Actuary Brett Riley runs us through the possibility that pay and incentive structures contribute to inappropriate risk taking.
Each institution’s Risk Management Framework (RMF) is a collection of systems, structures, policies, processes and people. Together these help a company to identify, measure, evaluate, monitor, report and control or mitigate all material risks that may affect its ongoing viability.
A material risk for many companies is remuneration risk – the possibility that pay and incentive structures contribute to inappropriate risk taking. This may lead to more variable financial performance and could even threaten a firm’s solvency. As an example, poor executive pay practices are widely regarded as one cause contributing to the global financial crisis. It was one factor behind many high profile corporate scandals of the past 25 years. A common scenario was that traders had an incentive to place large bets in financial markets in pursuit of high profits for the company (with large risks) and thus high bonuses for themselves.
|Examples of losses due (in part) to poor remuneration structures|
|Bausch & Lomb||US||1994||Aggressive sales targets led to false accounting of revenue, a SEC investigation and a shareholder lawsuit.|
|Kidder Peabody||US||1994||Star trader Joseph Jett faked $350 million in profits to secure higher bonuses from the investment bank.|
|Barings plc||UK/Singapore||1995||Trader (Nick Leeson) speculated in Nikkei futures and bankrupted this old merchant bank.|
|Allied Irish Bank||Ireland/US||2002||Currency trader at Allfirst (a US subsidiary) lost nearly $700 million by hiding trades.|
|National Australia Bank||Australia||2004||Foreign exchange option traders concealed accumulated losses of $360 million in pursuit of bonuses.|
|Ratings agencies||US||2008||Rating agencies reviewed structured credit products in the years before the GFC (e.g. collateralised debt obligations). They were paid by the product issuers. It is widely held that this lack of independence led to inflated ratings (relative to the underlying risks), contributing to the GFC.|
How is remuneration structured?
There are many ways to structure remuneration. Most pay packages comprise some mixture of the following types of pay:
- Short-term performance-based; and
- Long-term performance-based.
Performance-based components (i.e. those which are at risk) can be paid either as cash or in some form of equity in the company (e.g. as shares, or options over shares).
Performance-based pay might vest immediately after a financial period, or it might be deferred to give time for business outcomes to be reliably measured. Deferral is relevant for banks and insurers, as they typically face large uncertainties around some material balance sheet items.
Beyond the vesting decision, companies may also decide on a further deferral in paying the at-risk component. This may be done to incentivise the recipient or give the company further scope to claw-back the bonus if the company’s circumstances deteriorate.
The performance-based component might use a formula (which may be simple or complex) or be completely discretionary. Or it may be some mixture of the two approaches.
The following are used to varying degrees by companies to determine performance based pay:
In my opinion the desirable features of performance-based pay structures are:
- Final measurement must be deferred if there is high uncertainty around the outcome. For instance, a long tailed general insurer’s performance in one accident year cannot be fairly assessed after one year. Perhaps it could be after three or four years.
- Structures should capture all material risks, where possible, when applied for those with key responsibilities for the RMF (e.g. CEO). A balanced scorecard performs well here.
- Pure volume based approaches generally don’t work.
- Pay should only occur if the risk profile has not breached the firm’s risk appetite (or if key thresholds have not been exceeded).
The following quote shows that APRA is more focused with the “shape” of pay structures rather than the “level” of executive pay.
“For us, the issue is one of responsible governance. We don’t come to this with any value judgments about comparative wage justice. What we are concerned about is the promotion of sound risk management behaviours. For us, it’s the incentive arrangements that underpin remuneration packages that are of concern, not the amount of remuneration involved.”
Executive Remuneration as part of Risk Governance, David Lewis, General Manager, APRA
Speech by to the Financial Institutions’ Remuneration Group Annual Conference, Terrigal, 18 September 2012
What does APRA require?
Prudentially regulated companies (banks and insurers) face the strongest regulation in Australia, due to their obligations to pay depositors and policyholders. APRA covers remuneration risk as part of its supervision regime, and through its cross-industry prudential standard CPS 510 Governance.
APRA requires that performance-based components must include adjustments to reflect the outcomes from business operations, their associated risks (including the cost of capital, where relevant) and the time necessary for these outcomes to be reliably measured.
Under CPS 510 each company must have a Board Remuneration Committee and a Board-approved Remuneration Policy. This policy must:
- Set out who is covered by the policy. This must at least include:
- each responsible person (as defined in CPS 520 Fit and Proper), but excluding non-executive directors, auditors, external Appointed Actuaries and the Reviewing Actuary (for general insurers).
- risk and financial control personnel.
- all others for whom a significant portion of total pay is based on performance and whose activities may affect the company’s financial soundness.
- Allow the Board to adjust performance-based components downwards, if necessary, to protect the company’s solvency or respond to unforeseen consequences.
- Prohibit each responsible person who receives equity or equity-linked deferred remuneration from hedging the resulting economic exposure before this form of pay is fully vested in that person.
- Ensure that remuneration structures do not compromise the independence of risk and financial control personnel.
- Form part of the company’s RMF.
The Board Remuneration Committee must comprise only non-executive directors (with a majority independent). The committee’s responsibilities must include:
- Regular reviews of the Remuneration Policy, and making Board recommendations on it.
- Annual recommendations to the Board on the remuneration of those covered by the policy.
Why should companies bother with having sound remuneration structures?
For prudentially regulated companies, keeping APRA happy is an obvious motivation!
Beyond this, there are good commercial reasons for having appropriate controls around pay, including:
- Protecting the continued existence of the company by discouraging excessive risk taking. There are many highly publicised examples of companies experiencing an incident linked to poor pay structures (see examples in accompanying table). Not all of them fail. But some do.
- For affected companies which do not ultimately fail, the process is nevertheless costly and a significant distraction for management and the Board.
- Protecting the reputation of the company, its directors and executives.
- Managing relationships with stakeholders, in particular shareholders. The owners of Australian companies can make an entire board face re-election under the “two-strikes” rule introduced in 2011.
- Providing further support to the sound operation of the RMF. Remuneration risk is one specific aspect of the softer, behavioural side of risk management (often dubbed “risk culture”) which is now receiving increased attention from companies.
- Supporting better commercial decisions, measured in terms of risk-return outcomes. This makes achieving the company’s objectives more likely.
While executives will continue to shout “show me the money”, an increasing number of interested observers are replying “show me your controls”.
Adapted from APRA Prudential Standard CPS 220 Risk Management, paragraph 22
Ellis, L., 2009, The Global Financial Crisis: Causes, Consequences and Countermeasures, RBA Bulletin, http://www.rba.gov.au/publications/bulletin/2009/may/pdf/bu-0509-4.pdf
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