Inside the Boardroom
As Consensus Forms on Pay,
What is Your “Pay Risk Profile”?
By David W. Anderson, PhD, ICD.D
The Anderson Governance Group
A consensus seems to be developing
in executive pay philosophy – one
on which investors, regulators and
politicians are acting. Is it the answer?
Are we asking the right questions?
General Context and
Consensus On Pay
Pay is a powerful tool to motivate behaviour, but the
wisdom to use this tool with precision is elusive. In
response to demands for higher and faster returns from
investors, directors incented executives with significant
equity positions. The risk of losing executive talent
outweighed the risk of overpaying for it – but the full
risk of overpaying was not appreciated and the risk of
underpaying was not tested.
Misaligned pay practices helped to precipitate the
current financial crisis. A portion of the reported (and
rewarded) gains, supported by leverage, was not real.
Capitalism in many countries is now being rescued
by government. To prevent such future calamity, pay
philosophy is converging on the idea that executive pay
should be largely stock-based, market performance-
contingent, and time-tested.
Thinking About Pay Within Your Specific
Context
Before adopting this pay philosophy, directors
should question its veracity and applicability to their
organization’s mission, circumstance and understanding
with stakeholders.
Fundamentally, pay is a question of fair exchange,
predicated on expectation and delivery. It is vitally
important to appreciate that pay – its philosophy,
means and execution – introduces its own risks and
thus has its own risk profile. Thus, pay decisions must be
approached with strategic purpose, clarity and insight
relevant to the organization.
“Pay risk” represents opportunity as well as danger. “Pay
risk” is the potential for a given pay plan or decision to
result in a range of positive and negative outcomes for the
organization, through its influence on human behaviour.
Every pay plan has its own “pay risk profile”. A board ought
to choose a “pay risk profile” consistent with the general
risk profile the board has set for the organization – and
make strategic pay decisions accordingly.
Pay can be made to reflect many things in the value
chain defining executive leadership and organizational
performance (e.g., attributes of the person, demand
characteristics of the role, actual and expected outcomes
in the short and long term). Directors should also be
aware how pay decisions can be influenced by the
negotiating dynamic itself (e.g., apparent equilibrium
of supply and demand, negotiating prowess, use of
intermediaries, uncertainty, fear, ignorance).
Questions Directors Should Ask When
Making Pay Decisions
Regarding pay philosophy: What is our “pay risk
profile”?
Does the board understand the risk its pay
philosophy is introducing? Is this risk consistent
with the organizational risk profile? What is the
rationale for the desired “pay risk profile”? What
kind of leader does the pay philosophy and “pay risk
profile” attract?
Regarding the amount of pay: How much pay is fair?
What are the perceptions of pay among
stakeholders? Does the board think the pay is fair?
Does it appear that the company fails to attract or
loses talent over pay?
Regarding the components of pay: What forms of
pay are best?
What should the pay deal include (e.g., cash, equity,
perquisites, pension)? What is the appropriate
proportion of salary vs. incentive pay? How does
organizational strategy influence the optimal form
of pay? What is the competitive practice? Does the
company require a greater use of equity because of
its own inherent risks (e.g., start up, turnaround)?
Issue 147 | December 2009 | 35
I n s i d e the Boardroom
Regarding performance contingency: Are the right
contingencies in place?
Is incentive pay contingent on the right outcomes,
over the right time frame? Should pay be tied to
stock price in any time frame? Does the time delay
required for long-term performance verification
break the contingency in executives’ minds? Which
activities can be measured annually that reliably
build for future success by strengthening the health
of the organization (e.g., fostering the right culture,
developing infrastructure)?
Regarding pay decisions: Who should decide
executive pay?
What pay decisions, if any, should the board
delegate to the compensation committee?
Should shareholders influence or control pay
decisions (do the board and shareholders
communicate effectively)?
Recommendations For Directors
Getting pay decisions right is one of the toughest
challenges for directors. Boards have conditioned
executives to expect rewards in good times and bad.
Inconsistency in the message hurts board credibility
when communicating pay philosophy and decisions.
Directors should form a coherent pay philosophy
and “pay risk profile”, with input from shareholders,
as the basis of pay negotiations and pay decisions.
Disclosure about pay should be consistent with this
pay philosophy, noting deviations with candour
and stating the implications for pay philosophy and
“pay risk profile”. Egregious pay practices should
end: guaranteed executive bonuses (which make a
mockery of the term and reinforce pay entitlement);
extra years of credit in pension calculations1 (an
explicit gaming to achieve a desired pay outcome
in retirement, when no performance contingency
can exist); gross-ups to cover tax bills (an affront to
all taxpayers).
Some boards face the reality that many executives
now expect a certain level of pay. The high salience
(or motivating power) of reward can create its own
momentum, driving executive behaviour toward
the reward itself, without regard to the underlying
performance that was meant to produce the reward.
Boards must wrestle with this psychological reality as
they wean such executives from this expectation.
1 Other than to replace lost pension of a new hire.
36 | Institute of Corporate Directors
Directors should avoid the risk of paying too much.
Directors must choose carefully the type of reward
and its salience so as to guide behaviour but not
blind executives to the underlying performance
expectation in pursuit of the reward. This reduces
the risk that greater reward salience will be required
to command future attention, and the risk of
value destruction caused by executives’ loss of
perspective. Directors should screen executives
for susceptibility to this phenomenon, to avoid
selecting the wrong type of people into these
sensitive roles.
The consensus in pay philosophy emphasizes stock
awards to executives whose organizations demonstrate
long-term, sustained increases in share value. This
approach attempts to directly counter the excessive
payouts based on short-term stock appreciation not
associated with sustainable business growth.
Directors should be wary of introducing new pay risks,
despite this seemingly “pure” philosophy of aligning
executive and investor interests. The length of this
new contingency may be too long to offer meaningful
feedback to executives and may fail to provide the
board with levers of power to influence executive
behaviour in the short term. Pay should not be tied
to share price, as it is affected by variables beyond
executive control (especially as time elapses), but
rather to activities directly under executive control.
The board should focus attention on those activities
that reliably lead to long-term organizational health
and performance. Such activities can be monitored
annually and thus specified and incented under the
purview of the board and through direct engagement
with executives.
On a regular basis, each board must evaluate for
itself whether its pay philosophy, execution of such
and results achieved reflect its values and needs.
This includes revisiting the “pay risk profile”, testing
in advance possible outcomes of pay decisions and
looking back to assess the efficacy of those decisions to
refine the pay philosophy and “pay risk profile”.
David Anderson is the President of The Anderson
Governance Group (www.taggra.com).
He can be reached at (416) 815-1212 and
david.anderson@taggra.com