apple began selling its first iPod as it reaped the fruits of its investment and innovation strategy during the dot-com bubble.

Applications for HR Work

HR professionals should begin to look at risk management in a systematic way. Take turnover, for instance. Are the implications of turnover different for different talent segments? Where will reducing turnover bring a payoff? Where is increasing turnover likely to pay off? How would leaders react to the idea of analyzing turnover costs and benefits separately for the various segments?

To be sure, human capital risk management is in its infancy. Whether we are talking about strategies to retain top talent, incentive plans that encourage employees and managers to take reasonable risks, building a culture that values safety, or optimizing employee turnover, "The whole philosophy of risk management is moving from reactive to proactive … from the crisis management that we saw during the heart of the global economic meltdown to a forward-looking, enterprisewide approach that considers the whole spectrum of business risks," Steve Culp, managing director of the Accenture Risk Management consulting service line, told a Wall Street Journal reporter in January.

HR professionals have a great opportunity to be a player in this movement and to create value from optimizing human capital risks in sensible ways. The time to seize the opportunity is now. Employees, organizations and society will benefit from such progressive management practices.

The author holds the Robert H. Reynolds Distinguished Chair in Global Leadership at the University of Colorado Denver. This article was adapted from his remarks at the SHRM Foundation’s Thought Leaders Retreat in Chicago in October 2011.

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