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Article | Executive Pay Memo Asia Pacific

Appropriately factoring risk into executive compensation

By Don Delves , Shai Ganu and John M. Bremen | March 17, 2022

It’s time to do a better job of factoring risk into executive compensation.
Governance Advisory Services |Executive Compensation
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We are barely three months into 2022 and we are faced with yet another “one-in-a-hundred-year” risk event with the Russian invasion of Ukraine, and the related economic sanctions. This on top of a two-year multi-variant global pandemic, violent social unrest, supply chain disruption, an intense war for talent, inflation, massive wildfires and other environmental disasters — to hit the highlights.

Perhaps all these events happening in a two-year time frame are just happenstance or bad luck. And perhaps we are living in a riskier world, where our global interconnectedness compounds the level of risk and the potential damage from any particular event. Regardless of one’s view of this, it seems prudent for management and boards to focus on risk planning, prioritization, quantification and mitigation. Most risks — even the seemingly rare ones — can be assessed in terms of likelihood and potential cost or damage. And, since many risks are related to each other, a risk portfolio analysis can be conducted to assess possible combinations of events, which allows for more cost-effective risk mitigation and transfer.

Executive compensation and incentive design can also be modified or redesigned to reflect a company’s risk profile. There are a few possible ways to incorporate risk.

Risk Adaptation

As a new major risk unfolds, companies and their boards can assess the potential impact and adjust their incentive payout curves accordingly. We learned a lot about this process in 2020. While most boards are loath to adjust actual performance targets, payout curves can be adjusted. For example, if a risk event could make upside performance more difficult and downside performance more likely, a “risk adjusted” payout curve could be employed, with a steeper upside and flatter downside.

Part of the risk planning process could involve having a “current state” payout curve that is approved by the board, with an alternative “high risk” payout curve that can be implemented if a major risk event occurs.

Of course, management and the board will have to carefully assess the degree and direction of risk from a particular event. Some companies will be hurt badly by a major risk event, while others may experience a positive windfall.

Risk Scoring

In gymnastics or diving, athletes are scored both on the perfection of their execution and on the degree of difficulty of the routine. Similarly, boards could score management on both the achievement of results, and the degree of challenge or risk involved in achieving the results. This does not mean management should be paid for effort rather than achievement. Rather, in a year with major risk events, an earned payout could be adjusted up or down based on added challenges and how quickly, effectively and creatively management responded to those challenges.

Call it a “Risk and Resilience” score. In a normal year — assuming there is such a thing — it would not come into play. But in a year with significant risk events, the board would score the relative level of added risk, and the company’s resilience in responding to those risks. That score could then be used to modify the earned payout.

Management and the board could agree ahead of time on the factors involved in the “Risk and Resilience” score. Factors like anticipation of risks, having a plan in place, speed of response, limiting damage, taking advantage of opportunities, preserving jobs, customer and community relations, planned cost control, redeployment of assets, etc. could be spelled out ahead of time.

Risk Measurement

A company’s investors typically expect it to take a certain amount of risk in its investment and operating decisions. That level of risk is reflected in the relative volatility of its stock price, the variability of its earnings, the predictability of growth, its capital structure, and vulnerability to competition. Maintaining the level of risk within a certain range is part of management’s job and the board’s oversight role.

It should be possible to quantify a company’s overall risk level and incorporate that measurement into executive incentive plans. The measure(s) would likely be included in long-term incentive plans, as risk levels typically change more slowly over time. The risk measurement would also likely be a payout modifier that impacts earned payouts if the company takes on too much risk, or it does not take enough.

One could argue that risk is already incorporated into a company’s stock performance and does not need to be explicitly measured and included in incentive plans. However, in today’s high-risk environment, conscious, thorough, informed management and oversight of risk is imperative. What gets measured gets managed, and what gets measured and included in incentive plans gets managed even better. Including a measure in incentive plans also ensures it receives proper board oversight as well as a high and consistent level of attention.

Now more than ever, companies and their boards need to focus on risk. Incorporating risk into executive incentive plans is a great place to start.

A version of this article appeared in Workspan Daily on March 10, 2022. All rights reserved, reprinted with permission.

Authors

Managing Director, Executive Compensation and Board Advisory Practice Leader - North America (Chicago)

Managing Director and Global Leader, Executive Compensation and Board Advisory

Managing Director and Chief Innovation & Acceleration Officer

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