The escalating debate on executive compensation and risk means companies need to develop tools to understand the balance between risk and reward.
Forward View by Tapestry Networks
Despite widespread public outrage over how executive compensation programs drove excessive risk taking in financial institutions, recent conversations with audit committee members from a number of industries make it clear that boards are still grappling with the implications.
One audit committee chair remarked, “We’ve opened this up to the full board for discussion. It’s healthy. And it’s evolving.”
All public company boards, regardless of industry, are under pressure to address the issue of compensation. Reinforcing this agenda are the SEC’s new proxy disclosure requirements on the links between compensation and risk, board leadership and board oversight of risk management.
For some boards, assessing how compensation policies affect risk may be a new responsibility. Even in the Compensation Discussion and Analysis (CD&A), disclosures often contain extensive information about compensation levels and policies, but typically say little about the links to risk.
Pay for performance exists because greater risk often means greater reward — for the company and the executive. Examples of evaluation criteria to assess the link between compensation and risk include:
- The number and type of performance measures used to determine compensation. A higher number and diversity of measures may be less likely to distort behavior.
- The materiality of compensation payouts and the amount of variable compensation. Payouts that constitute a higher percentage of the company’s earnings, and compensation structures with very high variable pay components, constitute a risk that should be counterbalanced.
- The extent to which employee evaluations take into account the employee’s risk management practices. Rewarding specific practices (as well as outcomes) encourages better risk management and strengthens a culture of risk awareness.
When it comes to disclosing the link between compensation and risk, oversight may fall to the audit committee even though the disclosure will appear in the CD&A. Some of the activities audit committees are often involved in, usually with input from the external auditor, include:
- Assessing the quality of earnings and determining the data used by the compensation committees are accurate. An audit committee chair recently stated, “This has become a routine part of my audit committee role. We work with the external auditor and management to get together the raw material for the compensation plan.”
- Assessing whether the metrics used to assess performance are appropriate and unlikely to encourage the wrong behavior. An audit committee chair said, “Our audit committee approves the compensation plan. We ask, ‘Does this goal make sense or not?’”
- Reviewing the proxy statement and the related executive compensation disclosures for consistency with other disclosures in the financial statements. The audit committee should help the compensation committee make sure that the amounts disclosed, and the related explanations, are accurate, clear and consistent with other disclosures. As one member said, “There are so many numbers in the CD&A. It would be embarrassing to get this wrong.”
Forward View is written by Tapestry Networks. Views expressed by Tapestry Networks are those of Tapestry Networks and not necessarily of Ernst & Young. Tapestry Networks convenes eight audit committee networks sponsored by Ernst & Young that collectively consist of more than 120 individuals, who chair more than 170 audit committees and sit on over 300 boards at some of the world’s most admired companies.
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