Implementing risk-adjusted executive performance compensation; Risk-based executive performance compensation is the wave of the future.

• Author: Lipman, Frederick D.

Despite all of the articles urging risk-adjusted executive performance compensation, there is precious little to guide the compensation committee of boards of directors in implementing this process. The purpose of this article is to provide practical pointers to compensation committees in the tailoring of risk-adjusted incentive compensation packages.

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The two categories of risks for which executive performance compensation should be adjusted are:

* Accounting Risks

* Structural Risks

Determining the Product or Service Risk

Compensation committees must initially determine whether they are inadvertently creating financial incentives for risky behavior. To make this determination, the compensation committee must meet and coordinate with the risk managers for the company prior to designing any performance compensation package.

Determining the Risk Period for Accounting Risks

Let us start with a simple example. Assume that the CEO's annual bonus depends entirely upon the amount of operating income for the year. What happens if the company restates its operating income as a result of either aggressive or incorrect accounting which is discovered five years later? One answer is to have a claw-back policy which requires the CEO to pay back the compensation. However, it may be very difficult to enforce a claw-back policy. The CEO may no longer be working for the company at the time the accounting problems are discovered and, in any event, it may be extremely difficult to recover funds from the CEO.

In this example, the risk period can be as long as five years (and possibly longer), since it may take that long for the current auditors or new auditors to discover the accounting problem. The compensation committee should then assume a risk period of no less than five years and withhold all or a substantial portion of the bonus until the end of the risk period.

During the risk period the CEO could have the right to direct the investment of the withheld bonus funds to the extent permitted by Section 409A of the Internal Revenue Code. To avoid current federal and state income taxation, the deferred bonus would be funded using a 'rabbi trust' to protect the executive, except from bankruptcy risk. The deferred bonus plan would have a vesting date, namely the completion of the audit for the fifth fiscal year which occurs without any adjustments for the prior bonus years. The deferred bonus plan should be reviewed by tax counsel to make...