Compensation Risk Assessments -- What is Compensation Risk?

Prior to Dodd-Frank, the SEC published a final rule on Compensation Risk Assessments. Among other things, this rule requires that registrants make new or revised disclosures (in their proxies) about compensation policies and practices that present material risks to the company. To date, most companies have either ignored this requirement or given it short shrift. Perhaps that is a natural response to neither internal nor external compensation practitioners customarily dealing with risk and risk assessments.

Unlike many other proxy requirement related to compensation, this one in Item 402(s) is not restricted to executive compensation. Rule 402(s) asks companies to look at all of their compensation practices to determine what material risks are presented to the company. As a shareholder, I have yet to see a proxy that complies with the spirit of the rule.

What is compensation risk? Sadly, nobody seems to know. But, since I am writing here, I will take my shot at it. A compensation risk exists when a company's programs and policies are such that compensation could call fall significantly out of line with the company's earnings or with the company's ability to pay compensation as suggested by those policies and programs. This could occur when incentive payouts are keyed to too many subjective or non-financial measures. This could occur when a company has results that are particularly volatile year after year and as a result, long-term incentive payouts are more reflective of past years' performance than that in the most recent year.

Unfortunately, that seems to happen fairly frequently. And, as a result, I think that companies should take this compensation risk assessment more seriously. A benefit of doing so would be that their compensation programs would be less likely to present material risks.

You knew this would be the case, but I have some thoughts on the matter. If implemented, my thoughts might help companies to decrease these risks. They're not perfect -- nothing is -- but, here are a few.

Weight/Age the Years in Long-Term Incentive Plans

In a typical long-term incentive plan, an executive is rewarded for performance over an extended period of time (three years is not atypical). So, to use Total Shareholder Return (TSR) as an example, an executive would be rewarded at (or close to) the end of 2015 for his or her company's TSR over the period from the beginning of 2013 to the end of 2015. That's fine, but frankly, by the end of 2015, who cares all that much about 2013 TSR? Many shareholders will not have been shareholders in 2013.

Suppose instead, 2013 TSR was given a weighting of 0.5, 2014 TSR was given a weighting of 1.0, and 2015 TSR was given a weighting of 1.5. Rather than taking an arithmetical (or geometric) average, we would use a weighted (for aging) average.

It makes a lot of sense, doesn't it? It rewards long-term performance and it should, but it puts a bit more weight on what you've done for me lately. And, the great part about it is that each year over the 3-year period gets the same total weighting that it does right now, but it stops the executive team from resting on its laurels from a great 2013.

Discretionary Profit-Sharing Tied to Corporate Performance has Merit

Way back when, profit sharing plans were tied to profits. Gee, that sounds revolutionary doesn't it? If the company made a lot of money, it distributed more of it through its profit sharing plan. If it made less, it distributed less, and if there were no profits, it distributed none at all. Then, the good folks in the Treasury Department informed us that you don't need to have profits in order to share profits.

Say what?

Perhaps I am missing something here, but it makes sense to tie some elements of compensation, even at the lower-paid levels of the company, to corporate performance. It gives everyone a stake in how the company is doing. It's similar in the way that it motivates employees to an ESOP and according to the Employee Ownership Foundation, an ESOP advocacy group, companies that have ESOPs perform better. But, profit-sharing plans are, from my viewpoint, more compliance friendly and flexible than ESOPs.

Extend it to Unions

Labor unions will tell you that unionized companies perform better than those with non-union companies. They will also tell you that those with mandatory (for specific job categories) union membership perform better than those where it is optional or right to work.

Make the unions make the company perform better. Let the unions share in the success of the company, or the lack of success if that's the case. In other words, tie the rewards of the union and its members to the corporate performance. If the company does well, presumably the union had something to do with it. If the company does poorly, it's tough for the union to sit in the corner and say that the poor performance occurred despite the exemplary work of union employees.

Frankly, if the union says this is not the case, then all of its other words are just rhetoric. You're not a contributor to results in only the good years; you influence them in the bad years as well.

Measure the Risk

Companies and their shareholders really should understand their compensation risks. This may sound strange to some, but if the team currently considering these risks is not trained and educated in risk assessment, then find someone who is.

I'm biased in this regard, but since actuaries are trained in risk assessment and risk management and understand compensation and benefit programs, nobody may be better positioned to assist you with this. Ask an actuary.

Where Did We Go Awry With the 401(k)?

Section 401(k) was added to the Internal Revenue Code by the Revenue Act of 1978. It was such a significant part of that act that when I went to www.congress.gov to read the act summary, there was no mention of this new deferral opportunity. It was tossed into the legislation with little fanfare.

Why was that?

401(k) plans were never intended to be the primary retirement vehicle for the masses. In 1978, after the passage of the relatively new landmark law known as ERISA, defined benefit plans (DB) were all the rage and those companies that had chosen not to take the DB route frequently offered profit sharing plans, money purchase plans, or ESOPs, or because of the special tax treatment that they were given at the time, tax credit ESOPs, known back then as TRASOPs (bonus points for anyone who recalled TRASOPs before reading this).

Those were core retirement plans. Combined with Social Security, they were designed to be two legs of the so-called three-legged stool needed for retirement. The third leg was personal savings and the 401(k) plan was supposed to give people a more tax-efficient way to grow that third leg. Read that again; 401(k) plans were designed as savings plans, not as [core] retirement plans.

Somewhere, things went awry. I have written about this many times and blamed virtually everyone who had a voice. As our government and regulators made it more and more cumbersome to sponsor traditional retirement plans and the US economy took several turns for the worse, companies became less comfortable as sponsors of traditional retirement plans. They often placed the blame anywhere that they could. In fact, they placed it everywhere except where it belonged:

• Employees didn't appreciate the other plans (it turned out that the people who didn't have them sure thought their friends who had them had a good deal)
• They could be more competitive without them (don't you get higher productivity and better products and services from happy employees)
• The 401(k) would be enough (of course many of those same companies retained their executive retirement plans)

Now, in a workforce fraught with high turnover, low morale, and lots of part-time jobs, many of us expect employees to save for their own retirement. Projections done by proponents of those plans show that those who do will have a wonderful retirement. Those projections tend to leave out all of these complications:

• You can't defer when you are laid off and most of us seem to face one or more layoffs in our careers these days
• You will have periods in your career when you go through one hardship or another and can't afford to make the deferral you would like
• If you do have a hardship and have to pull money out, those penalties are severe
• You absolutely will not get the 7%-9% annual return on investment, net of expenses, that many of those projections would "promise"

But, companies persist in the belief that the 401(k) is the retirement plan of choice. Potential employees ask about the company's "401 plan." In the meantime, some people retire very early and many will be retiring well after the traditional retirement zone of ages 62 through 65 has passed them by. 

Isn't it time to bring back retirement plans and have more than just savings plans? Any of them can be designed today with the proper administration to show employees their account balance as of that day any day that they choose to look.

You can be an employer of choice.