65 % of the paper needs to be cited with scholarly articles.
There is no doubt that a solid compensation philosophy must address issues of equity and justice, both from an internal perspective and an external perspective. As such one must be very aware of the causes of inequity but also be much attuned to the relationships, internal and external, that promote concerns. A strong compensation program, driven by a philosophy of justice and equity, can define and placate problems before they occur.
Required Reading:
Please refer to the Activity Resources section of each activity for the required readings.
Assignment 4 Equity: Internal and External
As an HR professional, it is important to thoroughly understand the concept of internal and external equity in terms of pay and benefits. For example, you will need to understand how to answer the following questions. How is the concept of internal and external equity similar or different in discussing pay versus benefits? In the struggle to recruit and retain productive and motivated staff members, is it better to design and promote a compensation and benefit program that focuses on external market competitiveness or that is structured to promote internal equity? How does one articulate the concept of just and equitable within a compensation structure?
Activity Resources:
HYPERLINK “http://proxy1.ncu.edu/login?url=http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=44900327&site=ehost-live” Earle, J. E. (2009).
Main Task: Analyze Issues of Internal and External Equity
Write a paper analyzing the concepts of internal and external equity and apply these concepts to an examination of pay versus benefits in organizations. Include in the analysis, a comparison of the advantages and disadvantages in designing compensation and benefit programs that focus on external market competitiveness or that are structured to promote internal equity. Support your analysis based on current research incorporating three journal articles or publications into your response.
Support your paper with minimum of five (5) scholarly resources. In addition to these specified resources, other appropriate scholarly resources, including older articles, may be included.
Length: 5-7 pages not including title and reference pages
Your paper should demonstrate thoughtful consideration of the ideas and concepts that are presented in the course and provide new thoughts and insights relating directly to this topic. Your response should reflect scholarly writing and current APA standards. Incorporate reference page number within the context of the paper. Use current day examples to substantiate your research.
Submit your document in the Course Work area below the Activity screen.
Learning Outcomes: 3, 4
Assignment Outcomes
Analyze the importance of balancing internal and external pressures and effects of external competitiveness in designing pay structures.
Assess the role of performance measurement in compensation decisions.
The Evolving Role of Risk Management in the Design and Governance of Compensation Programs
James E. Earle
Historically, “risk management” and “compensation” were separate and dis- tinct disciplines within most companies. The economic meltdown that began inside the financial services industry, however, has launched a new social dis- cussion that will cause these two disciplines to become intimately linked going forward, and as a result will likely forge new ways of thinking about the design and governance of compensation programs.
How is it that a compensation plan can pose risks to a company’s business? What kinds of risks are associated with compensation plans? What steps can be taken to mitigate those risks? These are the questions that this article explores.
Risk management is normally associated with the process for identifying, assessing, and prioritizing business risks as part of a sound business management practice.1 The purpose of the risk man- agement process is not to eliminate risk from the business model, but to help the company make sure that it appropriately takes risk into account in its business strategy. This is especially true in the financial services industry, which is in the business of pricing risk with every loan made.
The types of risks that are the focus of a company’s risk manage- ment routines will vary by industry and company specifics. In the financial services industry, the Basel II Accord focuses on three key areas of risk: credit, operational, and market risk.2 Operational risk, in particular, is a very broad concept that includes any kind of risk arising from a company’s business functions, such as failed internal processes, fraud, legal and compliance risks, etc.3
Risk management attempts to not only identify business risks, but to assess the degree of risks by attempting to quantify both the
Mr. Earle is a partner in the Charlotte offices of K&L Gates. Mr. Earle’s practice involves counseling publicly traded companies and other complex employers on matters related to executive compensation. Clients include financial services companies, hedge funds, large national retailers, manufacturers, and service-companies with global operations.
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likelihood of occurrence and the severity of loss. After identifying and prioritizing risks based on this assessment, the risk management process considers potential risk management plans to avoid, mitigate, or otherwise address the key risks.4
But what does all of this have to do with compensation?
Although there is room for debate, there has emerged a general public consensus that compensation practices in the banking indus- try played a role in the credit market meltdown that has been at the eye of the current economic storm. Consider some of the following quotes.
The Financial Stability Forum, comprised of a group of G20 finan- cial industry regulators (including representatives from the US Federal Reserve), had this to say in their April 2009 report on compensation practices:
Compensation practices at large financial institutions are one fac- tor among many that contributed to the financial crisis that began in 2007. High short-term profits led to generous bonus payments to employees without adequate regard to the longer-term risks they imposed on their firms. These perverse incentives amplified the excessive risk-taking that severely threatened the global finan- cial system and left firms with fewer resources to absorb losses as risks materialised. The lack of attention to risk also contributed to the large, in some cases extreme absolute level of compensation in the industry.5
The U.K.’s Financial Services Authority (FSA) expressed a similar view in their March 2009 proposal on reforming compensation prac- tices in the financial services industry:
Although it is hard to prove a direct causal link, there is wide- spread consensus that remuneration practices may have been a contributory factor to the market crisis. Practices in common use during the period leading up to the crisis, mainly but not exclusively in investment banking, tended to reward short- term revenue and profit targets. These gave staff incentives to pursue unduly risky practices, for example by undertaking higher risk investments or activities which provided higher income in the short run despite exposing the institution to higher potential losses in the longer run. In many cases, remuneration practices were running counter to effective risk management, in effect undermining systems that had been set up to control risk.6
Finally, here is what Gene Sperling, Counselor to the Secretary of Treasury, had to say in his opening remarks this past June before the House Financial Services Committee:
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Risk Management in the Design and Governance of Compensation Programs
There is little question that one contributing factor to the exces- sive risk taking that was central to the crisis was the prevalence of compensation practices at financial institutions that encouraged short-term gains to be realized with little regard to the potential economic damage such behavior could cause not only to those firms, but to the financial system and economy as a whole.7
KEY INITIATIVES
This consensus view has resulted in a number of legislative and regulatory initiatives, both here in the United States and abroad, that will require banks and other companies to develop better risk management practices regarding the design and governance of com- pensation programs. The following highlights some of these key initiatives.
Emergency Economic Stabilization Act of 2008
The Emergency Economic Stabilization Act of 2008 (EESA)8 required compensation committees, with input from the company’s senior risk officers, to review compensation arrangements covering the company’s “senior executive officers” (SEOs) to ensure that the arrangements do not encourage “unnecessary and excessive risks that threaten the value of the financial institution.”
American Recovery and Reinvestment Act of 2009
The American Recovery and Reinvestment Act of 2009 (ARRA)9 substantially revised the executive compensation provisions of EESA and expands on themes about risk in compensation programs. The compensation committee must meet at least every six months with the senior risk officers to discuss, evaluate, and review:
• Whether compensation plans for SEOs encourage unneces- sary and excessive risks;
• Whether compensation plans for all other employees pose unnecessary risks; and
• Whether compensation plans for all employees encourage manipulation of earnings.
ARRA requires greater disclosures about these review activities. A narrative discussion must be included in the Compensation Committee Report in the annual proxy statement.
ARRA also requires an annual certification by the CEO and CFO that these review activities (as well as compliance with all other exec- utive compensation requirements under ARRA) have taken place.
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• • •
Properly measure and reward performance; Are structured to account for the time horizon of risks; and Are aligned with sound risk management.
Risk Management in the Design and Governance of Compensation Programs
Securities and Exchange Commission: Proposed Disclosure Rule Changes (July 2009)
The EESA and ARRA requirements apply only to Troubled Assets Relief Program (TARP) recipients. The Securities and Exchange Commission (SEC), however, has proposed new disclosure rules, potentially to be effective next proxy season, that focus on risk man- agement issues for all public companies.10
Like ARRA, the SEC proposal looks beyond executive officer com- pensation plans.
The proposal would require discussion in the Compensation Discussion & Analysis section of the annual proxy statement about how the company’s overall compensation policies for employees cre- ate incentives that can affect the company’s risk and management of that risk (to the extent such risks are material).
Financial Services Authority (U.K.): Update to Its Regulatory Code
In August 2009, the FSA updated11 its regulatory code to establish a new general requirement for certain larger financial companies covered by the U.K. code: “Remuneration policies must be consistent with effective risk management.”
It includes eight “evidentiary principles” to prove whether the gen- eral requirement has been met. These evidentiary principles include features related to both the design and governance of compensation programs.
Corporate and Financial Institution Compensation Fairness Act, H.R. 3269
The Corporate and Financial Institution Compensation Fairness Act, H.R. 3269,12 was passed by the House on July 31, 2009.
Section 4 of the Act would require certain “covered financial institu- tions” to have compensation structures that:
TWO MAIN TYPES OF COMPENSATION RISK
What kinds of risks can compensation programs pose to a business? We think there are two key risks, which are thematically reflected in
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the various legislative and regulatory initiatives described above. They are: (1) “short-termism” and (2) manipulation.
Short-Termism
“Short-termism” results when a compensation program encourages too much focus on short-term results to the potential detriment of long-term value creation.
Examples of the potential for short-termism include:
• A compensation mix focused very heavily on annual cash bonuses. This has been a prevalent practice in many lines of business in the financial services industry, and the primary source of regulatory criticism. The concern is that the perfor- mance generating the annual cash bonus, such as the closing of a loan portfolio, the generation of a securitized transac- tion, or the origination of a number of mortgages, does not adequately consider potential future losses as a result of the transactions. The individuals are paid for front-end produc- tion without having to accept risk for back-end losses.
• The use of performance metrics to determine incentive com- pensation that do not adequately reflect company-wide risk considerations. This concern is closely related to the con- cern about overemphasis on annual cash bonuses, and is an especially tricky topic that we will discuss further below.
• A heavy focus on stock options or other forms of equity compensation that do not require holding periods or that include accelerated vesting at termination of employment.
Perhaps New York Attorney General Cuomo captured the essence of short-termism in the title of his July 30, 2009, report on bank com- pensation practices: “No Rhyme or Reason: The ‘Heads I Win, Tails You Lose’ Bank Bonus Culture.”13
Manipulation
Manipulation is the risk that a compensation program could encourage individuals to manipulate data inputs to the compensa- tion process or information about the company in a way to increase compensation results.
Examples of the potential for manipulation include:
• Annual bonus programs based on a single financial metric.
• Compensation decision-making processes without meaning- ful engagement by independent control partners.
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• Heavy use of equity compensation without holding period requirements. One recent example of manipulation in this context is the option back-dating scandal.
TWO KEY RISK MITIGATION STRATEGIES
How can companies mitigate against the risks that their compensa- tion programs might result in short-termism or encourage manipu- lation? The mitigation strategies can generally be lumped into two categories: (1) design and (2) governance.
Design
The design of compensation programs covers a potentially wide array of considerations. Many companies consider the design of their compensation programs to be a market differentiator. For financial services companies operating multiple lines of business, there can literally be hundreds of different compensation programs within the company, each tailored to the needs of a particular business unit. There cannot be a “one size fits all” approach, which makes the con- sideration of design issues especially complex.
Some of the key considerations when addressing risk issues in the design of compensation programs include:
• Mix; • Metrics; • Deferrals or bonus/malus; • Equity design; and • Clawbacks.
Mix
What is the relative level of fixed versus variable pay? As the FSA has noted, if salary is too low it may be difficult to operate a “fully flexible” bonus program—that is, a bonus program where no bonus is awarded if there are losses.14 If salary is too low, this can also put undue pressure on the achievement of annual bonus results, which can encourage manipulation.
For variable pay, what is the relative mix of annual versus long-term incentives? The historic practice at most large US financial services companies was to focus on annual incentives, but to deliver a portion of the annual incentive in a deferred stock award. Some companies also provided higher level employees with stock options as part of their total compensation package. Having a balanced compensation
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package with elements that focus on longer-term performance can be one of the best ways to address short-termism.
There are a growing number of examples of changing market practices on mix of compensation. A number of banks, including Citi and Morgan Stanley, have announced an increased percentage of salary as part of the total compensation package.15 Morgan Stanley also announced for 2009 a new long-term compensation award that becomes earned based on return on equity and total shareholder return results, against both internal targets and results relative to peers, over a three-year performance period.16
The executive compensation restrictions under EESA and ARRA for banks that received financial assistance include a prohibition on most bonus payments, other than certain long-term restricted stock (LTRS) awards worth no more than one-third of total annual compensation. In response, several companies have announced a new compensa- tion mix made up of cash salary, stock salary, and a LTRS award. The LTRS award vests over two to three years and is subject to transfer restrictions linked to repayment of TARP funds. Figure 1 illustrates this compensation mix announced by Wells Fargo and AIG for their respective CEOs.17
Metrics
What metrics are used to determine variable pay? Do the metrics take into account the quality and sustainability of earnings? One criti- cism of historic compensation practices, especially in the investment banking industry, was that annual bonuses were based primarily on a single metric—typically, a percentage of revenues. In contrast, the FSA advocates that bonuses be based on a balanced scorecard of metrics, including the net income of the company as a whole and the business unit, but also taking into account more subjective consider- ations such as a demonstrated commitment to compliance, teamwork, and other individual factors.18
One of the trickiest topics in this area is whether performance metrics should be “risk-adjusted.” The concept is simple enough: All income dollars are not the same. For example, a dollar of income gen- erated by making loans, requiring the deployment of company assets,
Figure 1.
Pay Element
John G. Stumpf, CEO, Wells Fargo
Robert H. Benmosche, CEO, AIG
Cash Salary
$900,000
$3,000,000
Stock Salary
$4,700,000
$4,000,000
LTRS
$2,800,000
$3,500,000
Total
$8,400,000
$10,500,000
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Risk Management in the Design and Governance of Compensation Programs
which could be subject to future losses, is arguably not as valuable as a dollar of income generated by a one-time fee for services. However, the mathematical process for deriving the risk-adjusted return for a particular activity can get very complicated and may not work well for all business activities. The complexity involved in deriving a risk- adjusted return can make the incentive compensation process more opaque to the participant and therefore less effective as an incentive. This is an area where the risk management and finance functions can help to determine whether a risk-adjusted metric might make sense.
Deferrals or Bonus/Malus
Given that risk-adjusted returns can be difficult to apply in prac- tice, what other techniques can be used to mitigate against current performance that leads to future losses? One approach, already common to the banking industry, is to have a portion of the annual incentive delivered on a deferred basis, say over three years. Often the deferral is delivered as restricted stock, the value of which argu- ably depends on future performance—that is, stock price (although some naysayers contend that stock price alone is an insufficient performance indicator because of the variety of factors, such as macroeconomic changes, that can impact stock price). The deferred portion of the compensation is also usually subject to forfeiture in case the employee resigns, is terminated for cause, or engages in some form of detrimental conduct.
We will discuss more about equity design below. How much of the bonus should be deferred? That probably depends on the employee’s role and compensation level, although the FSA advocates a deferral of at least two thirds of the bonus.19
Another spin on the deferral design is the so-called bonus/malus. Under this design, a portion of the annual bonus each year is deferred. The collective amounts deferred are then subject to offset in future years if there are losses or other bad behaviors (the malus). The offsets can be based on objective measures (such as portfolio losses) or more subjective determinations about performance, such as misconduct, failure to observe risk management requirements, etc. One recent example of this kind of design is the new UBS “cash bal- ance program.”
Under this program, two thirds of an employee’s annual bonus is deferred to be paid in later years and subject to reduction for certain “malus” events, including:
• A large financial loss (firm-wide or business unit); • A large balance-sheet adjustment; • Misconduct on compliance issues;
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• Breach of risk parameters; and
• “Non-adherence to other quantitative and qualitative core objectives as expressed within individual target agreements and performance measurements.”
Figure 2 illustrates how the UBS program is intended to work.20
For any deferral or bonus/malus program, careful attention should be given to potential state wage and hour act issues. Most states pro- hibit amounts “earned” from being subject to future loss or forfeiture. Deferral or bonus/malus programs should be carefully worded and communicated to make clear that the portion of the annual incentive award that has been deferred is not earned until all conditions to the award have been met.
Equity Design
Equity awards often provide the most direct means to align the interests of key employees with those of long-term shareholders. However, the effectiveness of this alignment depends on the details of the equity award design. An award that may be cashed in at any time or that can become fully vested upon termination of employment might arguably encourage a short-term focus on increasing quarterly results for short-term gains.
To address this concern, most large public companies now require executives to hold a certain minimum level of stock ownership (often expressed as a number of shares or a multiple of base salary). Another related technique growing in popularity is to require execu- tives or other key employees to retain a significant percentage of their equity awards after vesting or exercise (and after covering taxes and the cost of exercise). And yet another technique requires executives to hold their shares not only until termination of employment, but for an additional year or two after.
Rather than fully vest and pay equity awards at termination of employment (such as termination due to severance without cause
Cash Balance
Previous balance