Understand The "Risk Versus Reward" Relationship

"How Well Do You Understand The Relationship Between Pay & Risk" questions whether there was too much risk inherent in business models during the financial crisis and as a result, also in the executive pay model used by those financial institutions?

They contend that poorly designed executive pay programs create unintended consequences in terms of behaviors and payouts. Pay models should be designed to support business models, not the reverse.

The Obama administration and Congress have actively targeted pay practices from financial institutions who became Troubled Asset Relief Program (TARP) recipients. Kenneth Feinberg, the "Pay Czar" recently reduced executive pay at seven major corporations by as much as 90% of base pay, and slashing total comp by 50%. The full article regarding the pay reductions can be accessed at "Pay Slashed at Bailout Firms."

The new rules regarding executive pay call for an in depth review of compensation agreements that result in "unnecessary and excessive risk." But how should we assess the risk/reward relationship to produce the desired outcome?

Human nature causes us to want to retain our jobs and avoid being fired, so we will take risks only when we're confident that they won't result in us becoming unemployed. We as compensation professionals need to get our arms around the risk versus pay relationship to effectively design executive pay programs for our clients and companies. Executives need to take some risk to do their job in leading their company, a paradox of sorts that goes against what comes naturally to us.

One simple recommendation that Mr. Reilly and Ms. Haraldsson recommend in their article is to insert a pay "circuit breaker." They use a model to demonstrate the relationship between risk and reward, identifying a threshold for performance, then defining an higher performance level which intersects on the graph when the target performance intersects with the target incentive for optimization. This defines the correlation between pay and performance for the executive.

In using a circuit breaker, board approval becomes necessary for any payouts above the optimization level of performance. Because it can be so difficult to set goals in building an incentive plan, this prevents an windfall payout for the executive and serves to strengthen the board's due diligence. This provision helps to contain pay before it becomes excessive with this check and balance approach.

The authors contend that the real solution to effectively designing executive pay programs is as individualized as companies are, because each company has a different business model. Even when companies are in the same business, their profits, sales, leverage, and other measures vary widely with each other. So the solution is to be cognizant of peer practices in executive pay, but ultimately individualize each company's program based upon their own metrics, desired performance outcomes, and business model.

Becky Regan, M.A., CCP began her own consulting practice in 1995, Regan HR, Inc. to provide human resources consulting services to businesses in California. She has been successful in growing her business through reputation and client referrals. Her work as a consultant includes the full spectrum of HR technical expertise, including C-level recruitment, compensation studies (design, market and executive pay studies, sales compensation plans), training & teaching, interim assignments as a HR Director for organizations, and employee relations, including workplace investigations and written responses to formal complaints. For more HR tips and to receive my FREE "The Top 5 Secrets to Building a Better Organization that Every HR Pro Must Know" go to www.ReganHR.com.