Unintended Consequences

The executive compensation reforms being floated today often contain an unspoken caveat: “all else being equal”. The next time you hear or read of a new fangled approach to compensation design, bear in mind that the alleged advantages of the new approach may only exist if all else is, in fact, equal. Odds are, of course, that they are not. In the U.S., two of the main directional changes being advanced by pay activists are (1) increase executives’ down-side risk (e.g., through escrows of bonuses, clawbacks, hold until retirement, etc) and (2) more careful consideration of the unexpected consequences of compensation strategy on business risk taking. I think it is also important to consider the unexpected consequences of changes in compensation strategy, such as increases in down-side risk, because it is highly unlikely that any such change can be made holding all else equal.

A good example of this is being played out in the British financial sector. The UK financial industry has been working on ways to enforce a longer-term focus on bankers. The notion there (as here) is that bankers did not care about the ramifications of their business decisions because bonuses were based on annual performance, rather than their firms’ longer-term performance. On that assumption, the industry and its regulators are thinking about reforms that would result in bankers’ pay being at risk for much longer periods of time. The leading reform is the escrowing of bonuses coupled with clawback provisions. (Exactly the same proposals are being made here, both in the financial sector and elsewhere.) But the additional hurdles to keeping a bonus do not reduce the fundamental desirability of that individual to competitors. It just increases the cost of hiring the individual away. This has raised the specter of more widespread and more valuable sign-on bonuses (i.e., new employers will have to make new employees whole for any escrowed bonuses that are forfeited). These guaranteed bonuses have been a favorite target of the British press and regulators, and encouraging them would be a PR disaster. Fixing one problem creates another.

To try to split that knot, an industry group has stepped forward and proposed that escrowed bonuses not be forfeited on departure, though they would still be subject to clawback for performance reasons. So, departing bankers would not lose their escrowed bonuses and hence no need for sign-on guarantees. All else being equal that might well work, but of course, all else is not equal. As the British newspaper, The Times, reports, the proposed solution doesn’t necessarily solve the problem at all as it leaves departed employees (now working for competitors) in the difficult position of leaving large sums of personal wealth behind in the control of their old firm, which creates obvious conflicts of interest. Not to mention that the contractual provisions necessary to put such an arrangement in place would be, as the paper puts it, “hellish”. (The article can be found at: http://business.timesonline.co.uk/tol/business/columnists/article6801247.ece)

Consider also one of the more aggressive proposals that has been advanced here in the U.S.--“hold past retirement”. Under this approach, executives would not receive cash or equity incentives until some fixed period of time, say two years, after they departed, subject to clawbacks. The advantage of the approach is that the executive is arguably prohibited from capitalizing on short-term gains (e.g., bonuses that are paid before losses are noticed; exercising stock options and selling the acquired stock at a momentary high in the stock price) and thereby increases focus on the long-term. So far, so good. But consider, among other disadvantages, what such a structure looks like from the executive’s standpoint. First, it looks like a significant pay cut, one that may be enough to trigger severance rights. Second, it subjects the executive’s earned compensation to the risks generated by his or her replacement and the rest of the executive team during the waiting period, which could be viewed as unfair and contrary to the pay for performance model. The most likely outcome is that other aspects of the compensation program would need to be modified as well; perhaps, an increase in base salary to offset the diminished value of incentive pay. But of course, those changes have their own repercussions (e.g., increasing base salary may increase target bonuses, pension benefits and severance), including on the relationship between incentives and business risk-taking. And on and on….

Bottom line is that each of the elements in a compensation program must fit together, and changing one has consequences for the others. Before taking the leap and adopting any of the latest panaceas, give careful thought to the side effects.