Posted by Tara Tays on May 18, 2017.
Boards of directors and management routinely scrutinize executive incentive compensation plans to understand whether the plans are in line with the company’s short- and long-term business objectives. However, oversight should not stop there, as plans to compensate and incentivize employees at all levels can expose the company to financial and reputational risks.
Recent high-profile instances of wrongdoing linked to incentive compensation arrangements highlight the risks of poorly designed incentive programs, including the lack of proper internal controls and corporate governance. Incentive compensation risk often stems from the potential to motivate self-serving behaviors among employees that ultimately have an unintended or adverse effect on the company, its shareholders, or its customers. For example, employees who are incentivized based on customer satisfaction scores may be motivated to pressure customers to complete the customer experience survey with only the highest scores possible. This behavior can have the opposite effect of what the incentive plan intended to do (i.e., enhance customer service). Similarly, requiring call center employees to handle a certain number of calls within a prescribed time frame may be intended to improve customer response timeliness, but it can also lead to a higher rate of unresolved customer issues.
Requirements for risk reviews of incentive compensation policies and practices began in the aftermath of the 2008 financial crisis. And in 2010, the Federal Reserve Board and five other agencies issued guidance suggesting that these reviews should cover credit, market, liquidity, operational, legal, compliance, and reputational risk as well as financial risk.
Seven risky areas to evaluate
Compensation committees are generally tasked with oversight of incentive plan risk at the executive level, but should also be overseeing risk reviews of plans for all employee levels. These reviews should evaluate the following seven aspects of incentives where risk can emerge to confirm that potential risks are properly mitigated:
- Compensation philosophy: Does it clearly articulate the performance that will be rewarded? Does it consider other aspects of performance beyond financial performance?
- Pay mix between fixed compensation and “at-risk” compensation: How does pay mix link pay to performance? Is the at-risk portion appropriate for each employee group?
- Performance measures: Do the performance measures used to award incentives reflect the organization’s objectives and values?
- Performance and payout curves: Does the relationship between the level of performance achieved and the corresponding payout appropriately balance risk, performance, and reward?
- Goal setting: How reasonable are the incentive plan goals? Are they too low (potentially resulting in out-sized payouts) or too high (potentially encouraging risky behavior to achieve unrealistic goals)?
- Calculation and verification of performance: Is there a reliable system in place to accurately capture, calculate, document, verify, and report on incentive plan performance results?
- Participant communications: Do plan participants fully understand the mechanics of the plan and how their performance ties to the accomplishment of plan goals? Do communications reinforce the company’s Code of Conduct and the consequences of engaging in unethical behavior?
The February 2017 edition of On the Board’s Agenda, published by the Deloitte LLP Center for Board Effectiveness, sheds more light on this topic in “Assessing risk in incentive compensation plans.” You’ll find more details on the critical areas to monitor and some key takeaways for the board’s role. I encourage you to share it with your company’s compensation group, senior executives, and board members.