Matching long term incentives to long term risks sounds easy until you consider that long term risks can fester for decades whereas a typical long term incentive has run its course within a few years.
Banks have started to address the issue. Goldman Sachs requires top management to hold up to 75% of bonuses as share awards until they leave the company, with many senior staff similarly obliged to hold 25% of any bonus award as shares until retirement. This leaves leaders with the temptation to time their departure as they are free to realise their career-long accumulation of shares as soon as they have left.
HSBC has followed Goldman’s example, requiring bonus shares to be held to retirement with a clawback arrangement. UBS not only has a bonus/malus system but pays most senior bonuses in bonds and shares and requires Executive Board members to hold at least 350,000 shares and the CEO to hold 500,000. At about twenty swiss francs apiece this means holding from 7 to 10 million swiss francs in UBS shares. And Credit Suisse pays part of bonuses in "bail-in-able” bonds that have to be held for 3 years and can be converted to equity or wiped out in the case of trouble.
But none of these arrangements matches the incentive time scale to the period at risk after top management leave, a time when longer term risks can still come home to roost.
Risky Rewards", Professor Andrew Hopkins and Sarah Maslen have proposed a solution that includes a 'malus' element that can be set to run for a period after departure to match the duration of post-departure risks.
The core of the scheme is a unitised trust fund into which a proportion
of all senior staff bonuses, long or short term, are paid. On payment in, participants
receive units in the fund at their current value. In the meantime the fund is invested in assets that are not connected with the employer.
The employee or former employee may only cash in their units after the
deferral period. This is done at the unit value prevailing at the time. However the first charge on the trust fund is to pay the company compensation in the event of defined catastrophic events.
The authors plausibly suggest that such a scheme would create a highly motivated corps of trusted, knowledgeable and experienced former senior staff keen to provide practical advice to current decision-makers. Those people would also know where any bodies were buried.
Such a scheme should also reduce sharply any temptation felt by senior executives to focus on short term profit (for example by cutting investment or maintenance or turning a blind eye to unethical sales) at the expense of the long term success of the firm. This balance between long term success and and short term profit can become even more acute as a leader approaches departure.
In scheme of this kind, the deferral period can be matched to the influence and seniority of the individual. Thus a less senior employee with less influence might have a smaller proportion of his bonuses paid into the scheme and the deferral period might be shorter.
In contrast a highly influential individual severely exposed to the temptation to cut corners or save cost to garner short term profit (and a bigger bonus) at the expense of exposing the organisation to long term catastrophic risks might have a substantial portion of her bonuses paid into the scheme and payment out might be deferred for a long period, which could run until several years after his retirement. The ideal deferral period would depend on the possible latency period of potentially catastrophic risks to which the company might be exposed.
Another practicality is the issue of compensation for the company if something goes wrong. This has two parts: defining 'what goes wrong' and quantifying compensation.
As to defining the event, Hopkins and Maslen were writing in the context of the oil industry. There the major accident they most had in mind was perhaps some kind of fire or explosion. However, taking that example, oil companies do other things: for example many have trading arms which might give birth to a rogue trader whose ability to operate can be as much due to a systemic risk as any oil accident - perhaps neglecting cuolture or cutting corners on control systems. This illustrates that the 'event' needs to be defined broadly if it is to capture all potentially catastrophic events driven by systemic forces.
As to compensation, this is perhaps more complicated than Hopkins and Maslen envisage. BP, with whose travails Hopkins is particularly familiar, is unusual in that it did not buy insurance. The result was that all losses resulting from the systemic failures at BP at Texas City and in the Gulf of Mexico were paid for by BP and thus suffered by its shareholders.
More typically, the consequences of a major physical accident will be insured at least in part, with only a modest part of the costs falling on the company. However, reputational damage is a widespread consequence of catastrophic events. It may not be insurable let alone insured but it is most acutely felt by shareholders in the share price. If a company comes to be seen as dysfunctional or its management comes to be seen as ineffective, the share price will fall. The scheme would need to reflect this kind of loss to shareholders. Making good shareholders' loss through a payment to the company confers a benefit directly to the company and indirectly to shareholders.
Indeed such a fund could come to be seen as the indirect insurer of damage to the reputation of the company resulting from the actions or inactions of senior management, important behavioural and organisational risks with which readers of this blog will be very familiar. Insurance of reputational risk is something of a 'Holy grail' for many corporate leaders and this could provide a practical solution to which insurers might then be prepared to add greater depth.
This interesting idea needs more thought and development before it, or something like it, becomes a practical proposition. We would welcome readers' comments on how it might be improved and, importantly, made attractive to Chief Executives and Finance Directors.
In the meantime we welcome "Risky Rewards". It is a readable, research-based analysis and explanation of many risks inherent in incentive and bonus schemes. It ranges over subjects as diverse as whether and when bonuses and other incentives actually work, how to target them effectively and how to avoid unintended consequences. And while its roots are in the world of physical accidents, its insights are relevant to all organisations that are run by people.
- This blog carries a series of posts and articles, mostly written by Anthony Fitzsimmons under the aegis of Reputability LLP, a business that is no longer trading as such. Anthony is a thought leader in reputational risk and its root causes, behavioural, organisational and leadership risk. His book 'Rethinking Reputational Risk' was widely acclaimed. Led by Anthony, Reputability helped business leaders to find, understand and deal with these widespread but hidden risks that regularly cause reputational disasters. You can contact Anthony via anthony.fitzsimmons At cranfield dot ac dot uk