Are You Ready for Compensation Risk Assessments? - 12 March 2010

http://www.boardmember.com/Article_Details.aspx?id=4712&page=2

by Irv Becker and David Wise, Hay Group

One
of the most important and immediate challenges for compensation
committees in the 2010 proxy season is developing a process to
assess—and then manage—the risks posed by the compensation programs they
maintain or oversee. In mid-December, the Securities and Exchange
Commission finalized expanded disclosure requirements to, among other
things, address the complex issue of excessive risk in compensation
programs.

As most companies know by now, these new rules require
that every public company discuss in its annual proxy statement whether
any of its compensation plans or practices create risk-taking
incentives that are reasonably likely to have a material adverse effect
on the organization. The curveball thrown by the SEC was the fact that
the rule covers not just executive programs, but any and all programs
throughout the organization. For many compensation committees that have
never been responsible for reviewing non-executive pay programs, the
learning curve has been steep.

Key challenges in
assessing risk
There are several acute complexities for
compensation committees and management in addressing this issue:

• 
  
  There
  is no universal definition of what is meant by ‘risk’, ‘reasonably
  likely’, or ‘material adverse effect’.
  
  
  


• 
  
  Risk
  assessment processes and methodologies are, to date, limited.
  
  
  


• 
  
  It
  will be many months before companies obtain feedback from the SEC on
  their initial compliance efforts.
  
  
  


• 
  
  If not
  conducted properly, an assessment can serve as a ‘roadmap’ to a
  plaintiff’s counsel.
  
  

Types of risk
Through
our experience working with companies on these assessments, we have
identified five areas of risk that companies need to be cognizant of in
the process of assessing the risk profile of their own compensation
programs. Each area can be linked to employee behaviors, and can be
triggered by specific compensation practices.

The
potential for this assessment to become overly complex is substantial.
Compensation committees should recognize that at its core, the question
of risk in compensation is about two things:

• Balance
  – assessors should look for balance in all the right places—in
  performance measurement, in incentives linked to short- and long-term
  performance, in fixed vs. guaranteed pay. Balance means that there is no
  single overpowering incentive that can motivate an employee to engage
  in conduct detrimental to the organization.
  


• Behavior – a
  program only motivates risky outcomes if behavior is impacted. For every
  element of every program reviewed, the question should be asked – how
  does this incentive truly impact behavior that could lead to getting the
  company into trouble?
  
  

Proposed risk
assessment process
As a board member, if you’re reading
this article in March, are a spring filer, and haven’t yet worked with
management to address this issue, then you’re behind in the game. Most
of the clients we have worked with on this issue have followed some
version of the following recommended process for conducting this
assessment:

1. Create a project team (which might well
include a senior risk officer, inside and outside legal counsel, a
senior HR or compensation officer, and a compensation consulting firm)
to assess the level of risk for each of the distinct compensation
programs to be reviewed against a key set of criteria.
2. Collect
and review the organization’s existing written and unwritten pay
policies, practices and plan documents, as well as similar items
pertaining to the company’s enterprise risk management.
3. Conduct
the compensation risk assessment and identify for the compensation
committee the risks that the organization faces that could threaten its
value or have a material financial, operational or reputation impact on
the company. Identify the features of the organization’s executive and
non-executive compensation policies, practices and supporting management
processes that could induce executives and employees to take those
risks.
4. Analyze the results of the risk assessment and discuss how
to mitigate and manage any such excessive risks, and/or establish a
process and timetable for revising those compensation and incentive
programs that contain excessive risks.
5. Document the process
results in compensation committee meeting minutes and discuss this
process in the company’s proxy statement (and/or Form 10-K, as
required). Be prepared to explain the process if questioned.

Also,
don’t forget that the one compensation program that is available for
public review, and therefore likely to be assessed by external parties,
is that of the Named Executive Officers. Companies should take special
care to ensure there are no glaring imbalances in this program—and if
there are, to be sure that there is a rationale for the features that
may stick out.

Moving beyond compliance
While
many companies are treating this new requirement as strictly a
compliance issue, the review presents an opportunity to ensure
compensation programs maintain balance. We expect that within the next
year, “best practices” will emerge from this process that will cause
companies to rethink some of their more traditional compensation
structures.

Companies should approach this process with an eye
towards the future – not just by looking critically at their own
programs, but by challenging some of the currently accepted market
practices being exhibited by their peers. Our research demonstrates—and
our experiences support—that the most effective compensation programs
are the ones that are grounded in the core identity of the organization,
and that motivate the right behaviors that balance financial
performance with operational and strategic performance, and today’s
performance with tomorrow’s.

About the Authors
Irv Becker is the National
Practice Leader of Hay Group’s Executive Compensation Practice. Irv
works with Boards and senior management in the design and development of
reward programs to align executive efforts and results with the success
of the company. David Wise
is a Senior Consultant in Hay Group’s Executive Compensation Practice.
David helps organizations work by advising Boards and executives to
motivate, develop and reward their top executive talent.

Hay
Group is a global management consulting firm that works with leaders to
transform strategy into reality and to help people and organizations
realize their potential.