Thursday, June 11, 2009

The Developing Compensation Philosophy of the Treasury Department

Here is a link to Gene Sperling's opening statement:

There are some very interesting quotes that help to frame Treasury's philosophy re systematic risk and executive compensation in this statement.
Compensation structures that permitted key executives and other financial actors to avoid the potential long-term downsides of their actions discouraged a focus on determining long-term risk and underlying economic value, while reducing the number of financial market participants with an incentive to be a "canary in the coal mine."
The testimony describes one investment bank which acknowledged the skew in its incentive structures:
Simply measuring bonuses against gross revenue after personnel costs with "no formal account taken of the quality or sustainability of those earnings."
It is clear that Treasury intends to broaden itself beyond its initial focus on financial services:
But what is important for our economy at large is the topic of this hearing: understanding how compensation practices contributed to this financial crisis and what steps we can take to ensure they do not cause excessive risk-taking in the future. And while the financial sector has been at the center of this issues, we believe that compensation practices must be better aligned with long-term value and prudent risk management at all firms, and not just for the financial services industry.
Here are the principles that were outlined in the "way forward":

Compensation plans should properly measure and reward performance.
- In other words, performance metrics should not just be based on stock prices but also relative performance and adherence to risk measurement. "Don't confuse brains for a bull market."

Compensation should be structured in line with the time horizon of the risks.

- The testimony discussed the trade-off of large short term gains that presented a "tail-risk" of large losses. Hence, the notion of stock compensation that is required to be retained for a long period of time, even beyond retirement, is being introduced. Also suggested that bonuses could be "at risk" and withdrawn if a poor year follows a good year.
Here is an abstract regarding executive pensions and their role in long term compensation.

Compensation practices should be aligned with sound risk management.
- The testimony refers to The Financial Stability Forum's Principles for Sound Compensation Practices. The authority and independence of risk managers is "all the more important in times of excessive optimism when consistent -though unsustainable -asset appreciation can temporarily make the reckless look wise and the prudent look risk-averse." The context of risk management is broadened to include all employees, not just executives, that may be incentivized for excessive and imprudent risks.

We should reexamine whether golden parachutes and supplemental retirement packages align the interests of executives and shareholders.
-The testimony describes that golden parachutes were in place at over 80 percent of the largest firms as of 2006.

We should promote transparency and accountability in setting compensation.
-According to one Congressional Investigation, the median CEO salary of Fortune 250 companies in 2006 that hired compensation consultants with the largest conflicts of interest was 67% higher than the median CEO salary of the companies that did not use consultants with such conflicts of interest.
House Committee Report on Executive Pay Also see blog for additional discussion.
Also please see Ferri and Maber abstract which describes the change that "say on pay" has made in making CEO compensation in the UK more responsive to negative results.
Also please see the CFA Institute survey's response to "say on pay"
Also please see "Shareholder Say on Pay:Ten Points of Confusion"


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