Executive compensation: balancing risk, performance and pay.

• Author: Reda, James F.
• Position: BENEFITS

With new executive compensation rules in the SEC pipeline, business leaders and board members need to assess how tougher federal regulations will affect their current policies.

The recent turmoil in the financial markets has raised questions about the effect compensation programs are having on executives and nonexecutives when it comes to undertaking risky business behaviors. If compensation programs are not structured appropriately, decision-making can be compromised by a desire to increase personal rewards--at the expense of the company and its shareholders.

This overarching concern has led to the following legislative and regulatory activity:

* Compensation risk assessment is mandatory for Troubled Asset Relief Program (TARP) recipients, those companies that are receiving government assistance;

* Annual compensation risk assessment for all publicly traded companies is included in the recent U.S. Securities Exchange Commission proposals; and

* United States Treasury Secretary Timothy Geithner has referred to compensation risk assessment in two of the five principles outlined for executive compensation/ governance reform.

The SEC believes investors would benefit from an expanded discussion and analysis of how the company rewards its employees, to the extent it creates risk to the company. If the SEC proposal is passed, companies will need to conduct a risk profile assessment of their overall compensation programs. This risk assessment would be disclosed in the Compensation Discussion and Analysis (CD&A) section of the annual proxy report sent to the SEC.

The proposed rules would require a company to discuss and analyze its broader compensation policies and overall actual compensation practices for employees in general, including nonexecutive officers, if risks arising from those compensation policies or practices may have a material effect on the company.

While the proposals are being finalized, each organization needs to perform an evaluation of its compensation program, paying special attention to the risk it is assuming with the policies and procedures currently in place. Further determination should be made as to the changes that companies can make to design the executive compensation program that is right for them.

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What is Risk?

The many definitions of risk vary by specific application and situational context. Some types of risk in a business setting are:

Reputation risk: The view of a company by shareholders, customers and the media. This type of risk is the most dangerous as it can affect even very profitable and well-managed companies. A hit to reputation may result in decreased revenues and difficulty in raising capital, among other factors.

Business sustainability risk: This risk is related to the underlying economics of the business. Changes in the economy can cause profits to be reduced and raise a risk to the business. That could lead to bankruptcy or a forced sale or merger.

Compensation-related risk: The risk that executives may act in ways to increase personal rewards at the expense of company and shareholders. That's the focus of this article.

Finding Balance

Incentive compensation comprises the bulk of executive pay packages at publicly traded companies. Boards of directors and senior management are continually searching for the right performance measures to balance rewards with financial, individual and operational performance. It's a complex task, and the stakes have been increasing each year.

In 2007, the SEC began requiring companies to disclose performance measures and goals related to executive pay programs. On July 1 of this year, the SEC voted unanimously to publish proposals that would require what it considers "better" disclosure of certain compensation- and corporate governance-related matters, and would establish rules related to the obligations of TARP recipients to implement "say on pay." With all of the controversy, hearings, proposals and new regulations, companies have been struggling to provide balance in their compensation programs.

For changes that collectively will better align corporate risk...