By NA BOON CHONG AND GRACE WU ZHONGHUA

EXECUTIVE compensation has again become a hot topic after most Wall Street firms suffered significant losses and governments around the world injected hundreds of billions of dollars into financial institutions.

At the heart of the financial crisis that has paralysed global financial markets is a mystery: How could top executives of the world's most sophisticated financial institutions stake the lives of their businesses on substandard mortgage-backed securities? While there are many contributing factors (operating at different levels) to the financial crisis, including the global economic imbalances between the fast-growing emerging markets and the matured markets, the role of the regulators and rating agencies, the operating model of the financial industry, risk management methodologies and techniques, there is also one factor at the behavioural level, that is, how executive performance is measured and incentivised.

The conventional wisdom in executive compensation is that high risks deserve high rewards. The board of directors is entrusted to monitor how executives grow the business and mitigate the downside risks in generating shareholder value, and then reward them accordingly. However, if the risk levels and duration are not priced into the relationship between performance and rewards, executives may be tempted to take excessive risks that could break the companies they work for, and get rewarded before that happens.

As what we have observed in this global financial crisis, when the 'unthinkable' happened, the companies and the shareholders suffered huge losses. The executives lost their jobs but got to keep the rewards given to them at an earlier time.

Something is clearly not working right. Risk-taking is part and parcel of doing business. How should executives be rewarded for taking the appropriate risks in order to grow the business, not just in the short term but in a sustainable manner? Some are arguing that the problem lies in excessive compensation, which led to a risky shift in executive behaviours.

While excessive compensation is unwise and does not make business sense, the more fundamental question is not whether a bonus payout is too high in absolute terms, but how to make sure that the executives share the losses as well as the gains, and to make sure that executives have struck a good balance among profitability, growth, risk and long-term sustainability.

When offering compensation plans to the executives in today's environment, the board of directors would expect to meet significantly more challenges. A number of the global banks are experimenting with new compensation models as a result of the crisis. A few examples follow:

• UBS is implementing a cash balance plan that has a deduction feature that reduces the individual account for losses, breach of compliance and risk control, and other performance conditions.
• Morgan Stanley is introducing both deferred and claw-back provisions (See definitions below) into its bonus plan.
• Credit Suisse is linking the incentive pool with the bad assets on the rationale that only if the bad assets turn around, there would be money in the pool.

  While there is no such thing as a perfect model, however, there are definitely steps and principles that a board compensation committee can consider to undertake.

• Firstly, audit the executive compensation plans to ensure they are aligned to support the business goals, not merely following what others are doing in the marketplace.
• Always ensure the compensation level is right for the level of contribution and performance. If it is not, then the chances of talent walking out of the door are high even in bad times or sow the seeds for discontent in the future.
• Review the compensation tools, such as cash, performance stock, stock option and convertible units to ensure the use of these tools is thought through and works in a coherent way to support the current intent. For example, simply granting executives more options to account for the under-water option value in today's stock market may not be wise without attaching any performance conditions.
• Identify and remove those compensation plan features that incentivise short-term behaviour at the expense of the longer-term goals.
• Consider the issue of measuring performance in relative and absolute terms.

Pros and cons

Both approaches have their advantages and disadvantages. One would need to determine what is appropriate for the business in the current downturn - when the whole market is down, how much would you reward the executives for doing better than their counterparts at the competitors? The answer may be a hybrid that rewards top relative performance as long as some absolute threshold is exceeded.

• Determine the appropriate performance measures. There are shareholder-friendly measures such as share price, EPS and TSR. There are also business measures that are critically important to have the executives focused on, such as revenue, profit, cash flow, margin and credit quality. Include an accurate 'price' of risks in all profitability calculations. Granted that targets are hard to preset in this turbulent time, a certain degree of discretion is needed to evaluate these factors after the fact.
• Measure performance at the company level and avoid having individual businesses taking a first call on 'their' profits unless they are autonomous units bearing their full funding costs.
• Decide on the time frame to measure performance. While the short term should remain to be one year to coincide with the budgeting cycle, the time frame for the long-term incentives is less clear as it needs to parallel the business cycle, and the past pattern of business cycles is disrupted at the moment.
• Consider the use of deferred bonus or claw-back provisions in the plans. The former refers to bonus plans that do not pay out fully at the end of the financial year but defer a portion to the next two to three years. The latter refers to clauses that stipulate that the incentives could be taken back in future years if certain conditions (such as profit realisation) are not met.
• Decide on the weights to be given to the short-term vs long-term incentives. Traditionally, the long-term incentives have been weighted one to two times the amount of the short-term incentives. This may increase as the emphasis over long-term results takes prominence.
• Lastly, create 'partnership' mindset and mechanisms in the company, going beyond stock ownership, by breaking down barriers between those designing and those taking risks.

Compensation is only one of the levers in shaping executive behaviour. Leadership values and beliefs, and role models convey strong messages and confer intangible rewards. Leadership, performance and compensation are the three priorities for the governing boards in terms of managing executive behaviours. Unprecedented times call for unprecedented solutions. This is the time to be creative and proactive to get ahead of the curve.

Na Boon Chong is director, consulting, SEA, and Grace Wu Zhonghua, principal researcher, Global Research Centre, Aon Consulting.

This article was first published in The Business Times on February 12, 2009.