Background
As a result of the Dodd-Frank Act, the SEC implemented a requirement for companies to disclose their compensation policies and practices for all employees, including nonexecutive officers, if these policies and practices create risks that are reasonably likely to have a material adverse effect on the company.
In order to comply with this SEC disclosure requirement, best governance practice is to annually evaluate compensation programs for all employees from a risk perspective.
Provided in this CLEARthinking article is an approach companies can use for implementing an annual compensation risk assessment, as well as examples of compensation principles that companies should look at for evaluating potential risk.
For support on compensation risk assessments or to learn more, please don’t hesitate to reach out or visit our website.
Approach
Provided below are the key steps in conducting a compensation risk assessment:
- Identify compensation program features (“compensation principles”) that either can encourage excessive risk-taking or can mitigate against excessive risk-taking (see next page for examples)
- Review all employee compensation plans and policies (not just executive officer plans and policies; should also include sales/commission/other plans)
- Review company’s business risks (e.g., risk factors disclosed in company’s 10-K) and identify compensation principles related to these business risks
- Assess the company’s business risk and compensation program relative to compensation principles
- Determine potential implications for the compensation program going forward
Examples of Compensation Principles on Risk Taking
Outlined in the table below are general principles that may encourage more risk-taking behaviors. Note that items listed do not necessarily result in excessive risk-taking but represent areas to assess relative to the company’s business and reputational risk.
| Compensation Principle |
Examples of Potential Risk |
Compensation Philosophy
Business environment created by compensation philosophy/pay strategy |
- “Tone-at-the-top” encourages risk-taking behaviors (e.g., doing anything it takes to achieve performance goals)
|
Pay Mix
Balance between fixed and variable pay, and short-term and long-term incentives |
- Compensation mix extremely skewed toward variable components (e.g., 90%+); where variable compensation makes up a significant portion, compensation is weighted more toward short-term performance
|
Incentive Plan Leverage
Pay/performance relationship and potential upside opportunity |
- Significant leverage above target to achieve maximum incentive payout (e.g., above 3x)
- Uncapped payout opportunity for performance/sales plans
- Overly stretch financial goals with large payout opportunities
|
Performance Metrics and Goals
Type and mix of metrics used (e.g., financial vs. stock-based vs. operational/strategic), use of discretion in goal setting |
- Use of only one financial metric, with no additional metric to create a “check and balance”
- Exclusive focus on financial metrics, with no ability by the Compensation Committee to apply discretion to adjust for “quality” of financial results
- TSR performance goal with stretch threshold hurdles
|
LTI/Equity Plans
Mix of vehicles and vesting/performance measurement periods |
- Overemphasis on the use of stock options vs. full-value shares
- Short performance measurement period (i.e., <1 year) to earn award with no additional service-based vesting requirement
|
Stockholder Alignment
Use of ownership guidelines, stock holding requirements, clawbacks, and antihedging/pledging policies |
- Lack of stock ownership guidelines or holding requirements
- Performance plan payouts without protection to the company in case of future adjustment of performance results and/or misconduct by the executive (e.g., clawbacks)
- Lack of restrictions on hedging or pledging
|
