An appropriate level of risk is essential for any business to survive and produce acceptable risk-adjusted returns to investors. Compensation Committees should go far beyond demonstrating a lack of material risk in reward programs. Use of an effective risk assessment process in the management of incentive programs positions Compensation Committees to emphasize how their programs contribute to creation of shareholder value.
1. Financial Risk: There is no universal definition of risk potential when applied to compensation. Company specific risk factors used in assessing other business risks, such as debt to equity ratios, potential for efficient incremental profits and stock beta should also be considered when assessing compensation risk. However, incentive plans that reward a single measure of performance, represent a disproportionately large percentage of overall performance incentives, and have a highly leveraged pay and performance relationship are almost certain to create material adverse financial risks.
2. Operational Risk: In general, compensation plans that operate and make payments solely by formula are risky compensation plans. Some discretion is needed to mitigate operational risks. The capacity to be informed by guidelines and exercise appropriate discretion in determining amounts to be paid under a formula based incentive can be an important part of executive incentive plan governance.
3. Talent Risks: Where financial risks are present for overpaying executives, significant talent risks may also exist for underpaying executives, based on performance.
4. Evaluate Your Pay Risk Assessment: Does your assessment …A.) Set priorities and monitor pay plans in high-risk business segments B.) Focus on maintaining a balanced mix of plan design features C.) Address any red flags that typically encourage excessive risk taking D.) Ensure performance metrics are right and E.) Test payment scenarios under a variety of realistic assumptions.
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