Robert Torok

Incentive Compensation and Risk Management

How and why incentive compensation is tied to future performance.

May 9, 2011
by Robert Torok, CA

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:

  1. The relatively short tenure of an executive in any given position;
  2. The very substantial incentive award that can be earned for single period results;
  3. The long term nature of many business decisions, such that a potential risk may not materialize for several years; and
  4. The irreversibility of past-period compensation payments.

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.

Reader Note: Don’t miss Robert Torok’s presentation at the upcoming AICPA National CFO Conference, May 19-20 in Boston.

These factors can be overcome through the use of a multi-period and multi-metric set of performance incentives which meet three objectives:

  1. Balance risk over multiple periods, with rewards earned in each period but adjusted and paid over time, reflecting the fact that business decisions may deliver positive results in the short term while creating risk in future years.
  2. Force the organization to consider multiple conflicting metrics when making decisions.
  3. Take a long term view, which may be 15 years or 20 years for a public utility, but only two years for a high-technology or software company.

To do so, organizations must:

  • Utilize a balanced scorecard, one that recognizes both financial and other performance targets, with portions of incentive compensation tied to each element thus meeting the second objective above; and
  • Implement an incentive pay-out structure that reflects the occurrence of a risk event, driven even in part by decisions of prior years thus meeting the first and third objectives.

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:

  • 30 percent in year one (i.e. three months after the end of fiscal Year 1 and similarly thereafter),
  • 35 percent after year two and
  • 35 percent after year three.

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:

  • Profitability, relative to named peer group;
  • Market share, in defined categories;
  • Customer satisfaction index;
  • Employee satisfaction index.

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:

  • Start with the column for Year 1. Since this is our base year, each index is set to 100 and based on the profit result, which was the same as the prior year, the executive would earn the same bonus of $1 million. In the traditional scenario, this amount would be paid out immediately after year-end.
  • But now look at the rows entitled “Rolling three-Year Average” and “Percent Change in Index”. For Year 1, the rolling index average is 0.41 percent worse than it was after
    Year t-1. As a result, the executive should not earn the expected bonus of $1 million but a little less, in this structure just under $996,000.
  • Not receiving the full pay-out immediately does not change the incentive or desire to influence results so as to earn the full award over the three-year pay-out, after all, it would be guaranteed and paid with interest.
  • So let’s look at how Year 1’s results were achieved relative to prior years and across our four metrics:
    • Profit was the same, continuing a positive trend over the prior three years;
    • Market share declined a little bit, some two points, continuing a negative trend; and
    • Both customer and employee satisfaction declined five points each, with employee satisfaction in particular declining substantially over the past three years.

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.

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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.