Robert Torok
Robert Torok

Incentive Compensation and Risk Management

Incentive compensation should be based on long-term enterprise performance, which requires a much broader and longer-term risk identification and assessment process.

May 5, 2011
by Robert Torok, CA

In his recent book on the 2008 – 2009 financial crisis, Charles Gasparino quoted one Citigroup mortgage trader:

"What's the worst that can happen? We make $200 million and then we get fired."
(C. Gasparino, The Sellout, New York: HarperCollins, 2009, page 195).

This mindset exemplifies precisely one of the major drivers of risk in many organizations: the super-sizing of short-term financial rewards with no recourse or consideration given to long-term success or even viability of the organization:

"There has been a widely held perception that the financial crisis was caused in good measure by the disconnect between compensation and risk. Management is perceived to have reaped immense benefits as a result of having companies take unreasonable risks; and those benefits were retained by management while shareholder value evaporated when the risks resulted in catastrophic losses."

(Source: Martin Nussbaum, "Focus Renewed on Risk Management," New York Law Journal, November 30, 2009)

The issue can be articulated clearly:

  1. One group, generally executive leadership, reap the rewards in the short term;
  2. A second group, generally shareholders and nonexecutive employees, live with the risks over a longer period of time and without the financial 'cushion' provided by short-term incentives.

Furthering both points is that most organizations have adopted cultures that focus attention on the short term, meaning that longer-term challenges are usually addressed within the context of shorter-term constraints and parameters.

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

This article presents an approach that links compensation and long-term enterprise performance clearly, using multiple metrics, thus providing greater assurance to shareholders, employees and other stakeholders that incentives are aligned to both short- and long-term enterprise success.

There are two principal elements to the solution presented — this article reveals why and how organizations must ensure that their risk identification and assessment process takes in a much longer time horizon than is usually the case. In an upcoming issue a structure and model will show how future years' performance can affect incentive compensation and place it in partial risk thus encouraging behaviors that better consider the long-term well-being of the organization.

Longer-Term Risk Identification and Assessment

Most organizations seek to identify risks that may impact the achievement of their objectives within the next 12 months to 24 months, which consequently means that events that are not expected to occur in that time window are excluded from analysis (and by definition, mitigation).

A limited-time horizon prevents line management from acting to prevent or build resiliency against events that may not occur for several years. Consequently, when the event does materialize or even fall into the time window, the time available to respond is not sufficient to adequately address the risk.

For example, nuclear engineers point out that if an organization has a substantial number of senior employees currently in the 53-year- to 60-year-old range, then it is highly likely that many, if not most of them, will retire in the next five years to eight years. The loss of deep technical experience and knowledge will not be felt as any one individual employee retires, but only when a significant proportion has moved on. Come 2015 or 2016, when half of that group has already retired, the organization will see the risk event as materializing in the subsequent two years and then try to act. But where will one find experienced nuclear engineers at that point in time? And how can inexperienced ones, such as new graduates, become experienced in a two-year to three-year period? But even if experienced ones could be hired from competitors, at what price, since all industry participants are likely to be in similar positions?

In fact, the time to act is now. If that same organization would look ahead five years to eight years, rather than just one year or two years, it would see the trend and be able to identify the likely solution, namely the aggressive recruiting of graduating engineers who would be mentored and trained in the next five years. In that way, the loss of knowledge from the retirement of the older group would barely be felt, as their knowledge and experience would have already been imparted on the new hires.

What Is Keeping Organizations From Looking Further Ahead and Acting Now?

Most organizations are constrained by short-term financial pressures: hiring constraints, earnings commitments to the financial community and financial incentives for executives. And unfortunately, investments in risk prevention or mitigation have clearly measurable costs with often intangible or uncertain benefits. While capital investments to mitigate risks, such as re-enforced foundations or improved physical security at enterprise facilities, do not reduce current period profits by the full amount of the investment, but merely by the cost of capital or slightly reduced rate of return on assets or equity — increased operating expenses are very measurable and visible. To make matters worse, there is no certainty of benefit from improved management of risks: after all, the risk event itself may never occur! How many executives are going to be incented to spend against current profits thus negatively impacting their own current period compensation to mitigate a problem that most likely will not be felt on their watch?

And perhaps that last comment — not on his or her watch — best underlines the problem. Many senior executives change roles every two to three years, with each successive position dependent on demonstrating accomplishments in the prior one. Which accomplishment is more likely to lead to promotion and reward:

  1. Positive financial results or
  2. The mitigation of a risk that may occur five years down the road at a financial cost felt in the current period?

What Is the Recommended Solution?

Organizations must provide the structure, culture and incentive to look further ahead, identify risks that may materialize over time and provide mitigation efforts explicitly in the years before the risk itself is felt. On the positive side, that requires some change in corporate culture as well as the explicit recognition in performance scorecards of potential future risks that may impact an organization or one of its units. One might picture an additional element to typical scorecards showing risks that may come to fruition in the next three years to five years and what need be done in the current period to mitigate them.

In terms of immediate performance, there is a need to provide a mechanism to link current period incentive payments to future period risks, which will be covered in an upcoming article.

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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.