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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 organization, through its influence on human behaviour.


in executive pay philosophy – one Every pay plan has its own “pay risk profile”. A board ought
on which investors, regulators and to choose a “pay risk profile” consistent with the general
politicians are acting. Is it the answer? risk profile the board has set for the organization – and
Are we asking the right questions? make strategic pay decisions accordingly.

General Context and Pay can be made to reflect many things in the value
Consensus On Pay chain defining executive leadership and organizational
Pay is a powerful tool to motivate behaviour, but the performance (e.g., attributes of the person, demand
wisdom to use this tool with precision is elusive. In characteristics of the role, actual and expected outcomes
response to demands for higher and faster returns from in the short and long term). Directors should also be
investors, directors incented executives with significant aware how pay decisions can be influenced by the
equity positions. The risk of losing executive talent negotiating dynamic itself (e.g., apparent equilibrium
outweighed the risk of overpaying for it – but the full of supply and demand, negotiating prowess, use of
risk of overpaying was not appreciated and the risk of intermediaries, uncertainty, fear, ignorance).
underpaying was not tested.
Questions Directors Should Ask When
Misaligned pay practices helped to precipitate the Making Pay Decisions
current financial crisis. A portion of the reported (and
rewarded) gains, supported by leverage, was not real. Regarding pay philosophy: What is our “pay risk
Capitalism in many countries is now being rescued profile”?
by government. To prevent such future calamity, pay Does the board understand the risk its pay
philosophy is converging on the idea that executive pay philosophy is introducing? Is this risk consistent
should be largely stock-based, market performance- with the organizational risk profile? What is the
contingent, and time-tested. rationale for the desired “pay risk profile”? What
kind of leader does the pay philosophy and “pay risk
Thinking About Pay Within Your Specific profile” attract?
Context
Before adopting this pay philosophy, directors Regarding the amount of pay: How much pay is fair?
should question its veracity and applicability to their What are the perceptions of pay among
organization’s mission, circumstance and understanding stakeholders? Does the board think the pay is fair?
with stakeholders. Does it appear that the company fails to attract or
loses talent over pay?
Fundamentally, pay is a question of fair exchange,
predicated on expectation and delivery. It is vitally Regarding the components of pay: What forms of
important to appreciate that pay – its philosophy, pay are best?
means and execution – introduces its own risks and What should the pay deal include (e.g., cash, equity,
thus has its own risk profile. Thus, pay decisions must be perquisites, pension)? What is the appropriate
approached with strategic purpose, clarity and insight proportion of salary vs. incentive pay? How does
relevant to the organization. organizational strategy influence the optimal form
of pay? What is the competitive practice? Does the
“Pay risk” represents opportunity as well as danger. “Pay company require a greater use of equity because of
risk” is the potential for a given pay plan or decision to its own inherent risks (e.g., start up, turnaround)?
result in a range of positive and negative outcomes for the

Issue 147 | December 2009 | 35


I n s i d e the Boardroom

Regarding performance contingency: Are the right Directors should avoid the risk of paying too much.
contingencies in place? Directors must choose carefully the type of reward
Is incentive pay contingent on the right outcomes, and its salience so as to guide behaviour but not
over the right time frame? Should pay be tied to blind executives to the underlying performance
stock price in any time frame? Does the time delay expectation in pursuit of the reward. This reduces
required for long-term performance verification the risk that greater reward salience will be required
break the contingency in executives’ minds? Which to command future attention, and the risk of
activities can be measured annually that reliably value destruction caused by executives’ loss of
build for future success by strengthening the health perspective. Directors should screen executives
of the organization (e.g., fostering the right culture, for susceptibility to this phenomenon, to avoid
developing infrastructure)? selecting the wrong type of people into these
sensitive roles.
Regarding pay decisions: Who should decide
executive pay? The consensus in pay philosophy emphasizes stock
What pay decisions, if any, should the board awards to executives whose organizations demonstrate
delegate to the compensation committee? long-term, sustained increases in share value. This
Should shareholders influence or control pay approach attempts to directly counter the excessive
decisions (do the board and shareholders payouts based on short-term stock appreciation not
communicate effectively)? associated with sustainable business growth.

Recommendations For Directors Directors should be wary of introducing new pay risks,
Getting pay decisions right is one of the toughest despite this seemingly “pure” philosophy of aligning
challenges for directors. Boards have conditioned executive and investor interests. The length of this
executives to expect rewards in good times and bad. new contingency may be too long to offer meaningful
Inconsistency in the message hurts board credibility feedback to executives and may fail to provide the
when communicating pay philosophy and decisions. board with levers of power to influence executive
behaviour in the short term. Pay should not be tied
Directors should form a coherent pay philosophy to share price, as it is affected by variables beyond
and “pay risk profile”, with input from shareholders, executive control (especially as time elapses), but
as the basis of pay negotiations and pay decisions. rather to activities directly under executive control.
Disclosure about pay should be consistent with this The board should focus attention on those activities
pay philosophy, noting deviations with candour that reliably lead to long-term organizational health
and stating the implications for pay philosophy and and performance. Such activities can be monitored
“pay risk profile”. Egregious pay practices should annually and thus specified and incented under the
end: guaranteed executive bonuses (which make a purview of the board and through direct engagement
mockery of the term and reinforce pay entitlement); with executives.
extra years of credit in pension calculations1 (an
explicit gaming to achieve a desired pay outcome On a regular basis, each board must evaluate for
in retirement, when no performance contingency itself whether its pay philosophy, execution of such
can exist); gross-ups to cover tax bills (an affront to and results achieved reflect its values and needs.
all taxpayers). This includes revisiting the “pay risk profile”, testing
in advance possible outcomes of pay decisions and
Some boards face the reality that many executives looking back to assess the efficacy of those decisions to
now expect a certain level of pay. The high salience refine the pay philosophy and “pay risk profile”.
(or motivating power) of reward can create its own
momentum, driving executive behaviour toward David Anderson is the President of The Anderson
the reward itself, without regard to the underlying Governance Group (www.taggra.com).
performance that was meant to produce the reward. He can be reached at (416) 815-1212 and
Boards must wrestle with this psychological reality as david.anderson@taggra.com
they wean such executives from this expectation.
1 Other than to replace lost pension of a new hire.

36 | Institute of Corporate Directors