Executive incentive pay and risk management – a checklist for the board remuneration committee
01/06/2010
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Risk management, with a focus on the optimisation of risk and return rather than on risk minimisation, is now an essential remuneration committee consideration. 

This article provides a checklist of issues for the board remuneration committee in their consideration of risk and reward as they apply to annual short term incentives (STIs) and long term incentives (LTIs).

1.Review all remuneration in terms of its impact on three aspects of risk

When reviewing executive pay, assess the extent that its elements impact risk.  While there are many ways to view risk, one way is to classify risk as either financial, operational or systemic.

Financial risk is the additional risk a shareholder has when a company uses debt in addition to equity financing.  The more debt a company has, the higher its financial risk because more cash flow is needed for interest and principal payments, and less is available for investment and dividends.

Operational risk is defined as internal or external factors affecting the business.  An example of an external factor is the economy.  Internal factors like declining sales may be due to a weak sales force.  Restructuring the sales effort will reduce this risk.

Systemic risk includes risks that the entire financial system or market will collapse as a result of a catastrophic event.  An example of systemic risk is the recent global financial crisis, where all lines of credit to and between the major banks were cancelled in a very short span of time – causing liquidity to dry up.  Systemic risk could also relate to sovereign risk associated with a country changing the rules say, on tax, and applying these retrospectively.

2.Review financial measures to reduce financial risk

To ensure that managers deliver on the company’s operating plans, many organisations use internal earnings versus budget or other lagging indicators that are captured by their financial reporting system.  However, return on invested capital tends to be better as a measure as it reflects return on total capital, which includes debt.  Another measure that is not widely used because of its complexity is economic profit ( or economic value added).

3.Consider forward looking indicators as well as financial indicators to minimise business risk

From an operational perspective, organisations usually structure their annual incentive plans to address the most important business issues and risks, from increasing sales to improving customer service and manufacturing or service efficiency, which would act as leading indicators and help balance financial metrics, which measure after-the-fact results.  From the long-term perspective, the theory is that the performance of the business and the risk of nonperformance are eventually reflected in the share price and the company earnings. 

4.Use multiple measures

In the real world using multiple measures helps to ensure balance and good judgment — there is no “one size fits all” measure.  In addition, multiple measures diversify the risk of unintended consequences associated with focussing on a single outcome. 

5.Review reward vehicles

To correct for the owner vs. manager conflict of interest, managers could receive grants of equity-related rewards that are tied to the share price and dividends.  For the long term, the impact of leverage and excessive risk is reflected in the share price.  Thus, the use of restricted shares or performance rights should encourage executives to limit risky behaviour — otherwise the share price will drop. On the other hand, being too risk averse may not be in the interests of the diversified investor.  So a balance of equity payment vehicles that have high leverage when share prices go up (e.g. share options) and retain some value when share price goes down (e.g. share rights) may be a better choice.

6.Build cash into short-term performance metrics to survive systemic risk

Cash on hand is perhaps the best way to protect your organisation from this risk.  For example, Warren Buffet keeps considerable cash on hand and has a rule not to allow his cash to drop below $10 billion.  He feels this will enable him to survive a catastrophic event.  While $10 billion cash on hand is a stretch for most companies, having adequate liquidity factored into performance metrics is a wise choice.  

7.Build adequate capital buffers into performance metrics to remain solvent when the next crisis occurs

The share price, in theory, reflects all available information.  Some highly leveraged firms were caught in a bind, as they did not have enough of a cash cushion as the financial system shut down.  Although systemic-risk events rarely occur, as we have recently seen, they do happen and all companies need an adequate capital cushion to withstand such an event.  Monitor the extent of capital cushion to match the business risk.  Staying out of some risky businesses if the capital-cushion requirement will be too expensive to maintain will be easier if appropriate capital adequacy requirements are reflected in executive performance metrics. 

8.Review incentive payments for capping

While not applicable in all circumstances, it is usual to cap the maximum payment to avoid excessive risk taking.  However, if your company is positioned as a risk taker (and there is a place for these companies in all share markets), or the board believes there are adequate risk management controls in place (say for the allocation of capital), then you may choose to not cap incentive pay.

9.Calibrate performance to pay requirements to manage risk

Executives need to take some risk; otherwise investors are better off buying government bonds.  Rewards need to encourage high performance.  But on the other hand, they should not encourage excessively risky performance.  This is best managed by keeping in mind the probability of reward.  Typically the minimum performance requirements for paying an incentive should have about an 80% probability of achievement.  Target should have about a 50% to 60% probability, while the maximum requirements should be about a 20% probability.

10.   Avoid cliff vesting

Closely related to the performance and pay calibration issue, is the problem associated with cliff vesting.  An example of cliff vesting is where 50% of reward vests at 50th percentile relative TSR performance, but nothing vests for 49th percentile relative TSR performance.  This sort of cliff vesting may have unintended and excessively risky consequences as management performance approaches the threshold performance level on which a big payment is contingent.

An alternative is to have more graduated vesting.

11.   Match the executive pay mix to the job

Not all executive jobs are the same.  The corporate counsel and CFO jobs are to keep you out of trouble.  So load them with long-term equity based remuneration.  But the business unit head that applies only working capital could be loaded with annual incentives.

12.   Consider deferral and claw back

The Australian government’s recent interest in companies clawing back executive pay for financial misstatements (see HERE) could be more broadly applied, as APRA prudential guidelines require (see HERE), for risky behaviour  discovered after the fact.  This may require deferring part of the annual bonus in the form of share rights.

13.   Consider executive shareholding requirements

Requiring executives to hold shares assists in shareholder alignment.  In fact research indicates that there is a sweet spot in the extent that management holds shares and longer term shareholder returns.  Certainly Guerdon Associates’ own research supports this notion (see HERE).  But too high a requirement may make management too risk averse, and there may be issues in how such a policy is framed (see HERE)

14.   Match the time impact of the CEO’s decisions with payment post retirement

While the Australian government’s share plan taxation does not consider holding an executive accountable for decisions made on his/her watch as a worthy enough governance initiative (see HERE), this does not preclude the board from approving incentive arrangements that vest post retirement to ensure better risk management.  While the vehicle of payment cannot be shares, share rights or share options, phantom versions of these payable in cash are well worth considering (for example, see HERE

© Guerdon Associates 2021
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