Pay and Risk – Avoid rolling the dice
The Compensation Committee of this publicly-traded Fortune 500 company engaged Farient to obtain a better understanding of whether its executive compensation program might encourage excessive risk-taking.
The Challenge
The Committee wanted a systematic way to measure compensation risk relative to its business risks, and to ensure that its compensation system was not structured in such a way as to encourage their taking undue and/or hidden risks. The Committee wasn’t worried that immediate problems existed, but wanted to make sure that the compensation system wasn’t creating an environment in which problems would arise. It also wanted to make sure that the performance measurement system adequately recognized risk.
Farient’s Approach
Farient knows that companies are in business to take prudent risks to optimize long-term shareholder value. But shareholders and boards alike need to understand whether executives and other employees are being encouraged by the pay system to take financial risks that are inappropriate for the business. Farient’s Quantitative Risk Assessor ™ evaluates the propensity of the compensation system to cause undue risk-taking relative to a company’s business context.
Our client was in a long-term, capital-intensive, and moderately high-risk business relative to the broader universe of companies. Our Quantitative Risk AssessorTM showed that the client’s compensation system could lead to unintended risk. This was because despite the high capital intensity and long-term nature of the business, the compensation system was driven largely by a focus on revenue and income growth, with no focus on capital efficiency. In addition, the time horizon of vesting and performance measurement was three years or less, with no holdbacks or ownership guidelines, encouraging short-term profit taking before long-term returns would be known. Farient assisted in redesigning the compensation plans to include a return measure, and to institute clawbacks and ownership guidelines to effectively lengthen the measurement period.
The Results
The Compensation Committee and management are confident that the changes to the pay programs are a better fit with the company’s business strategy and risk profile. Moreover, the Committee now has a good story to tell in the Compensation Analysis and Discussion (CD&A) section of the company’s proxy.
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