Compensation arrangements are key mechanisms used in the effective management of any organization. These arrangements assist in attracting and retaining talent, fostering organizational behaviors and driving employee performance. Most commonly we see compensation arrangements that include bonuses based on overall company performance, department performance, and individual performance, paid out in cash or combined with stock options.
But we have seen that an ill-designed compensation arrangement can incentivize employees to take reckless risks that are out of step with the risk position that is best for the long-term health of the organization. Such arrangements can also encourage behaviors that lead employees to take risks that could dangerously exceed the capability of the organization to manage and control these risks.
In 2010, attempts were made to address this matter through the Dodd-Frank Wall Street Reform and Consumer Protection Act revisions. To further strengthen the reforms, the Federal Reserve issued their "Guidance on Sound Incentive Compensation Policies." The guidance aims at ensuring incentive compensation at banking institutions does not encourage "imprudent risk-taking."
The three principles in this guidance are "incentive compensation should balance risk and reward and not encourage imprudent risk taking; risk management processes and internal controls should reinforce the support, development and maintenance of balanced incentive compensation arrangements; and incentive compensation programs should be supported by strong corporate governance."
Even though these guidelines were directed at our banking institutions, what about the rest of us? Can your organization clearly articulate the relationship between incentive programs and your company's desired risk position?
Increasingly, we are seeing new imperatives pushing our risk offices to play a bigger role in the design of incentive compensation arrangements. Our risk offices should be able to offer independent assurance and to help implement more disciplined approaches to improve the efficacy of risk management, control and governance processes around compensation programs.
That is good news. An expanded role for the risk management function in compensation can address the risk of "imprudent risk-taking" by employees.
But what about the incentive compensation for members of the risk office? Can an incentive compensation plan and potential for stock ownership compromise a risk team's objectivity around employee risk taking?
If so, how do we structure compensation for risk teams in order to avoid the potential result of the "fox guarding the henhouse," yet at the same time motivate and reward the performance of our risk management team in such a way that they don't feel short-changed or disconnected.
I feel it is best not to further tempt fate. It is best to endorse the importance of the risk team's work and independence by creating a separate and distinct incentive compensation structure for them.
JOANNA MAKOMASKI is a specialist in innovative enterprise risk management methods and implementation techniques. She can be reached at firstname.lastname@example.org.
April 13, 2012
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