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In light of recent headline-grabbing problems stemming from incentive risk, boards are being urged to ensure that compensation committee members are well versed in risk management. An engaged compensation committee should be involved in the decision-making process, and aware of pay plan elements. This is especially important as shareholder activists and proxy advisors are increasingly targeting comp committee directors at election time.
“Directors and compensation committee members have become subject to an increasing amount of external scrutiny, and as a result they are much more engaged in the process not only of determining what somebody’s base salary and incentive targets are, but in thinking carefully about the moving parts within the program,” says David Bixby, managing director at Pearl Meyer.
The SEC requires the compensation committee to perform a risk assessment of the company’s compensation program and then include a disclosure of material risk in the proxy. “The risk part of it is how do you drive the intended consequences without driving the unintended consequences,” Bixby says.
Compensation committees are also evaluating the design of their incentive plans to assess risk. Aggressive goals are an area that can raise red flags. While some stakeholders might favor aggressive incentive targets, those could be a driver for too much risk-taking in the short term. Consequently, comp committees should take the balance of pay plans into account in their risk assessment. “If you have an inordinate amount of compensation based on the short term, there’s the potential risk that management is going to focus only on increasing earnings in the current year, for example, and try to do everything to hit that number, potentially at the expense of long-term growth and success,” says Bixby.