Incorporating Risk into Executive Compensation

In the last few years, companies have faced multiple unprecedented, once in a generation risk events, including the global pandemic and its related supply chain, talent, and inflation crises, social unrest, and now, the first major European war in more than two decades.  Now, more than ever, management and boards should prioritize risk planning, including considering factoring it into executive compensation design.

Risk adaptation, risk scoring, and risk measurement are the three essential aspects of risk management when it comes to executive compensation, according to a new article from Willis Towers Watson. The report’s suggestions include:

• Risk Adaptation. Companies can nimbly adapt to new and changing risk events through adjustments to payout curves in accordance with assessed potential impact. For example, payout curve upsides and downsides can be flattened or steepened depending on the potential impact of specific risk events. Companies can design “current state” payout curves that are Board-approved, while also retaining alternative “high risk” curves that can be implemented upon the occurrence of a major risk event.
    
• Risk Scoring. Boards can score company leadership on risk management results in ways that factor in the degree of risk difficulty over given periods. For example, in a year with major risk events, an earned payout could be adjusted up or down based on added challenges and how quickly, effectively, and creatively management responded to those challenges.
    
• Risk Measurement. Companies can quantify their overall risk level and incorporate that measurement into executive incentive plans. Such measurements can be included in long-term incentive plans, as risk levels typical change more slowly over time, and should also be a payout modifier that impacts earned payouts if the company takes on too much risk, or does not take on enough.

Overall, incenting better risk management through pay is an underdeveloped area that we may see get traction, especially given current events.