The collapse of several large financial institutions and the accompanying economic meltdown ushered in a new era in the United States, perhaps even in the entire world. Frugality and a new level of contemplation became commonplace. Along with this new sobriety came new rules, designed to prevent (or at least mitigate) what many view as one of the primary sources of the collapse—excessive compensation.
In spite of the old saying that a salesperson cannot be overpaid, it seems that one indeed can be. And they were. Jack Dolmat-Connell, president and CEO of compensation experts Dolmat-Connell, Inc., points to AIG as a prime example of where things went wrong. “They had traders whose pay was $100,000 a year, but had the potential of earning $20 or $30 million bonuses,” he says. “That caused excessive risk for the organization. When faced with that kind of potential for financial gain, people sometimes do unnatural things.”
The resulting rules, issued December 16, 2009, by the Securities and Exchange Commission, require publicly traded companies to disclose in their annual proxy statements any of their compensation practices that could subject the company to excessive risk. The disclosures will be a hot topic during the 2011 proxy season, although Dolmat-Connell says many companies have yet to really begin the process.
Public Lessons for Private Companies
Of course, yours may not be a publicly traded company. However, if nothing else is learned from the financial meltdown of the last 2 years, we should at least take away this lesson: Tight oversight of your executive and incentive compensation plans should be de rigeur for companies of all sizes.
Don’t let a situation that was (through the clear view of hindsight) excessively risky take your company down. Instead, says Dolmat-Connell, make a plan to keep strict watch over compensation.
“Particularly when you’re talking about sales compensation, there are things you can do to head off trouble,” Dolmat-Connell says. “A lot of the problems we’ve seen came about with plans that weren’t capped, or perhaps were incenting the wrong things. There is a real belief with AIG, and some of the other companies, that they were incenting people to sell product for short-term benefit without really understanding the long-term implications for the company.”
Step One: Create a Compensation Review Team
“Take a careful look at your sales compensation plans,” Dolmat-Connell continues. “Make sure they’re incenting the right kinds of behaviors, and that there aren’t any unintended consequences of the metrics you choose.”
Obviously this kind of scrutiny requires time and input from a variety of specialties. Publicly traded companies will be assessing their compensation risks for real; other companies, though, can benefit from going through many of the same processes. If you’re working with a compensation consultant or outside legal resources, the amount of time required from your own staff will be less.
But if you’re curious about how you’re doing and want to take a crack at a compensation risk assessment on your own, start by gathering the people with the most knowledge of your compensation plans such as risk managers, department heads, salesforce leaders, and human resources managers, for example.
Remember—your objective is to identify any compensation plans or practices that might encourage unnecessary risk-taking that could threaten the stability of the company. “What you’re really trying to take a look at is whether or not these plans and practices could cause a material financial impact on the company,” Dolmat-Connell says.
Step Two: Summarize All Compensation Plans
Once your team is in place, gather information about all incentive compensation plans. Review your company’s compensation philosophy, and compare the plans against it. If the philosophy statement was created more than a few years ago, does it still make sense in light of any changes the company has undergone, a change in management, or a change in direction?
If it doesn’t, write a new one. Just make sure the compensation philosophy statement is always the standard against which you measure comp plans.
Step Three: Identify the Kinds of Risks You Face
Next, identify the kinds of risk that could be at play. Risks may appear in several areas including operations, credit, reputation, and others. As it compares the incentive plan structures against the categories of risk, the team should identify behaviors and actions that could promote excessive risk.
For example, a high-profile executive has a greater chance of bringing negative scrutiny to a company due to high discretionary pay than does an employee who is less well-known with a lesser title (reputational risk).
As the process continues, the team should examine the origin of each plan, how it was created, and by whom. What is the process for ensuring that the plans are properly executed and tracked? Is there more than one individual or department who must review the plan’s payouts? Which department has ultimate oversight over the plans? All of these questions should be easily answered; if they are not, the plans need your attention.
“We’ve looked at hundreds of companies’ plans,” Dolmat-Connell continues. “I guess if you could boil it down, our advice would be, first of all, to make sure you don’t have uncapped plans. Number two would be making sure you balance the short and long term. That was another problem at these financial institutions: The people were paid all in cash, every year.
“If you pay some of the compensation in cash and some of it in stock that people have to hold a certain amount of time, then they’re probably going to act in the better long-term interests of the company because they’ve personally got a lot of money at stake.
“Then, third (and this is being mandated quite a bit these days), have clawback provisions in the compensation program,” says Dolmat-Connell.
“If there are restatements of the financials or any kind of unethical behavior, you need to have the ability to clawback the person’s compensation, both short and long term.”
Preventive Measures
In order to mitigate some of the risk of incentive compensation plans, the team should consider adding some features to the compensation plans. Multiyear performance periods can encourage longer-term thinking and, therefore, reduce risky behaviors.
Examine any stock ownership and retention requirements you may have. And bonus deferrals, where earned bonuses are paid out in a later year, can also be effective.
While none of these measures is perfect, they can encourage executives and salespeople to think about the overall, long-term interests of the company.
Dolmat-Connell says that your compensation consultant or legal counsel can help you develop a sound strategy for paying people in a way that encourages them to build the company but not to take excessive risks.
By taking a thoughtful approach to examination of the compensation plans you have, and any you may develop in the future, you may be able to avoid some of the problems seen in the last few years.
“The kind of excessive risk-taking we saw can actually cause material failure of an organization,” he warns.
And in one of his firm’s publications, Executive Compensation in a Troubled Economy: Different Thinking for Different Times, Dolmat-Connell suggests that you govern your compensation plans as if you will end up on the news. Now is the time to take action.