Analyze Compensation Programs to Reveal Business Risks
April 19, 2012
Steven Slutsky and Scott Olsen, PricewaterhouseCoopers LLP
Compensation governance in the U.S. is drawing increased scrutiny as legislators, regulators, shareholders and the news media focus on how—and how much—companies pay employees in general and executives in particular. The attention has been heightened by recent headlines and media stories on perceived abuses in executive compensation, with a specific emphasis on financial services firms.
The landscape for compensation governance, design and administration is shifting in response to legislative and regulatory action, including enhanced proxy disclosure requirements, Dodd-Frank proscriptions, the Federal Reserve Bank’s guidance on incentive compensation and non-U.S. regulatory intervention. Companies are evaluating their compensation governance practices, re-examining compensation and business strategy integration, aligning amounts granted with employee value created and adjusting for risk and the cost of capital. Human resource executives and boards of directors are devoting more time to reviewing pay decisions, homing in with an especially penetrating look at company performance and sustainability.
Not all of what companies are doing relates solely to how much or how executives are paid. They’re identifying and correcting the compensation governance process, which can be undermined by inadequate documentation and other examples of looseness. Nor are financial services firms alone in introducing risk management into compensation processes; it’s a practice that has reverberated throughout numerous organizations as businesses look to reduce the chance of surprises and threats to reputational risk.
HR professionals can aid in these efforts by reviewing and, if necessary, changing internal process considerations to keep the organization on solid, sustainable ground.
The current corporate governance environment, infused with the influence of stakeholders such as investors and regulators, features new expectations for the HR function. Companies that once focused primarily on the market competitiveness of their compensation programs now find they need to consider multiple factors in evaluating those programs. While market competitiveness is still important, it’s no longer the endgame but one of many data points that influence program decisions. The focus has shifted to include these compensation program analyses:
• The appropriateness, rationale and continued viability of the compensation philosophy/policy.
• Well-defined modeling of the linkage between compensation levels and performance, not only at the executive level but also throughout the organization, to increase the likelihood that shareholders are getting the right bang for the buck.
• The use of equity grants on annual and aggregate levels to align the use of shareholder resources with return to shareholders.
• Whether compensation programs encourage employees to take unnecessary and excessive risks.
• How compensation payouts are adjusted for risk and the cost of capital.
• How wealth accumulation, retirement and other benefits integrate with direct compensation philosophy.
• Whether compensation programs support leadership development and management succession plans.
• Appropriateness of employment agreements, including severance and change-in-control arrangements.
• The story that compensation programs tell about how the company is being managed as reported in the Compensation Discussion & Analysis (CD&A) section of the proxy statement.
These new compensation program imperatives have been layered on top of already complex and demanding compensation-related requirements. Changes in accounting and tax provisions—such as the Financial Accounting Standards Board's ASC Topic 718 stock-based compensation rules and the Section 409A deferred compensation regulations—have heightened the challenge of understanding all aspects of compensation. These rules have increased the complexity of executive and broad-based employee compensation plans, with an increasing number of companies using a greater number of equity vehicles and more complex performance-based plans.
Pressure from Stakeholders
The new corporate governance environment and legislative imperatives have ratcheted up complexity and transparency to a new level, placing much greater demands on the HR function and the board’s compensation committee. In addition, companies face continued changes in proxy disclosure rules, which provide investors and other stakeholders with a far more detailed understanding of the committee’s decision-making processes.
The U.S. Securities and Exchange Commission (SEC) has taken a perspective consistent with other regulators that the greater the compensation program disclosure, especially related to risk taking, the better for companies and stakeholders. Recent proxy disclosure enhancements require companies to explain as much about the how and why of executive compensation decisions as the CD&A numbers. Disclosures provide shareholder advisory groups with the information that grants them a public forum through which they can hold companies and their boards to higher standards—or face "no" votes on their re-election.
The SEC requires that companies disclose whether their compensation programs are “reasonably likely to have a material adverse risk” to the company. While companies that conclude that their programs don’t meet SEC standards aren’t required to issue additional disclosures, many CD&A disclosures feature a section that describes the process used to measure the risk arising from compensation programs, the company’s findings and remediation efforts. As a result, companies are engaging in robust analyses of how their incentive and other compensation programs interrelate with business risk and the extent to which the programs might encourage employees to take unnecessary or excessive risks.
Legislators are getting into the picture. The Dodd-Frank Act imposes additional compensation-related governance and disclosure responsibilities, including:
• Holding a nonbinding, advisory vote on executive compensation programs ("say on pay") and discussing the impact of that vote on executive compensation programs in subsequent proxies.
• Disclosing "golden parachute" executive compensation protections in the context of a change in control and a shareholder advisory vote on those payments before the transaction can be completed.
• Confirming that board compensation committee members are independent.
• Developing and implementing clawback policies for cash and equity incentive plans.
• Determining and disclosing the ratio of CEO total compensation to the median total compensation of all employees.
• Describing the pay-for-performance relationship in executive compensation programs.
• Following special rules relating to how much incentive compensation can be paid in cash vs. equity for certain financial services institutions.
The SEC is not the only organization focusing on risk. The Federal Reserve Board, along with other federal banking regulators, is focusing on the compensation-risk relationship with new incentive compensation guidelines that banking organizations must follow. These include:
• Balancing risk and financial results so incentive programs don’t encourage employees to expose the organization to imprudent risks for personal gain.
• Developing effective risk management and internal controls processes that oversee and support the balance between risk and financial results.
• Implementing corporate governance processes (up to the board level) that are strong and effective enough to enable sound incentive compensation practices.
The Federal Reserve Board participated in a multi-agency effort to develop sound financial and compensation practices in broad-based financial services organizations as mandated by the Dodd-Frank Act. This has resulted in proposed rulemaking that would prohibit companies from providing excessive compensation and from implementing incentive compensation plans that reward inappropriate risks. Proposed rulemaking related to the "Volcker Rule" of the Dodd-Frank Act would prohibit financial institutions from implementing incentive plans that reward underwriters, market-makers and hedgers for proprietary trading based on the appreciation in value of the underlying securities.
These financial services-specific regulations appear to be making their way slowly out of financial services and into general industry through the corollary actions of investors and non-executive directors. The SEC’s proxy disclosure rules for compensation risk assessments and say on pay are among the first indications that these requirements will soon apply to all companies.
Managing Risk and Transparency
Given the scrutiny by stakeholders on enhanced compensation program reporting and the examination of compensation risk, companies are focusing on compensation risk management in ways they had never contemplated. Well-managed companies rely on robust compensation risk assessment processes that include:
• Identifying enterprise business risks on product/service, business unit and corporate levels and developing relative risk ratings.
• Determining the relative ability of each employee and aggregated groups of employees to influence business risk and identifying employees/groups that can materially influence risk (known as "covered persons" in banking organizations under the Federal Reserve’s guidelines).
• Assessing governance, controls and other mitigating factors (outside of incentive programs) that limit the influence that individuals or groups can have on risk.
• Correlating the relative business risk and employee risk influencers to determine which employees’ incentive and other compensation plans should be reviewed.
• Inventorying incentive and other compensation programs throughout the organization.
• Reviewing and modeling payouts under the compensation programs to determine the level of risk they encourage covered persons to take and whether they encourage employees to take unnecessary and excessive risks, especially under unanticipated but possible "Black Swan" events.
Some companies are learning through this process that their compensation programs might be fueling unintended results. In a few cases, these programs might be jeopardizing long-term organizational viability. In other cases, companies are finding that their compensation programs are working at cross-purposes with each other—or with the company’s business strategy—because of behaviours created by performance metrics and operation of their programs. At the very least, companies are uncovering areas where their incentive programs can be governed better and aligned more effectively with business performance.
Aligning Programs with Risk
Even with increased activity and oversight by management and boards, there are still areas where companies can improve processes to address areas of risk and business vulnerability, for instance by conducting a robust pay-for-performance analysis that reviews the overall pay-for-performance relationship in each element of the compensation program as well as in the aggregate.
When performing this analysis:
• Acceptable performance for incentive payouts should consider fully forward-looking business risks and shareholder expectations rather than just backing into payments that are market competitive.
• The levels of pay should be balanced against the risks to the organization that are being taken to deliver the performance.
These organizational risks should include not just the possibility of not achieving performance goals, but also the reputational, liquidity and business risk to the company of employees’ actions. In other words, payouts should be lower not only where the risk of not achieving performance is lower, but also where the risk to the organization is higher, in order to reduce the motivation to bet the company to derive outsized rewards.
In addition, to align compensation with risk better companies should:
• Include the cost of capital in determining appropriate goals. Similar performance levels should not result in similar payouts if there are differences in the amount of capital needed to drive that performance.
• Analyze fully the pro forma data rolled up from business unit levels. This can help to ensure that distortions in financials across business units don’t result in outsized awards relative to overall corporate results.
• Understand fully and vet competitive market analyses. For example, the compensation programs of your industry peers ("peer comparators") might be based on premises that differ from those at your organization, leading to a different mix of executive rewards. They might, for example, have a philosophy that provides for job security through non-pay-for-performance elements such as high-value defined benefit pension plans, supplemental executive retirement plans and service-based equity and other awards.
• Develop a robust decision-making process to counter pressure to sidestep shareholder perspectives by providing incentives such as special awards in the event of poor financial performance. Special awards in these circumstances (and setting easier-to-achieve goals for the following year) are especially troublesome to shareholders when the company’s performance is lagging its peers.
• Test the linkage between incentive plan payouts and performance over the time horizon of the risks being created as well as over multi-year performance periods.
• Stress-test incentive plans under various scenarios, ranging from poor to superb performance. Be prepared for "Black Swan" events such as macroeconomic developments that could hurt company sustainability and result in reward payouts for performance that’s outside of management’s control.
• Include rigorous mitigating controls so that the company can be assured that it’s paying for performance properly and that the system is free of fraud. To the extent possible, risk and control functions should be represented in the development and testing of incentive compensation arrangements.
In addition, new and revised compensation programs should undergo a structured risk assessment before they are implemented. This review should include the groups that have responsibility for compensation, including the HR, risk, finance and legal functions. Assistance from an objective third party—one that can act as project manager and traffic cop among the internal constituencies—will help advance the review.
Although many companies are improving their understanding of how compensation programs affect business risks, changes to the compensation and business risk environment require continued diligence and improvement. Compensation processes should be reviewed regularly so that their role in exacerbating or mitigating business risk is understood fully. Rigorous reviews and modeling of the effectiveness of the programs and the risk mitigation processes should be part of this process. Through constant attention to these areas, companies can improve the likelihood that their compensation programs will promote the desired business results without encouraging employees to engage in activities that can compromise the viability of the business.
As artificial intelligence technology continues to develop, the demand for workers with the ability to work alongside and manage AI systems will increase. This means that workers who are not able to adapt and learn these new skills will be left behind in the job market.
A vast majority of U.S. professionals say students entering the workforce should have experience using AI and be prepared to use it in the workplace, and they expect higher education to play a critical role in that preparation.
An organization run by AI is not a futuristic concept. Such technology is already a part of many workplaces and will continue to shape the labor market and HR. Here's how employers and employees can successfully manage generative AI and other AI-powered systems.