Friday, January 8, 2010

Risky Business - More Than Just a Tom Cruise Movie

It seems that every new proxy season brings with it a renewed focus on compensation issues, and more specifically, executive compensation issues. Last year the focus was on the connection between pay and performance, with the Securities and Exchange Commission (SEC) sending out comment letters to public companies demanding more disclosure on performance metrics. This year, with the financial services industry in a tailspin (along with the rest of the economy), the focus has turned to the risk on a company's long term viability and success brought on by compensation practices, policies and programs. 

The new rules for public company proxy disclosures emphasize this increased attention to risk through requirements that all compensation programs be reviewed for risk.  The review applies not just to executive officer programs, but to all compensation programs. Any compensation programs which may be “reasonably likely to have a material adverse effect” on the ongoing viability of an organization must be disclosed and discussed in the proxy. In addition, the FDIC may be considering imposing higher premiums for deposit insurance upon those financial institutions who engage in risky compensation practices.

In anticipation of the need for organization's to assess compensation risk, a number of consulting and legal firms have presented issues to consider and approaches to take when conducting a compensation risk analysis. I expect that we will continue to see more of these discussions in the coming weeks. Unfortunately, as many of these advisors note, a risk analysis is not a "one size fits all" proposition.

Each organization will have unique characteristics to consider when reviewing its programs to determine which, if any, present the risk of a material adverse effect on the viability of their company. To complicate matters further, certain practices and policies, while not necessarily excessively risky on their own, may present a risk when reviewed within the context of other practices and policies currently in effect at the organization.

Although each risk analysis will be unique, I thought I would touch on some of the basic issues I believe an organization should consider when conducting such a review. I will break the issues down by focusing the discussion to each of the various compensation components, and then expanding the discussion to address compensation as a whole. The first of the compensation components is often considered the most simple and basic, base salary. As basic as it may be, there are definitely areas related to base salary programs that may place the organization at risk.

Base Salary
What is the primary purpose of base salary payments? In discussions with a number of clients the following items have been identified as the purpose of base salary payments:
  • to provide a guaranteed level of compensation
  • to attract and retain talent
  • to recognize the experience and education required for position
  • to recognize the importance of the position to the ongoing success of the organization
In consideration of these purposes, how does base salary present a risk to the organization and what should be examined with respect to base salary practices? The first concern is that base pay is a guaranteed level of compensation. Therefore, base pay does not vary with the performance of the organization, and is considered a "fixed" compensation expense (along with allowances, perquisites and other forms of non-variable compensation). It is important for a company to carefully monitor its fixed compensation expenses and ensure that these expenses stay within reason. Excessive fixed compensation expenses may present a material adverse effect and significant risk.

Note that the last three bullets presented above relate to the attraction, retention and recognition of employee talent. Base salaries, because of their guaranteed nature, are critical to employees. In the context of the current economy with corporations typically failing to achieve those goals set over the past year, base salary often becomes the total compensation package.

In volatile periods, employees focus on compensation they can trust will be delivered. As a result, comparisons of the competitiveness of base salary to market become more meaningful. Plans with below-market base salaries tempered by above market incentive components often lose their appeal to employees.

Employees in roles key to the success of an organization pose the greatest danger to long term organizational viability if base pay is poorly managed. Even in times when the job market is weak, employees with highly desirable and difficult to find skills may more easily find employment elsewhere. A couple of examples come to mind. Positions tied to loan recovery/workout and risk management in financial organizations have been highly recruited in the past year. The same may be said for guru development talent in a software firm, or high-level sales talent with proven track records. Despite the poor economy, employees with certain key talents and experience will be sought after. In some cases, it is the poor economy that drives the demand.

Mitigating Risks Linked to Base Salary
So in light of the recognition that base salary, despite being the most basic of compensation forms, still carries risk, what might you do to minimize your exposure? What processes or practices mitigate these risks and make them less likely to pose a material adverse effect to the organization?

With respect to the risk associated with the expense of base salary as a whole, an annual comparative assessment may be a worthwhile practice. A comparative analysis of base salary expense in terms of comparing levels to organizations similar to your own is useful in determining if base pay is excessive. One common metric is to examine payroll expense as a percentage of revenue. Of course this does not necessarily work for start-up organizations, or other pre-revenue companies. These sorts of organizations may want to examine average or median base salary per employee to see if an issue exists with respect to base pay compensation for the organization as a whole.

If base salary expense ratios run high or low compared to peers, it may point to a number of issues to consider before placing the blame on base pay levels. Companies need to review staffing and structure. Is the organization top heavy or perhaps too light in management staffing? Is each functional area, sales, finance, development, etc. appropriately staffed to meet the demands of the business and the strategic goals? If structure and staffing considerations fail to account for the discrepancy in salary expense, out of alignment base salary levels are a likely culprit.
Examining the total of base salary expense and making certain base pay expenses are within reason is only the first base pay risk consideration.  Losing key employees or finding your voluntary turnover rate to be high in comparison to other peer organizations is an indication that something may be amiss at the individual job/employee level. In a weak job market it would be quite surprising to see increases in voluntary turnover. 

To address the issue on a job-by-job basis, salary market benchmarking is in order. Conducting a formal base salary market analysis will identify employees with base salaries out of alignment with market and with your compensation philosophy. A formally defined salary structure, with pay ranges primarily based on market benchmarking is another useful tool to identify employees receiving base salaries out of alignment and non-competitive to market.

Such an analysis should be done in conjunction with an assessment of the job's internal worth to the organization. An internal worth assessment will assist with the identification of key roles in the organization. Once the job market recovers and salaries begin changing more rapidly, benchmarking for these key positions may need to be done semi-annually to ensure you maintain the market competitiveness of base salary levels. 

As noted earlier, base salary is just one piece of the compensation pie. In relation to executive employees and sales employees, it often is the smallest portion of the entire compensation package. Best practices in the management and administration of base pay go far in addressing and minimizing the risks associated with this form of compensation.

A more complex and risky aspect of compensation involves the design and implementation of incentive programs, both short-term and long-term. In my next post, I will discuss issues and concerns to consider with respect to short-term incentive plans (plans with an annual or shorter measurement and payout timeframe). Short-term incentive compensation programs due to the nature of their timing present a likely source of risk and therefore require thorough scrutiny when conducting a compensation risk analysis.

Contact CompWiser Consulting
CompWiser provides a complete suite of compensation consulting and related services, from a custom compensation risk analysis to salary benchmarketing and the creation of formal salary structures and administration policies. Visit for details.

CompWiser Consulting
San Francisco, CA

phone: 415.894.5556