Comp Collapse

November 7, 2008
Who is to blame for the collapse of Wall Street icons like Lehman Brothers and Merrill Lynch? Is there a common denominator in the simultaneous fall of these icons, along with countless other banks, insurance firms and mortgage brokers?

    These are questions everyone is asking, but few in HR seem to be taking responsibility. Everyone agrees that one of the primary causes was excessive risk taking. Mortgage brokers and banks sold loans to extremely high-risk individuals and then packaged those debts into insanely complex derivative products that were bought and sold with little consideration of the risky foundation on which the products were based.

    You can blame the lack of government oversight, but a lack of regulation doesn't force risk taking; it only allows it. The blame should fall solely on the firms that engaged in such behavior. So the key question should be: What incentives drove such risk taking inside the firms themselves? Obviously executive expectations played a role, but the compensation function also needs to be looked at when assessing the blame. Several errors and omissions by the compensation function played a major role in the excessive risk taking by loan officers and the buyers and sellers of mortgage derivatives:

    Excessive rewards: If you look at a list of failed firms, from Enron to Bear Stearns to Lehman Brothers, you'll find a consistent pattern of paying out what can only be described as huge bonuses. Obviously, rewards for performance are a good thing unless the amounts offered become so staggering that people lose their sense of ethics and are driven to exceed reasonable limits on risk. Whose job is it, in conjunction with management, to create pay-for-performance plans? The compensation function, of course.

    Compensation design failed to forecast the desired level of risk taking: Compensation focuses on pay and rewards but seldom ties either to risk models. Compensation professionals need to assume partial ownership of risk (along with the controller), because just as compensation can drive desired behavior, when misaligned or unthrottled it can also drive disastrous behavior. Whenever incentive or bonus plans are drafted, it's critical that the design process evaluate and forecast what level of risk taking will be rewarded by the plans so that senior managers can be informed and held accountable for approving them.

    No penalties for failure: Compensation schemes routinely offer rewards, but rarely do they leverage penalties or punishments to drive desired actions. Employees should receive rewards for exemplifying the correct behaviors, but should also be penalized for bad behaviors (excessive short- and long-term risk taking in this case). In addition, employees should be rewarded for reporting excesses when noticed.

    No feedback loop after implementation: When compensation professionals set pay and incentives, they traditionally ``drop them over the wall'' for managers to implement, with little concern for what happens afterward. As a corporate function, compensation has a fiduciary responsibility to monitor and adjust rules, policies or rewards to prevent critical incidents. The compensation function needs processes to warn managers when negative behaviors and risks point to a high probability of error.

    A short-term perspective: The perspective of the compensation department rarely extends beyond the current year, which is a problem. Many business activities require execution cycles lasting longer than a year and carry with them repercussions that can extend for decades. CEO compensation packages are a prime example: Many of them give executives ample reward for taking excessive risks to increase top-line growth or stock price. To be more strategic, compensation professionals must learn to directly measure the impact of job activities over a multiyear period and create incentives for desired behaviors throughout that life cycle.

    No skin in the game: Unfortunately, compensation managers fail to tie their own budget, pay and bonus criteria to the long-term performance results of the compensation department.

    The lesson to be learned is that with rewards, just as with ice cream, too much of a good thing isn't a good thing. When the post-mortem on this financial disaster is complete, don't be surprised when one finger is pointed at the compensation function. I hope that compensation professionals don't need to wait until that day to realize their true role and take ownership of the impact of their decisions.

Workforce Management, November 3, 2008, p. 50 -- Subscribe Now!