Executive pay and excessive risk

Jun 05 2009 by Nic Paton Print This Article

Here's a surprise. The assumption that top bankers, executives and business leaders brought the world economy to its knees because their pay and remuneration structures encouraged excessive risk-taking may not actually be right.

In fact, many elements of the executive pay models put in place by corporations on both sides of the Atlantic discouraged excessive risk taking, a new analysis has suggested.

The investigation by consultancy Watson Wyatt has concluded that the relationship between risk and executive pay and remuneration may be more subtle, and complex, than previously thought.

With legislators still under intense pressure from public opinion to reform pay programmes to reduce excessive corporate risk taking, its conclusions raise the question of whether too much regulation and reform could either stifle future growth or, even more worrying, simply make matters worse.

"Many believe that executive pay played a substantial role in the financial crisis by encouraging excessive risk taking. As a result, public support has swelled for reforming and regulating the basic executive pay model," said Ira Kay, global director of executive compensation at Watson Wyatt.

"However, traditional methods for evaluating executive compensation risk do not accurately gauge the true relationship between risk and pay," she added.

The consultancy evaluated the executive compensation architecture at more than 1,000 firms and identified which elements of the executive pay programmes encouraged or discouraged corporate risk taking.

Its conclusion, surprisingly, was that many of these elements contradicted widely held beliefs, including the common critique that high incentive levels encouraged reckless risk taking.

Similarly, it questioned the conventional wisdom that higher amounts of annual bonuses, long-term incentives and stock options encouraged excessive risk taking.

In fact, the analysis found that these actually incentives could encourage executives to take less risk.

For example, high levels of stock ownership were associated with reduced risk while excessively high levels of pay opportunity encouraged taking more risk, it argued.

"Finding a way to assess risk taking will have a significant impact on the next generation of executive pay plans," said Kay.

"Ultimately, the companies that find the sweet spot between executive pay for performance and rewarding proper risk management will be better positioned to reward and motivate executives while delivering higher long-term shareholder returns," she added.

The difficulty for many management teams, as Andrew Pettigrew, professor of strategy and organisation at Oxford University's SaÔd Business School, discussed on Management-Issues last month is that they are completely having to adjust their thinking around risk after a decade of boom, while at the same time having to navigate the recession at a practical level.

Similarly, there is a question of whether such a thoughtful and nuanced analysis as Watson Wyatt's will hold any truck with a general public still deeply angry over the contribution of business and finance leaders to the downturn.

Watson Wyatt, for example, in March pointed out that there had been a sharp increase in the number of firms acting to freeze salaries, slash bonuses and implement claw-back policies on executive pay programmes, as much in response to public anger as a practical reaction to the recession.

What's more, in the current climate companies have to be keenly aware of even the slightest any whiff of pay excess in the boardroom.

Just this week, for example, research from consultancy Manifest suggested that there had been precious little sign of pay restraint among Britain's top 100 business leaders and executives in the past year, against a backdrop of growing disquiet among shareholders at firms such as Shell and Lloyds TSB over their pay plans.