Incentive Compensation and Risk Management
How and why incentive compensation is tied to future performance.
May 9, 2011
A key driver of risk is the incentive that an individual may have to achieve a certain result. This situation is further amplified by four factors:
Fundamentally, the problem is that individuals earn rewards based on business results for a single period, receive those rewards immediately and cannot ‘lose’ the reward virtually no matter what happens in the future.
These factors can be overcome through the use of a multi-period and multi-metric set of performance incentives which meet three objectives:
To do so, organizations must:
Incentive Payment Structure
Consider an organization whose customer buying cycles, product and technology life cycles, etc. suggest that the long term is three years. An executive focused on the short term can maximize financial results in the first year of his or her tenure: cut back on product and process development, avoid seeking new markets, reduce staff through down-sizing and attrition and minimize spending on training, etc. But now imagine that this executive’s incentive award, while earned on the profits of year one, are actually paid out as follows:
Would that change the executive’s thinking? Not likely, since the amount earned is still fully paid and presumably with interest. So let’s add a new wrinkle: the amount earned grows or shrinks with the three-year average change in a number of metrics (which we have weighted equally), such as:
Furthermore, the amount actually paid out is even more volatile, reflecting both minimum performance thresholds and larger awards for improvements in performance.
The table shows how this works, covering a nine-year period from the three years prior to the start of to the three years following the last year of our example:
Was the profit increase achieved by reducing exposure to new markets, cutting back customer service, or reducing employee training programs? Might the loss of market share, reduced customer satisfaction and lower employee satisfaction negatively impact future years’ performance? In other words, have short-term actions generated greater risk to performance in future years? Is that financially based bonus now fully justified?
Not in this model! Look at the rows titled “Formula — Negative Index.” Where the overall index score has declined by less than one percent, the pay-out to the executive drops to 90 percent (a 10% cut); if the decline is one percent to three percent, the pay-out drops to 75 percent; and for declines of more than three percent, the pay-out is zero. This may seem harsh since a three percent decline does not seem all that substantial. But it is when looking at a three-year average! Similar logic is applied to increases in the index, as shown in the rows titled “Formula — Positive Index.”
So in our Year 1 scenario, although the cumulative index declined by just under one percent, the pay-out in such a scenario is reduced by 10 percent and therefore the executive receives about $269,000. In Year 2, index performance improves fractionally resulting in a standard pay-out of about $349,000; in Year 3 performance improves markedly resulting in a superior payment of $383,000. As it happens, the executive receives almost exactly the expected amount of $1 million over the three-year period.
But our results changed as the years went on. The total payment in respect of Year 2 was about $1.08 million largely because Year t+1 was better than Year 1. On the other hand, the pay-out in respect of Year 3 was very low, only $726,000, driven by the fact that Year t+2 was very poor, and therefore the share of Year 3’s bonus to be paid out after Year t+2 is zero.
View the full picture.
How Does This Discussion Tie to Risk Management?
Simply put, the combined use of multiple metrics, a deferred pay-out and pay-out at risk, will force the consideration of longer term risks to business decisions.
Look back at our example. Although profit in Year t+1 was constant over the prior year, every other metric shows a decline; by Year t+2 the decline is widespread and very visible. It suggests that actions taken in Years 3 and t+1 may have had a delayed effect: the initial slow decline in customer and employee satisfaction accelerated rapidly in year t+2 at which time profitability was impacted. Why would be a bonus be deserved for actions that later undermined the enterprise?
Consideration of longer-term risks is the prime objective of this adjusted compensation approach, as it creates a very strong incentive for managers and executives to openly assess the longer term risks of business decision; in other words, pay for risk-adjusted performance.
Robert Torok, CA, is an executive consultant with IBM Global Business Services, leading the development of solutions and methods and delivering Enterprise Risk Management (ERM) services for IBM clients.