Compensating Executives Under the New 162(m)

Except for those who are either executives or people involved in determining the ways that executives are compensated, one of the changes to the Internal Revenue Code last fall seemed like a little throw-in designed to appease a small constituency, but that few would really care about. That small group that does understand the change, however, knows it is a pretty big deal.

Let's recap so that we can all be on the same page. Prior to the Tax Cut and Jobs Act (TCJA), and oversimplifying somewhat, public companies were entitled to deductions for executive compensation so long as such compensation did not exceed $1 million per year for a covered employee. Performance-based compensation was not to be counted against that limit and covered employees were the CEO plus the four other highest compensated employees.

Since the passage of the TCJA, there have been several key changes to Section 162(m):

• Once you become a covered employee of a company (beginning in 2017), you remain a covered employee of that company, essentially forever;
• The CEO plus four other highest paid has been changed to CEO plus CFO plus three other highest paid;
• Companies no longer get an exemption for performance-based compensation; and
• Some grandfathering exists for certain agreements that existed in writing.

That does not leave a whole lot of wiggle room for companies. And, for companies that have provided large amounts of performance-based compensation to their executive group, meaningful deductions may be gone.

I'm not about to suggest that I can fix this new problem. But, you should note that amounts that have been deductible under Section 404 are unaffected by these changes. Section 404 of the Internal Revenue Code relates to qualified pension plans. What this means is that to the extent that parts of an executive's compensation which would be subject to Section 162(m) are somehow moved into a qualified pension plan, the funding of that plan will, subject to the rules of Section 404, generally qualify for a corporate tax deduction.

Of course, there are a myriad of rules around what it takes to keep such a pension qualified including the nondiscrimination rules of Section 401(a)(4). But, for most companies that still maintain ongoing pensions, the ability to transfer some otherwise nondeductible compensation to such a pension plan may still exist. It's one of the tools in the tool box that companies should look into.

Laws Affecting Benefits and Compensation Nearly Always Failures

I suspect that the authors of every law that affects employee benefits and compensation have good intentions when they draft those laws. As T.S. Eliot said however, "Most of the evil in this world is done by people with good intentions."

Where do these laws go wrong? To understand this, it's helpful to understand the process.

Usually, bills are drafted by Congressional staffers perhaps with the assistance of outside experts, often lobbyists. From there, bills are introduced and then haggled over by 435 people with no subject matter expertise in one chamber of Congress and then by 100 people with a similar lack of subject matter expertise in the other chamber. Once the sausage has been ground sufficiently, a bill may be approved and passed to the President for signature.

What could possibly go wrong?

Assuming that nothing could go wrong up until that point, these bills that by this point in the process have become laws leave it up to the various government agencies to create regulations that help to implement these laws. Some of the regulations make sense, and then there are the others.

Looking at this as someone who doesn't work for one of those agencies, it strikes me that each of them seeks to assert their power where possible. After all, if a government agency cannot show that it has power, why should it not simply cease to exist?

Further, if between Congress and the various government agencies, a bill and then law has not been messed up, there is still the court system to fall back on.

As an example, let's consider Internal Revenue Code Section 401(k). Essentially, it was added to the Code by the Revenue Act of 1978. And, while it was a throw-in, as we all know, once 401(k) plans were truly discovered, they took off in their popularity.

There are several things that we know about 401(k) plans. They are qualified retirement plans, thus governed by ERISA. They provide tax deductions and are thus also governed by the Internal Revenue Code. They have become very popular, so the amount of plan assets in many 401(k) plans is massive.

So now, let's look at the evolution of a current nightmare.

401(k) plans were created by the Revenue Act of 1978. They provided employees with an opportunity to save money for retirement on a tax-favored basis. Employers have the ability to match those employee deferrals and receive a tax deduction for those matching contributions. The Investment Committee (or some similar name) for the plan or its designee is responsible for selecting and monitoring investments in the plan. In that role, the Committee must act in the best interests of plan participants and in a fiduciary manner.

What does that mean?

The old regulations were very vague. Vagary has led to different courts imparting their wisdom in different ways. To be acting in the BEST interest of plan participants, what does a committee need to do? Does it need to find the LEAST expensive investment options? Does it need to find the HIGHEST returning investment options? If not, then how close to that optimum? Where is the bright line?

So, now we have new Department of Labor (DOL) fiduciary regulations. What they do more of than anything else is make more people fiduciaries of the plans than were before. Or, if they don't, then they certainly make clearer who the fiduciaries are and establish that there are, in fact, a lot of fiduciaries out there. Does this mean that more people will  be sued for fiduciary breaches?

Looking back, Section 401(k) should have been a great addition to the Code. And, weighing everything, perhaps it was (although regular readers of this blog will know my opinion that the addition of Section 401(k), more than anything else, probably ruined the American retirement system). But, over time, through this process, the 401(k) plan has become a mess. Each government agency thinks it has turf to protect. Employers feel that they have to offer a 401(k) plan, but few are equipped to handle one according to the current state of regulation and litigation.

The good news is that 401(k) plans through the Revenue Act of 1978 don't represent the only benefits or compensation law that is broken. Yes, that's also the bad news.

Consider these:

• The Pension Protection Act of 1987 and the Pension Protection Act of 2006 have probably done more to drive down the number of US pension plans than any other laws.
• A provision in the Multiemployer Pension Reform Act of 2014  that was intended to address the problem of serious underfunding in plans such as the Central States Teamsters Plan was dealt its first major setback specifically with respect to the Central States Teamsters Plan.
• The million dollar pay cap in Code Section 162(m) that was designed to limit executive compensation has done more to increase executive compensation than probably all other legislation combined.
• The Affordable Care Act of 2010 as we are seeing with announcements of 2017 exchange premiums is making health care anything but affordable.
• The Pension Benefits Guaranty Corporation's (PBGC) shortsightedness in addressing its self-determined shortfall has taken millions of participants out of the pension system thus increasing the PBGC's shortfall.

I could go, but you get the picture.

CFO Priorities and Benefits and Compensation

CFO magazine did their annual survey of the priorities of chief financial officers recently. I read their article summarizing the findings from the survey and considered what this might mean for benefits and compensation.

Before I go on to my main topic, however, I need to bring up a few of the issues that I found near the bottom of the article. Three priorities that the article highlighted were written communication, networking with peers and presenting to large groups. Frankly, these are not just CFO priorities; they should be priorities for every professional in our 2015 world, and I was absolutely thrilled to see written communication in the list.

Returning to the main points of the article, I point out some of the top priorities that are more day-to-day for CFOs.

• Precision and efficiency in cash forecasting
• Budgeting
• Balanced scorecards
• Margins
• Risk management
• Performance management

Additionally, and in many cases perhaps more important, but less relevant for this blog is cybersecurity.

Let's also consider what some of the main elements of traditional benefits and compensation packages look like (with some grouping at my discretion).

• Health and wellness benefits
• Retirement benefits
• Other traditional welfare benefits
• Feelgood benefits
• Base pay
• Short-term incentives (bonus)
• Long-term incentives (often equity)

Health benefits are now essentially a requirement. Either you provide them or pay a fine under the Affordable Care Act (ACA). But, companies have lots of techniques that they can use to control costs. Popular today are high-deductible health plans (HDHP) where oftentimes, companies contribute fixed amounts to health savings accounts (HSAs) to help employees pay for costs up to those deductibles. Among the major advantages of these designs are that companies do a much better job of locking in their costs. In other words, more costs are known and far fewer costs are variable or unknown. 

On the subject of retirement benefits, I'm going to give you a shocker. In matching those CFO priorities, the single worst sort of retirement plan that a company can sponsor is a traditional 401(k) plan with a company match. That's right -- it's the worst! Why is that? In a 401(k) plan, the amount of money that a company spends is almost entirely dependent upon employee behavior. If you, as an employer, communicate the value of the plan, employees defer more and that costs you more. Most companies budget a number for their cash outlay for the 401(k) plan. Very few, in my experience, look at potential variability. One that does and that I worked with on this a number of years ago, estimates that between best case and worst case, that the difference in their cash outlay could be in the range of several hundred million dollars. That is a lot of money.

So, what is better?

Believe it or not, I can come up with lots of rationales (much beyond the scope of this post) for why having a defined benefit plan as a company's primary retirement vehicle is superior to using a 401(k) plan. Understand, I'm not talking about just any DB plan. But, the Pension Protection Act of 2006 (PPA) opened the door for new types of DB plans that either were not expressly permitted previously or, in other cases, that were generally not considered feasible. Think about a cash balance plan using a market return interest crediting rate with plan investments selected to properly hedge fluctuation. Cash flow becomes predictable. Volatility generally goes away. Budgeting is simple. The plan can be designed to not negatively affect margins.

I may write more in a future post, but for now, suffice it to say that this design that has not yet caught on in the corporate world needs some real consideration.

How about compensation? 

Base pay is the easiest to budget for. If you do have a budget and commit to not spending outside of that budget, base pay is pretty simple to keep within your goals. 

Incentive compensation is trickier. While many organizations have "bonus pools", they also tend to have formulaic incentive programs. So, what happens when the some of the formulaic incentives exceeds the amount in the bonus pool? Either you blow your budget or you make people particularly unhappy. There is little that will cause a top performer to leave your company faster than having her calculate that her bonus is to be some particular number of dollars only to learn that it got cut back to 70% of that number because the company didn't budget properly.

Perhaps it is better to assign an individual a number of bonus credits based on their performance and then compare their number of credits to the total number of credits allocated to determine a ratio of the total bonus pool awarded to that individual. After all, isn't the performance of the company roughly equal to the sum pf the performances of individuals and teams? And, if the company has a bad year, isn't it impossible that every individual and team exceeded expectations? Be honest, you know that has happened at lots of companies and the companies don't know what to do or how to explain it.

There is lots more to be said, but I want to keep it brief for now. If you have questions on some of the specifics, please post here or on Twitter or LinkedIn in reply to my post or tweet. And, if you have one of these areas on which you'd like to see me expand in a future post, let me know about that as well.

Proxy Hysteria Arrives -- I Was Right

I told you it would happen, didn't I? I said that companies whose executives participate in defined benefit (DB) pension plans, especially nonqualified plans were going to report massive increases in CEO compensation. I said that there would be a big name company for which the increase in CEO compensation due in large part to the amount from pensions would create hysteria.

It has happened. Bloomberg reported in a video and an article that GE CEO Jeffrey Immelt was rewarded with an 88% increase in compensation despite sluggish performance. The company attributed the compensation increase to his reshaping of the company and to an increase in the value of his pension.

In my opinion, this could have been handled better. They could have focused on the message from my January 7 post. It said right there what was going to happen. I wouldn't lie to you and I wouldn't lie to GE.

Let's digress for a moment and think about how executive compensation is disclosed for the named executive officers (NEOs), including the CEO, at a public company. The company discloses compensation generally in the Summary Compensation Table (SCT) of the proxy. In the Compensation Discussion and Analysis section (CD&A), the company is afforded the opportunity to discuss its compensation practices, procedures, and policies. As the CD&A is a narrative, the company is required to discuss its rationale for its policies, but it is certainly not precluded from explaining changes. In fact, this is a great place for the company to explain what happened.

According to the Bloomberg article, Immelt's total compensation was approximately $37.3 million. I am neither condoning nor condemning that level of compensation here; that's not my point. Bloomberg says that that amount represents an 88% increase in compensation. Using that figure suggests that Immelt's compensation in the previous year was approximately $19.8 million. Further, Bloomberg says that GE noted that without the pension increase, Immelt's 2014 compensation would have been $18.9 million.

Opportunity knocked, but nobody opened the door. Apparently, GE did give Immelt a roughly 6% increase in base pay apparently from $3.2 million to $3.4 million. There appear to have been no other changes in compensation structure or policy with regard to the CEO.

Suppose GE took the step of explaining the pension increase. The pension plans in which Immelt participates did not change. He wasn't granted a massive benefit increase resulting in his total compensation doubling. What happened was that his 2014 compensation replaced his 2009 compensation (remember 2009 was a horrible year for the US and global economies) in a 5-year average, pension discount rates dropped (this increases the present value of pension benefits), and the Society of Actuaries released a new mortality table (I suspect GE adopted it) reflecting longer life expectancies in general.

What could GE have controlled in an effort to keep Immelt's disclosed compensation relatively steady? They could not have controlled discount rates as they are based largely on the high-quality corporate bond market. They could have chosen, subject to the approval of their external auditors, to not update the mortality table to use for the calculations, but that would only have been obfuscating the issue and frankly, the updated table is likely more appropriate for them. Finally, 2009 happened in 2009. It can't be undone. Incentives paid out more in 2014 than they did in 2009. That's true for almost all companies. What it is reflective of, that corporate performance has improved, is true for many companies and it's a good thing.

So, GE and Immelt didn't do anything evil. Their crime, so to speak, was not an error of commission, so much as it appears to have been one of omission.

GE had to know that this "increase in compensation" would set off alarms. Bloomberg appears to have received or at least heard statements from GE. Why did GE not prepare its spokesperson to address this? The fault was not in changes to their compensation program; the fault was in their lack having a prepared message.

I don't expect that they will be the only company to face this issue. I can help you craft the message. Get out ahead of this problem.

You'll thank me later.

Proxy Hysteria Coming For Companies With DB Plans

You read it here first. During the upcoming proxy season, there is going to be hysteria over the executive compensation disclosures in proxies for companies with defined benefit (DB) plans, especially those with nonqualified plans for their named executive officers (NEOs).

What's going on? As part of an NEO's compensation, filers are required to include the increase in the actuarial present value of DB plans. The actuarial present value is a discounted value of the anticipated payment stream just as it was a year earlier. While there are many assumptions that actuaries select in determining an actuarial liability, two, in particular, have changed for many companies from 12/31/2013 to 12/31/2014. One is the discount rate which will have decreased by somewhere in the neighborhood of 100 basis points and the other is the mortality assumption. Late last year, the Society of Actuaries (SOA) released its newest mortality study and many companies elected to adopt the new tables.

The effect of the change in discount rate will vary, largely on the age of the NEO in question, but it's not unreasonable to think that for most NEOs that just that discount rate change will have increased the actuarial liability attributed to them by 8%-12%. Yes, Americans are living longer. Mortality assumptions should be updated from time to time. But, for proxy purposes, the year of the update causes an additional spike in the liability attributed to the individual NEO, perhaps an additional 5% depending upon age and gender.

So consider an NEO whose 2013 compensation included $1,000,000 due to the increase in the actuarial present value of accrued pension benefits. If that person is still an NEO at the end of 2014, he or she will have had an increase in liability due to surviving one more year (interest and mortality totaling perhaps 6%), an increase due to increases in included compensation (a large bonus could have increased even 3-to-5 year average compensation by 25% (recall that in the case of a 5-year average that 2014 which was a good year for many businesses replaces 2009 which was a dismal year for many businesses)), and increases due to changes in discount rates and mortality assumptions.

So, with no changes in compensation practices, our NEO who had $1,000,000 of compensation attributable to him or her in 2013 might see that turned into an increase of $1,500,000 in 2014.

There will be outrage. Proponents of the pay ratio rule of Dodd-Frank Section 953(b) will point to these increases and say that the rank-and-file got 2%-4% increases. The media will not understand what happened. Congress, and this might be the year that it matters as the new Republican control has suggested that it will try to repeal some parts of Dodd-Frank, will not understand.

But those people who chose to read my ramblings will get it. Companies that foresee the issue can address it. It can't be solved in its entirety, but it can be managed.

I know how.

Do you?

PCAOB Expands Purview of Accounting Profession to Review Compensation Arrangements

Unless you are in a field related to accounting or review of public companies, you may never have heard of the PCAOB, or more formally, the Public Company Accounting Oversight Board. It is actually a private-sector, non-profit company that was created by the Sarbanes-Oxley Act (SarbOx or SOx) in 2002. According to SOx, the PCAOB is to, among other things, oversee the audits of public companies. In part, to do so, the PCAOB creates a set of auditing standards that must be approved by the Securities and Exchange Commission (SEC).

Got that?

So, why am I writing about this? Earlier this year, the PCAOB issued Auditing Standard 18. In late October, the SEC approved it. And, so it is.

Auditing Standard 18 (AS18) is a lovely document. It's 223 pages of, and I can't think of a better word for it, stuff carrying the clearly far too brief title, "Related Parties and Amendments on Significant Unusual Transactions and a Company's Financial Relationships and Transactions with its Executive Officers."

Got that as well?

Among other things, AS18 asks that auditors, among other things:

1. Read the employment and compensation contracts between the company and its executive officers
2. Read the proxy statements and other relevant company filings with the SEC and other relevant regulatory agencies that relate to the company's financial relationships and transactions with its executive officers
3. Obtain an understanding of compensation arrangements with senior management other than executive officers including incentive compensation arrangements, changes or adjustments to those arrangements, and special bonuses
4. Inquire of the Chair of the Compensation Committee as well as outside compensation consultants
5. Obtain an understanding of expense reimbursement policies with respect to executive officers

All of this is to be done to identify risks of material misstatement.

I understand why all of this is being done. Early in this century, there were a number of corporate scandals resulting from apparently fraudulent misstatement of financials. Many of you remember Enron, WorldCom, and Tyco. This is intended to be one more step to lessen the likelihood of such abuses and to restore faith that corporate America, as a whole, are being good citizens.

We place lots of faith in auditors in this regard. Now, I have friends and acquaintances who are auditors. Some of them are very good and knowledgable. And, this is not intended to say that the rest (the complement of some of them) are not good, but in any profession, some practitioners will always be better than others.

Here, however, the PCAOB and the SEC are either assuming that auditors have sufficient expertise in compensation arrangements to handle this undertaking or that the firms of which they are a part have this expertise internally to which the auditors may refer. At the Big 4, this is probably the case. They have massive staffs and are able to engage specialists to handle such complex questions. How about the next tier of auditing firms? Do they have this expertise? I don't know, but I suspect the answer is sometimes. Let's take it down one more tier. Do those firms have that expertise? Again, I'm guessing, but I suspect that the answer is not very often. And, if we move to the smallest of the auditing firms, I would be inclined to move the needle to rarely, if at all.

Most auditors that I know are nice people. Most auditors that I know are pretty smart. Most auditors that I know are pretty honest. That said, most auditors that I know are being asked here to weigh in on matters in which they have no training and are frankly not likely to have it anytime soon.

What is the answer? I'm not sure. I'm not a fan of more regulation or more government control generally, but perhaps people who engage in review of compensation arrangements of public companies need some sort of licensure. Actuaries need it for many functions that we perform and we are also, as a group, pretty nice, smart, and honest.

I think that the PCAOB and SEC have used their unencumbered power to stretch too far. Perhaps, it's time to rein them in?

Black Friday Sales Down -- It Goes Back to Benefits and Compensation?

I heard it this morning. Black Friday sales were down. Not only were they off last year's huge numbers, they were well below forecast. Many economists and other prognosticators were shocked. Of course, people were going to spend more as they are paying far less for gasoline.

That connection doesn't hold; it never will. People, by and large, make larger purchases, the kind that fuel the Christmas economy, when they feel good about their futures. They do it when their long-term view of their personal economy is optimistic. Today, it's not.

Why not? Yes, fuel prices are down and down significantly. But, take-home pay is not increasing for most people. I think that most people view that fuel prices down are a temporary phenomenon -- a good one, but not one that will last for the long haul. But, take-home pay has been eroded for years now. Across the board pay goes up nearly every year, but not by much. In a good year, it might be a 3% to 4% increase. In a bad year, it's below 2%. At the same time, the employee's portion of the cost of their own benefits is increasing. Have you noticed your health plan? Your deductibles have gone up, your out-of-pocket maximums have gone up and your premiums have gone up by a bigger percentage -- likely significantly bigger -- than your pay. The same can be said about other employee benefits. Either you are paying more or getting less or both.

Does this mean that your employer is evil? They might be, but not because of the scenario described here. Companies have to be competitive in the marketplace. If their cost of goods sold or cost of providing services increases by too much, then their margins will be down. And, if that happens, then those pesky owners, be they the people who started the company or the broad group of shareholders will make less money. They don't like that. In fact, they are in business to make money.

I know; that's not a nice way of thinking about it. But, suppose you started a business. Wouldn't you want to turn a profit? After all, the person starting the business takes a risk. There is point in taking a risk if the reward is not at least commensurate with that risk. If you invest in a company, you expect that company to have increased, not decreased profits. So, the people who run the business cannot afford increases in labor costs that cut into those profits by too much.

Going full circle, employees notice what's in their paychecks. If your employee receives less money in the first paycheck of 2015 than she did in her last paycheck of 2014, it just doesn't matter how big you told her that her raise was. To her, it looks like a pay cut. When she sees a pay cut, she spends less, not more. And, because she is expecting that, Black Friday was not as busy as the stores wanted.

Rewardsball -- Where HR Meets Moneyball

I'm sure that many of you read Michael Lewis' excellent book Moneyball. Whether you have or not, it's the true story of the Oakland Athletics baseball team with a focus on their General Manager, Billy Beane and his focus on the value that players actually deliver. It's the story of how a smaller-market baseball team without a lot of money uses its money wisely to be competitive without a lineup full of superstars. It's a story that instructs that certain statistics are undervalued and that certain other statistics are overvalued. It's a story that tells us how to efficiently use our payroll budget to achieve the best results.

That seems like a really cool idea. It seems so simple, doesn't it? All we have to do is to develop a simple set of metrics and apply them to our company and we will use our payroll more efficiently than our competitors, generate more profits for our shareholders and pay all of our employees commensurate with their contributions to our profitability.

Wow, John, that is a fantastic idea. You should start a business, preach this to the masses, make millions of dollars implementing it, go on the banquet circuit and eat lots of really bad chicken.

Not so fast.

Baseball is a relatively ideal forum for the concept of Moneyball. There are 30 teams. Each team has the same rules. Each team's goal is to win as many games as possible of 162. Each team wins games by scoring more runs than its opponent. Each team scores a run when a player safely crosses home plate. So, a player who generates a lot of runs for one team is highly likely to generate a similarly large number of runs for another team (if he is traded).

Tell me two companies that play by the same set of rules. That's tougher, isn't it? In order to have the same set of rules, they need to have similar goals. Perhaps they need to offer similar products and services. We could argue that they need to have similar financial situations, but we know that the Oakland Athletics and New York Yankees do not have similar financial situations. Yet, the Athletics with a payroll often dwarfed by what the Yankees pay their starting infield currently sit five games ahead of the Yankees.

Even McDonald's and Burger King, though, have different jobs. They have different products. They have different locations. Presumably, they have different goals.

But, let's take a different approach that can be applied to any company. Suppose a company currently spends $1 million per year on its health care benefits for employees (and their families). Perhaps $800,000 is the minimum that they could spend. What is the value of that additional $200,000? Does the company get a good return on its investment for the additional $200,000? If not, should they cut benefits or enhance them.

This is actually what I am referring to as Rewardsball although I think I can come up with a better name. It's an interesting concept, isn't it?

Call me. Write me. +1 this post. Re-post it. Re-tweet it. Help me out please.

Compensation Risk

I was reading Mike Melbinger's blog today about compensation risk assessments (if you want to read online legal analysis of compensation issues, I strongly recommend his blog) and I got to thinking that oftentimes, the people who may be assisting clients with this assessment may not know much about risk. You see, in evaluating compensation risk (and the SEC doesn't really tell us what that means), companies are to look at all elements of remuneration for both executives and for other employees. So, that includes things like deferred compensation which includes both qualified and nonqualified retirement plans.

I've written a lot about risk in retirement plans from the employer standpoint. How much cost variability is there? Does this benefit properly align with corporate goals? In an enterprise risk framework, where do these plans fit in? Is there compliance risk? Is there risk associated with having retirement benefits that are so large that you can't get employees to leave when you'd like them to? Is there risk associated with not having a defined benefit plan when some of your competitors for talent have them?

That last question is confusing, isn't it?. But, think about it. Defined benefit plans to favor older workers, not because they are discriminatory, but because of the shorter discount period until retirement date. So, if you sponsor a generous 401(k) plan and your top competitor sponsors a generous defined benefit plan, then a knowing employee might work for you until they get to be about 45 and then just when they really know the business, take off to your competitor who has a generous defined benefit program. It just makes sense.

So, compensation risk isn't only what you probably think it is. If you want to do a really thorough analysis and consider all of your rewards programs, consider people who have sufficient expertise to help you through the process. You might just learn something about your programs that you hadn't thought of before. And, it might be really useful.

Are You Sleeping? Who is Managing the Compensation Risk?

Risk management used to be viewed with a somewhat jaundiced eye. It was something that the geeks did. I know, at your company, you just didn't need it because you understood your business better than some guy with a fancy degree, a pocket protector, and an HP-12C.

While companies had full-time risk managers and even risk management departments before then, this mad science really came to the forefront in the early 2000s. Suddenly, companies were seeing that risks that they had taken, especially in the area of leveraging themselves perhaps a bit too much, were starting to bite them in their proverbial hind quarters.

With that, the CRO or Chief Risk Officer, became the new sought after geek. Here was a person with specialized training who could look after the store, so to speak. If the CRO approved, then the CEO and CFO had a special comfort that all would be well.

Yes, CROs, as a group, do have specialized training. They tend to be smart people who can model the risks of a veritable cornucopia of corporate transactions. But, even the smartest person doesn't have the capacity to consider every possible risk. Sometimes, they are just not aware of certain risks. Sometimes, the other departments take actions without consulting the CRO and his staff because they just don't think the particular decisions has a risk potential that hits that threshold.

Perhaps that department was Human Resources. I know, you think I am wrong; by the early 2000s, the Risk Management Department was heavily involved in working with pension plans. Well, I am focused on a different part of Human Resources here, the part that develops compensation programs.

Way back when, you know, about 25 years ago, a typical bonus program worked something like this. Everyone in the program had a target bonus -- some percentage of their base pay. To go with that target bonus, you had a set of goals. They were, in theory, set up so that you had a roughly equal chance of exceeding your goals or of falling short. And, your bonus was typically capped, on the upside at twice your target and on the downside at zero.

Ah, theory, what a wonderful concept.

Picture yourself as a manager. You have three employees to review for their performance in 2011. Let's call them Larry, Moe, and Curly. Larry has always been a star performer. Each year, he has exceeded expectations. But, in 2011, Larry did not have a good year. He fell short of every goal. But, somewhere in your mind, although you can't quite put your finger on the exact cause, you think there must have been extenuating circumstances. You are sure that Larry will have a good year in 2012, and what's more, you don't want to lose him to a competitor. So, on your 1 to 5 scale with 5 being the best, you grade Larry as a 3.5. You tell him that he is being rewarded for a prolonged period of high performance, but that he needs to step it up in 2012.

Moe has always been your man in the middle. He's been a consistent performer, always meeting goals, but rarely exceeding them. But, Moe has those intangibles. They are not in his goals, but you just have to reward him because he makes everyone around him better. In 2011, Moe exactly met his goals, but because of that special something, you gave him a rating of 3.5.

Curly has been your problem child. Each year, he has been the laggard of the three, but you have kept him around both because the team has been meeting its goals (due mostly to Larry) and because of his wonderful sense of humor. Curly keeps you laughing and he is just so likable. Finally, for the first time, in 2011, Curly beat his goals. You gave him a rating of 3.5

Let's look at what happened. Your team exactly met its goals. Yet, you awarded each team member with a rating that gets them a bonus of 125% of target. Hmm?

And, then in another year, business was really good. You find out that the bonus pool is going to be really big. Curly had another very good year. You give him a rating of 4.5. Moe had a better year than Curly, and you know that somehow, Moe also contributed to Larry's success this year, so you give him a 4.9. But, Larry, oh Larry, had the year of a lifetime. If Moe got a 4.9, there is no rating that does Larry's year justice, so you take it up the line to get Larry a bonus of 3 times target. And, because business was so good, it gets approved.

But, the next year, the economy goes into the tank. Nobody meets their goals, and in fact, the company lost money. It would like to have a negative bonus pool, but that can't happen. And, all of your employees tried really hard, so you want to give them something. You beg to your superiors just as every manager is doing, but where will the money come from?

As time went by, companies survived this strange concept where everyone got a bigger bonus than they really deserved. So, it became accepted that there was really no upside limit to bonuses, at least not for the top producers.

But, I digress for a brief commercial. If you haven't read Michael Lewis's book, The Big Short, then you should. To a large extent, it shows how having no upside limits to incentive payouts encourages absolutely ridiculous risk-taking. Without giving away the whole book, people were making and taking 12-figure risks on bets that they didn't understand. Hmm?

And, they were being rewarded for it. People who had budgeted incentive payouts in the range of several hundred thousand dollars were suddenly getting 8-figure payouts. They were betting on these wonderful instruments known as credit default swaps, and most of them were taking what turned out to be the wrong side of the bet. But, the risk management people didn't understand them either. In fact, very few people did.

So, now we are really in 2011, very close to the end of it, in fact. Managers with explicit incentive compensation plans will be facing the same issues all over again. Far more visibly, Compensation Committees will be facing the same issues all over again.

Let's peek in at a deliberation as the Compensation Committee decides how much of an incentive payout to give to CEO Lou Abbott and CFO Bud Costello. The company didn't have a great year, but neither did any of their competitors. And, Abbott and Costello, everyone knows, are legends in the industry. We really can't afford to lose either one of them. Last year wasn't too good either. We really can't risk losing them over a bad incentive payout. Let's give them something extra this year and we'll go harsher on them the next time their scheduled payout would be huge. [Hopefully, this behavior isn't occurring in any real Compensation Committees, but you never know.]

Do you think the Compensation Committee will remember?

So, here's the deal. In a bad year, bonuses in total may be more than the company can afford because they can't afford to pay out that little and risk losing people over it. In a mediocre year, bonuses in total may be more than the company can afford because everybody had something positive about their year. And, in a great year, the risk-takers won and they will get bonuses so big that the company will pay out more than it can afford.

And where is the Risk Management Department to ask who is managing the compensation risk?

How Much Should a CEO Be Paid?

That sure sounds like a simple question. It has no difficult words. It's not a compound question. It's the type that if an attorney asked a witness on cross-examination, there would be no objection as to form.

I've noticed the Occupy [Wall Street] movement and one of their major beefs is how much CEOs of US companies are being paid. On Facebook, I have seen a chart suggesting that US CEOs make on average 475 times as much as the median US worker (the data being used suggests that the median worker earns $33,840 per year) which suggests that the average CEO makes somewhere in the neighborhood of $15 to 16 million per year. That's a lot of money, but there are not a whole lot of CEOs that actually make that much. And, when the people who put together that chart did their homework, so to speak, they used compensation from proxy disclosures.

Executive compensation (and related topics) practitioners will know that this is not an apples to apples comparison. While many of the components of CEO pay do not apply to the median worker, note that CEO pay includes the value of retirement plans, for example, while median worker pay does not. Further, in the years where CEO pay, relative to the median worker is highest, this is significantly a function of prevailing interest rates on corporate high grade bonds. I'm not saying that this is the right way or the wrong way to do this, I'm just saying that this is the way it is.

But, we still haven't approached the answer of how much a CEO should be paid. So, I asked a few people who have been objecting quite strenuously to CEO compensation. They don't know either. But, the only answer that I got more than once was "less than 10 times what the average worker makes."

You know what. I know a few corporate CEOs (not real well, but in passing). And, not a single one of them would do their job if their pay was limited to less than 10 times what the average worker makes. A good CEO delivers value to a company. How much value? I don't know. Perhaps we will see as we watch Apple over the next couple of years in the post-Steve Jobs era.

Should a CEO earn more than 'talent'? In my opinion, generally a good CEO should earn more. They have larger responsibilities. While talent can swing earnings significantly for a segment of a business, the CEO sets the direction for the business.

So, I asked one of these people who thought that CEOs should less than 10 times what the average worker makes how much they thought that talent should make. I asked them if Lady Gaga should have made upwards of $50 million in 2010. They answered probably not. PROBABLY not! That means that there is a chance that she should earn that much, but the person who is responsible for having a recording contract shouldn't earn more than about $340,000. How about Peyton Manning. I think his football earnings for 2011 are between $10 and 20 million. Add that to his endorsement earnings and he is pretty well compensated. Is he earning that much in 2011? Does he deserve it? He's had a pretty good career, far better than most, but if he were a CEO in 2011, his compensation would be hit a lot more by his inability to do his job this year.

I know. CEOs don't get career-limiting injuries. But, in any case, it's a tough comparison to make. I don't know how much a good CEO or a bad CEO should make, but neither do the protesters. Perhaps, though, they should get a few facts straight before they present them.