The financial crisis of over a decade ago drastically increased the focus on risk in the design and administration of incentive programs. While pay for performance is the objective of all incentive programs, there are also potential negative consequences if incentives motivate behavior exposing the company to excessive risk. The Center’s checklist for Compensation Committees on risk in incentives outlines how to assess incentive programs to ensure they do not encourage risky behavior, but there is also a significant external component to risk.
As a complement to the Checklist for Risk in Incentives, the Center’s Charlie Tharp has authored a checklist on assessing risk and incentives from a multi-stakeholder perspective. This checklist encourages companies to go beyond a review of financial materiality in assessing risk in incentives and engage in a broader assessment assessing issues such as reputational, political and organizational risk from ill-designed incentive arrangements.
The checklist focuses on five areas of potential risk:
- Financial Risk, including restatements and financial penalties;
- Operational Risk, such as manufacturing quality or safety;
- Reputational Risk as the result of harm to the company from behaviors motivated by poorly designed incentive arrangements;
- Political Risk, including financial penalties, debarment and ongoing legislative and regulatory scrutiny; and
- Organizational Risk, including the impact of company culture, reinforced by incentives, in encouraging detrimental behavior toward employees who raise legitimate concerns about management behavior.
The checklist makes several recommendations for implementing a multi-stakeholder approach, including integrating a broader discussion of risk into business reviews, having the compensation function involve key functional leaders throughout the company, and the involvement of external advisors in ongoing assessments.