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Eldercare Pay and reward

Managing risk in executive incentive programmes: a checklist for HR professionals

The past six months have been spent reacting to the downward spiral in equity markets, rising unemployment, wide-ranging government interventions to stabilise the global financial systems and local economies, and declining corporate revenues and earnings. HR professionals have had to implement workforce reductions and become creative about other ways to manage the expenses associated with their human capital. It has been difficult to take proactive steps to position for the future. But there are important items that warrant HR's attention now, including addressing risk in HR programmes.

One area of risk is executive remuneration, particularly incentive plan design and operation: organisations can minimise the potential for damage to their brand and to the reputations of their senior executives and non-executive directors by minimising the chances that compensation programmes will operate in unexpected ways.

How can HR ascertain common areas of risk in short and long term incentive programmes?

Take a fresh look at performance measures across all incentive plans. The wrong measures can encourage behaviour that is inconsistent with business goals and can result in payouts that seem to be unrelated to performance that creates value for the long term.

  • Do the measures align with the financial and non-financial elements of the business strategy?
  • Do the measures reflect growth, profitability, efficiency (such as margins, or use of capital), and shareholder experience? If not, why not?
  • Are the measures both relative (to external guideposts) and absolute (hard targets)?
  • Do the plans use risk-adjusted measures or reflect the cost of capital?
  • How are targets established? Basing targets solely on internal considerations is a red flag, but relying solely on external factors may make them meaningless to participants.
  • Are the same measures (or category of measures) used in different plans, essentially paying twice for the same performance? (We often see earnings per share, income and profit measures used in this manner.)
  • Are the weightings of the measures encouraging the right behaviour or is there too much emphasis on short-term profit at the expense of long-term growth, for example?


Plot the payout curve for each measure in each plan (goal along the x-axis and payment opportunity along the y-axis)

  • Are the curves consistent with your philosophy and objectives?
  • Is the range very narrow, perhaps encouraging manipulative behaviour, or are the ranges broad, suggesting that the goals are too easy?
  • Do the payouts correlate with the difficulty of the goals?
  • Are your curves straight lines where each incremental increase in performance results in an additional increment of reward? Is that warranted?

 

  • Are the plans uncapped? Could an unanticipated event result in a windfall that would be inconsistent with the notion of sustainable performance?
  • How would each plan function under extreme performance scenarios?
  • Have do the plans function in the aggregate (across all plans) under extreme scenarios? For example, what happens if there is strong three-year shareholder return with weak annual profit?
  • Is the process for selecting performance measures and setting targets aligned with the company's broader process for assessing and managing risks? Is the risk management function involved?


Vehicles

  • Is the balance between cash and equity appropriate?
  • Are executives required to hold shares? Is the amount and time horizon reasonable to align with shareholders' interests?
  • Are the equity vehicles consistent with the reward philosophy and business strategy? For example, stock options may make sense in a high-growth, high- risk business but may not in a mature, low-risk one.
  • Do deferral programmes operate to minimise the risk of short-termism and promote sustainable performance?


Time horizons

  • Is the balance between short-term and long-term compensation elements consistent with the business strategy and the talent strategy?
  • Is there a long-term incentive for sustainable performance or is the horizon really a mid-term programme with no emphasis on long-term value creation?
  • Does the time horizon of the programmes align with the business cycle?


Comparisons

  • Peer groups that are not properly constructed can lead to inappropriate compensation decisions, misaligned pay and performance and public criticism. Reassess the peer group in light of the changed economic circumstances and any change in company business strategy, taking into account that continued market volatility may further affect a company's suitability for inclusion.
  • Internal equity - how does the compensation of senior executives compare with that of other executives and rank-and-file employees? Internal equity that is out of line for similarly situated organisations (with similar business strategy and talent profile) is a red flag.

    
Sharing ratios

  • What percentage of profits is being paid as incentives? Is it reasonable? How does it compare with peers (where data is available)?
  • How do executives' gains (or potential gains) compare with shareholders'?


While this checklist is not exhaustive, it will help identify how incentive programmes could be revamped to make them more effective and more aligned with business strategy and performance. 

Working through this checklist may also identify related areas that should be addressed including the magnitude of the compensation programme and the compensation and benefits that are paid on termination of employment, whether because of retirement, death or involuntary separation. And finally, working through the list may help identify areas where the governance process could be strengthened.

Diane Doubleday is global head of executive remuneration at Mercer
Mark Hoble is a principal in Mercer's executive remuneration business