ho is to blame for the collapse of Wall Street icons like Lehman Brothers and Merrill Lynch? Is there
a common denominator in the simultaneous fall of these icons, along with countless
other banks, insurance firms and mortgage brokers?
These are questions everyone is asking, but few in HR seem
to be taking responsibility. Everyone agrees that one of the primary causes was
excessive risk taking. Mortgage brokers and banks sold loans to extremely high-risk
individuals and then packaged those debts into insanely complex derivative products
that were bought and sold with little consideration of the risky foundation on which
the products were based.
You can blame the lack of government oversight, but a lack
of regulation doesn't force risk taking; it only allows it. The blame should fall
solely on the firms that engaged in such behavior. So the key question should be:
What incentives drove such risk taking inside the firms themselves? Obviously executive
expectations played a role, but the compensation function also needs to be looked
at when assessing the blame. Several errors and omissions by the compensation function
played a major role in the excessive risk taking by loan officers and the buyers
and sellers of mortgage derivatives:
Excessive rewards: If you look at a list of failed firms,
from Enron to Bear Stearns to Lehman Brothers, you'll find a consistent pattern
of paying out what can only be described as huge bonuses. Obviously, rewards for
performance are a good thing unless the amounts offered become so staggering that
people lose their sense of ethics and are driven to exceed reasonable limits on
risk. Whose job is it, in conjunction with management, to create pay-for-performance
plans? The compensation function, of course.
Compensation design failed to forecast the desired level of
risk taking: Compensation focuses on pay and rewards but seldom ties either to risk
models. Compensation professionals need to assume partial ownership of risk (along
with the controller), because just as compensation can drive desired behavior, when
misaligned or unthrottled it can also drive disastrous behavior. Whenever incentive
or bonus plans are drafted, it's critical that the design process evaluate and forecast
what level of risk taking will be rewarded by the plans so that senior managers
can be informed and held accountable for approving them.
No penalties for failure: Compensation schemes routinely offer
rewards, but rarely do they leverage penalties or punishments to drive desired actions.
Employees should receive rewards for exemplifying the correct behaviors, but should
also be penalized for bad behaviors (excessive short- and long-term risk taking
in this case). In addition, employees should be rewarded for reporting excesses
when noticed.
No feedback loop after implementation: When compensation professionals
set pay and incentives, they traditionally ``drop them over the wall'' for managers
to implement, with little concern for what happens afterward. As a corporate function,
compensation has a fiduciary responsibility to monitor and adjust rules, policies
or rewards to prevent critical incidents. The compensation function needs processes
to warn managers when negative behaviors and risks point to a high probability of
error.
A short-term perspective: The perspective of the compensation
department rarely extends beyond the current year, which is a problem. Many business
activities require execution cycles lasting longer than a year and carry with them
repercussions that can extend for decades. CEO compensation packages are a prime
example: Many of them give executives ample reward for taking excessive risks to
increase top-line growth or stock price. To be more strategic, compensation professionals
must learn to directly measure the impact of job activities over a multiyear period
and create incentives for desired behaviors throughout that life cycle.
No skin in the game: Unfortunately, compensation managers
fail to tie their own budget, pay and bonus criteria to the long-term performance
results of the compensation department.
The lesson to be learned is that with rewards, just as with
ice cream, too much of a good thing isn't a good thing. When the post-mortem on
this financial disaster is complete, don't be surprised when one finger is pointed
at the compensation function. I hope that compensation professionals don't need
to wait until that day to realize their true role and take ownership of the impact
of their decisions.
Workforce Management, November 3, 2008, p. 50
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