Practical definition: Excessive risk

Posted by Marc Hodak on July 29, 2009 under Executive compensation, Practical definitions, Reporting on pay | Read the First Comment

Congress is trying the belt and suspenders approach to keep the market from having another meltdown as we experienced last year.  The belt is tighter controls at TBTF firms.  The suspenders are the elimination of perverse incentives.

The thing is, if you want to eliminate perverse incentives, you have to know what they look like.  According to an Equilar survey, here are some of the questions that companies are considering as they examine issues of excessive risk:

• Are we over using stock options?
• Do our incentive plans promote short-term thinking?
• Do we have the right mix between short and long-term goals?
• Do large maximum bonus opportunities promote risk taking?
• Are we using overly aggressive performance goals?
• Do our bonus plans focus on too narrow a set of goals?
• Do we have the right mix between fixed and variable compensation?

Six of these questions are sensible.  One sticks out as completely bizarre to an incentive expert:  “Do large maximum bonus opportunities promote risk taking?”

Of course they do.  Is that supposed to be a bad thing?  Entrepreneurs have unlimited bonus opportunities–thank goodness.

The question of a maximum bonus opportunity is simply the wrong question when talking about reward systems.  The question they should be asking is whether steep bonus opportunities are combined with zero bonus opportunities.  All the governance risk faced by a company is in the area where the participant would earn no bonuses unless they can get up into the green zone of bonus payouts with an all-or-nothing, double-down, longshot bet.

So, guess which of those questions most congressmen view as the most critical in determining “excessive compensation risk?”  Yep, the risk that business executives might get paid too much.

Unfortunately, the reporting on the proposed regulation of compensation risk doesn’t even bother to define what “excessive risk” means at all, instead focusing on the political considerations of supporting or opposing any bill that purports to “contain” the excesses.