Karen DeToro, a senior manager with Deloitte Consulting LLP, is a fellow of the Society of Actuaries and a member of the American Academy of Actuaries. Her recent work focuses on the intersection of incentive compensation and risk management. During the past several weeks, I conducted an e-mail chat with DeToro to learn more about risks related to incentive compensation.

Eric Krell: Karen, thank you for taking the time to chat. You presented on the topic of incentive compensation at the Enterprise Risk Management (ERM) Symposium earlier this year. Compensation – especially incentive compensation – marks a topic that I’m seeing crop up more frequently in ERM-related discussions this year.

Can you share some high-level insights on compensation-related risks companies ought to recognize? Later, I also want to find out if you’re seeing any links between incentive compensation and risk-management-related measures.

Karen DeToro: In my experience as an actuary, I have found that there are various risks that companies need to consider when evaluating their compensation plans.

At the broadest level, companies need to consider the risk that poorly designed or overly generous incentive compensation may incent employees and management to take inappropriate risks in order to maximize their personal compensation. On the other hand, companies must balance this with the risk that an overly conservative incentive compensation plan will restrict the ability to attract and retain needed talent. The specific manifestations of these risks will vary, depending upon the company’s structure, business model, industry, and compensation plan design.

The first type of risk may manifest itself through events such as management misstatement of financials to achieve income targets; adoption of overly aggressive strategies to drive top-line growth; or excessive reduction of corporate expenses through headcount reduction in order to drive earnings, leading to compromised service and productivity levels. Unfortunately, it is not always clear that these events are being driven by compensation issues.

The second type of risk can be observed through high attrition levels, low hiring rates, and unfavorable comparisons against industry compensation benchmarks; these are more readily recognized as being tied to the level and type of compensation being offered.

Eric Krell: I know that poorly designed incentive compensation plans exist in many organizations. I’m amazed at how many times a straightforward question appears to be neglected: “What behaviors do our compensation plans motivate among our employees, and do these collective behaviors help us execute our strategy or not?”

My guess is that the “poorly designed plan” risk crops up more frequently than either the “too generous (but well-designed)” risk or “too conservative (but well-designed)” risk.

Which of these risks do you encounter most frequently in practice? And, more important, what are some of the most effective high-level steps for addressing and managing these risks?

Karen DeToro: One could argue that a too generous plan or a too conservative plan is actually a plan that is not well designed. A well-designed plan should award the appropriate level of compensation and align compensation with the risk and reward profile of the company.

However, it is possible to have a compensation plan that appears to award the “right” level of compensation under a fairly narrow range of scenarios but behaves in an unintended manner when circumstances deviate from expectations.

In order to manage this risk of unintended consequences, there are a couple of important steps that companies can take:

• Perform a qualitative analysis of the compensation plan with a view toward exactly the question you’ve asked above: What behaviors does our plan incent and are these the intended behaviors? This can provide companies with a great deal of information about where plans may need to be adjusted.

• Utilize more sophisticated metrics in compensation plans that base compensation on both risks and rewards to the company. These may include risk-adjusted return on capital (RAROC), embedded value, value at risk, enterprise value, and others, depending on the industry.

• Stress-test the compensation plan under a range of risk scenarios. This allows the company to quantify the impact of potential risks in the plan and, perhaps more importantly, measure the impact of mitigation activities on that risk.

• Give chief risk officers (CROs) accountability for measuring, monitoring, and managing the risks inherent in compensation plans. Chief risk officers should be empowered to work jointly with the chief HR officer to understand the risk in compensation plans and take constructive action to manage this risk.

Eric Krell: Your guidance on performing a qualitative analysis of the compensation plan to identify and understand the behaviors that the plan drives strikes me as very useful …

When CROs, top HR officers, CFOs, and others perform this type of analysis, what are some of the ah-has that occur? Also, are you seeing any trends in the adoption of more “risk-management-friendly” types of incentive compensation links? (I’m curious about the types of links that drive risk-savvy behaviors.)

Karen DeToro: Some of the insights that occur when companies perform a qualitative analysis of their compensation include the following:

• Deferral or clawback provisions either do not exist or aren’t sufficiently robust to be effective. These provisions help to mitigate the risk of financial results being purposely misstated in order to hit compensation plan targets.

• Over time, there are many exceptions to the company’s stated compensation philosophy. There may be valid reasons for a company to deviate from its stated compensation philosophy in a truly exceptional (upward or downward) period. However, upon review, a company may find that these exceptions have become the rule, suggesting a potential lack of oversight and consistency in the management of the compensation plan.

• Short-term and long-term compensation are out of balance. The balance between short-term and long-term compensation is critical to ensure that employees and executives are not incented to drive short-term results at the expense of the long-term success of the company. Reviewing expected levels of short-term and long-term compensation in the current economic environment and under a range of potential scenarios may provide transparency to this imbalance.

• Performance metrics have become misaligned with company strategy. Over time, as the company strategy changes and as recruiting and retention goals change, the portion of compensation tied to company strategy may either become very small relative to total compensation or may become completely misaligned with the company’s strategic objectives. As a result, employees and executives may be incented to drive performance that is actually inconsistent with a company’s underlying strategy. A periodic review can help to identify areas of misalignment.

• The company lacks proper governance and oversight for the compensation plan. Upon review, the company may find that there is less governance and oversight of the compensation plan than they thought. It is important that compensation be given at least the same level of oversight and governance as other risks that the company faces. By understanding the complete governance framework as it relates to compensation, management and the board can ensure consistency of the governance with other risk management procedures in the organization.

Since compensation plans are typically managed on an annual cycle, it has taken some time for more effective risk management practices to work their way through compensation plans. We have seen a significant increase in risk management around compensation in the latest round of plan adjustments, and we expect to see this trend increasing in the next round of annual plan changes. Overall, companies are becoming more aware of the need for effective risk management with regard to compensation, and we expect to see a steady increase in risk mitigation activities over time. These include effective risk mitigators such as those outlined in the comments above, including clawback and deferral provisions, an improved mix of short-term and long-term compensation components, and improved alignment of performance metrics with company strategy, among others. ###