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Send  Share  RSS  Twitter  15 Sep 2011

EXECUTIVE INCENTIVES: Avoiding Executive Incentives That Encourage Poor Decisions

 





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Unless executive incentives are carefully designed and implemented, they can have the effect of steering companies towards disaster rather than success. And if this contention appears unlikely in practice, consider that inappropriate reward schedules and incentives are included among the underlying causes of the global financial crisis which has shaken the world economy since 2008. Consequently, a new category of risk is emerging - appropriately dubbed reward risk.

That’s according to Ray Harraway, Human Capital Partner at Ernst and Young South Africa, who says building a control environment for rewards and widening the scope of risk assessments to cover reward risk requires new skills, and collaboration across the organisation.

Why Executive Incentives are Used


“Executive incentives are designed to influence decisions that are aligned to shareholder value. Poorly designed incentives can encourage the wrong kind of behaviour by rewarding executives incorrectly or unethically, causing significant reputational or other damage. It is this that constitutes reward risk,” Harraway explains.

However, he adds that understanding the relationship between pay and risk is a new challenge and the management of reward risk is itself a new discipline.

Regulators are turning their attention to examining how pay programmes affect risk taking, Harraway continues, specifically but not exclusively in the financial sector. “At the same time, organisations need to build internal assurance capabilities that will address and manage reward risk.”

He points to the Basel, Switzerland-headquartered Financial Stability Board (FSB – not to be confused with the local Financial Services Board), which has introduced Principles and Standards for Sound Compensation Practices. This guideline requires that the board of directors monitor and review the compensation system to ensure that it operates as intended. “Remuneration is thus seen as a system that must include controls, and regular compliance reviews against the design principles, policies and procedures.”

The intention is not to eliminate risk-taking, but to rather encourage appropriate and prudent risk taking, Harraway stresses – pointing to the old adage that risk and reward are interlinked. “In practice, it is recognised that there are a number of pay plan design features that could contribute to excessive risk taking.”

These include:

•    Extreme pay mixes – between cash and equity, long term and short term focus, guaranteed and variable;
•    Steep pay curves – large variations in pay for small variations in performance. This results in windfalls on the one extreme and unrecognised performance on the other;
•    Uncapped payouts – this could encourage excessive risk taking;
•    Formulaic awards – hard wiring bonuses to profits without board discretion;
•    Misaligned payouts and term structures – paying cash before the actual outcome of the business decision materialises;

Risk emanating from these factors can be mitigated by appropriate design elements, Harraway says.

Keeping an Eye on the Governance of Executive Incentives


There are other issues which require oversight with regards to remuneration and incentive plans, he continues. “For example, assurance that the pay plan operates as intended has been a gap in many organisations. Plan governance, or internal assurance, is taking on a new distinctive role within larger organisations, particularly in the financial sector,” he explains.

Governance of the pay plan can be as important to risk management as plan design itself. “This entails setting up a reward control environment with regular reviews to ensure that all pay plans operate in accordance with the plan’s governance principles. A separate oversight function is often required,” Harraway says.

More than that, he advocates integration of reward risk with existing risk management frameworks, processes and methodologies.

Reward risk is emerging as a new specialist discipline, Harraway says, which will require a new breed of reward practitioner and new skills on the board. “The allocation of rewards must be based on a wider definition of performance and include non-financial measurements. In other words, it’s no longer simply about what results are achieved. Equally essential is how it was done.”

Desired behaviours should be specified in the individual performance scorecards, says Harraway, and the performance rating should be used as a primary driver of pay decisions. “Organisational values should be translated into desired behaviours for executives and other company representatives. In short, the performance management system should enable identification, differentiation, and reward of appropriate performance and not be about bloated executive incentives.”

 
 
 
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