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Jesuthasan: 'Deleveraging Pay-The Proof is in the Bathwater'

One major bank's recent announcement that it will boost base pay while reducing bonus opportunities for certain employees spawned headlines around the globe, and with good reason.

Given that the clear trend among major companies (and financial services firms in particular) has been toward putting more pay at risk, the bank's move is a true “man bites dog” story.

It also illustrates how companies continue to struggle to strike the right balance between stability and opportunity in their compensation programs.

Over the past few decades, Towers Perrin’s compensation surveys have consistently found companies putting more emphasis on the latter, variable forms of compensation. This has accelerated in recent years as organizations look to contain fixed costs by limiting annual merit increases to 3-4% while aggressively increasing eligibility for bonuses along with opportunity levels.

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In the current economic environment, however, the balance may begin tilting back toward stability in compensation delivery. In fact, the economic crisis may be the high-water mark in the variable-pay movement because of changing employee and company perceptions of risk. In a series of surveys we conducted over the past year, we saw a noticeable flight to security in what employees value most in the reward package. As recently as last summer, things like challenging/interesting work and the opportunity to maximize earnings were high on the list of what people looked for in their employers. By December, a secure job and adequate benefit protection topped the list.

Companies also have been rethinking their emphasis on incentive pay since the financial meltdown. Critics of the financial industry have been quick to point to highly leveraged pay programs as a primary cause of the meltdown, claiming they promote excessively risky behavior by executives, traders, lenders and others.

The economic stimulus legislation requires companies receiving bailout funds to ensure that their pay programs don’t encourage excessive risk-taking, while an emphasis on risk management is a centerpiece of the Obama Administration’s recent proposal to regulate executive compensation more broadly.

So, perhaps the bank's move marks a tipping point in the evolution of corporate compensation, although it’s worth remembering that the bank's situation is somewhat unique. As a recipient of bailout money, it’s under tight new restrictions on the bonuses it can pay and faces a very real prospect of losing key talent to foreign banks and other institutions that remain free to offer uncapped incentive opportunities. And it’s also worth noting that while bigger salaries may help with employee retention, at least in the short run, high-performing employees tend to have a higher risk tolerance and will eventually look for bigger opportunities wherever they can find them.

Based on my experience as a compensation consultant for more than 15 years, I believe that variable compensation plays a critical role in the pay mix, and we shouldn't lose sight of its advantages. Putting a meaningful portion of pay at risk aligns the company’s cost structure with business performance and aligns employee behaviors with critical financial, customer and other objectives. In the current drive to de-risk companies’ pay programs, it would be unfortunate if we threw the baby out with the bathwater.

One can legitimately question whether it makes sense to pay a derivatives trader $30,000 in base salary and hold out a million-dollar bonus opportunity for selling a boatload of credit-default swaps. Yet, such an aggressive compensation structure may be perfectly appropriate if the company has effective risk controls, tolerances and safeguards in place to prevent reckless trades.

Risk is not the problem, but unmanaged risk is clearly a concern. Companies should spend more time understanding and managing the risks posed by their incentive compensation programs, rather than doing away with those programs to mitigate risk, whether it is for the employee or the organization.

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Ravin Jesuthasan is a managing principal in Towers Perrin’s executive compensation and rewards business.