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Five Common Ways Management Incentive Plans Create Stealth
Enterprise Risk

Management incentive plans are under tremendous scrutiny for many good reasons. But when Main Street shareholders and the media focus purely on the amount of management compensation and where it stands compared to others in a particular peer group, they are missing an essential point. The question they should be asking is not how much management is making, but how much risk the compensation formula allows for – or indeed encourages.

Alvarez & Marsal has seen how poorly designed management incentives can sow the seeds of destruction. In recent years, a number of major enterprises have experienced such destruction as a result of the cumulative effect of countless human actions over time – actions that are directed by enlightened self interest. But when they are grounded in flawed pay systems and the toxic cultures they create, the results speak for themselves. Poorly designed programs can lead to numerous enterprise “maladies” ranging from having never met a revenue dollar management didn’t like, to a range of other myopic pursuits, including market share at all cost, excessive leverage and scale.

A 2011 Conference Board study found that of the 2,704 companies that had “Say on Pay” votes, only 37 rejected executive compensation. Whatever the reasons for this 98.7 percent approval, none of the 37 “no” votes cited undue enterprise risk as the rationale. Nearly all cited misalignment of the amount of executive pay relative to company performance.

Of the 2,667 companies whose shareholders were completely comfortable with their executives' pay, how many understood how much uncompensated risk was undertaken to achieve their results? Institutional investors should be particularly focused on this issue given their resources, influence and stake in the outcome.

We live in an uncertain and volatile economic climate that has placed greater regulatory pressures on businesses and leadership. Rather than engaging in traditional discussion as to how much executives should earn, boards, C-suite executives and institutional investors would be better served to understand the hidden dangers their company’s incentive plans may hold for their business in creating unforeseen or excessive risk.

There are five common conditions for incentive plan failure:

• Creating Unnecessary or Uncompensated Risks: All enterprises by definition are in the risk business, some explicitly (banking or insurance), others implicitly. Value comes from taking risk. Too much focus on risk mitigation will undoubtedly reduce the potential for value creation. However, businesses should be adequately compensated for the risks they take. Poorly designed incentive plans can entice management to introduce additional uncompensated risks to hit targets that become unattainable because of changes in the environment or in the underlying business assumptions. Risks can take the form of additional leverage, reduced quality standards, poor pricing, flawed product design, altered underwriting standards or other practices that may be less than obvious at the outset, but have serious long-term consequences.

• Focusing on How Much and Not How: The primary scorecard by which businesses are judged is their financial performance. Although often overlooked, how management gets there can be as important as how much profit or shareholder value is created. For example, if management takes a flawed path toward a result that leads to a transaction bonus, the cracks in that path will reveal themselves eventually. It may take time, but they may come back later in indemnifications and reps or warranty provisions that result in a clawback or, worse, litigation. Targets for excessive cost take-outs or lack of capital investment in infrastructure can weaken the base for future earnings after the present management team is gone.

• Aggressive Binary Threshold Targets: To be effective, incentive plans require certain hard targets. In setting these targets, aggressive binary thresholds can push management to introduce unnecessary or uncompensated risks. Although somewhat counterintuitive, these types of targets often won’t affect the highest or lowest performers. They will impact the most dangerous components and perhaps the largest population, “bubble performers.” Managers or divisions that are within sight of a threshold goal and find themselves “on the bubble” have the highest probability of cutting corners or taking risky actions to meet objectives. Typically, the other two groups (highest and lowest performers) tend to represent the 20 percent of the business population that gets 80 percent of the attention. The largest risk to the business is lurking on the bubble.

• Misalignment of Time Horizons: Shareholders and their proxies, the board and senior management, tend to take a longer view than the people in the trenches. Boards, through the compensation and audit committees, need to assure that provisions are in place to keep management’s eyes on the future. They need to extend beyond quarterly and year-end objectives. Long-term plans that are equity based are generally designed for this purpose, however in a world of market volatility and uncertainty, management may de-value equity-based, long-term plans over cash today. A heavier emphasis on cash may keep the players engaged, but needs to be combined with staged payouts and good governance to support time horizon alignment beyond the current period.

• Weak Governance: Weak governance starts with the compensation and audit committees and works its way down through management and all the way to outside advisers. Boards are more engaged than ever, but are they up to the task? Do they have the necessary knowledge, support and leadership capacity to set strong guidelines and provide the oversight needed to assure checks and balances in the system? It is not a matter of knowing every risk undertaken, but of knowing where to look and how to avoid creating the conditions that promote unnecessary risks. Checks and balances should be both organizational and programmatic down to the Key Performance Indicators driving executive compensation – and ultimately, actions and behavior.

Properly reviewed incentive programs will provide a true roadmap to corporate strategy, vision and culture that is more accurate than any disclosures made in publicly available information. Management will act in alignment with optimizing their reward system and take the risks they deem necessary to get there. Just make sure the risks taken are conscious and compensated.

Companies that periodically assess their incentive plans using the law of unintended consequences as a guiding principle can overcome these five common failures. Those that do will dramatically improve their chances for better alignment between shareholder value and management action, while at the same time managing and mitigating hidden risks taken to achieve performance objectives.