Short Term Incentive Risk Aversion in Boards

Boards, shareholders and proxy advisers are increasingly engaged in oversighting any company activity which fails to account for its exposure to risk, including short term incentive plans.

This is a direct result of the questionable behaviours which exposed organisations to potential risks and represented a significant contribution to the downfall of a number of high profile North American organisations, as well as the Global Financial Crisis of 2007.

This article examines the impact that short term incentives may have had in some of these significant cases and looks at considerations for organisations when developing both measures and assessment protocols for short term incentives.

  1. VA Healthcare

Veterans Health Administration is the US’s largest integrated healthcare system providing care for Veterans across the country. In this tragic case, it emerged in 2014 that Department of Veterans Affairs officials falsified wait-list data in order to meet targets which were, in reality, not achievable due to the extreme high demand for services.

A target of 14 days was set for seeing a patient after their initial request for an appointment.  Achievement of this target was tied to annual performance reviews which were used to determine pay increases and incentives as well as other benefit entitlements.

While the intention was to ensure veterans received healthcare as quickly as possible, the outcome of setting the targets and linking them to financial rewards led to the creation of falsified data to ensure financial rewards were paid.  As a result, the real wait time (closer to 115 days on average) was kept a secret resulting in a number of veterans dying while on the wait list.  It also led to highly stressed and overworked staff. In the aftermath of the scandal, US Congress and the White House took steps to reform the Department, including eliminating incentives for wait-time goals.

  1. Global Financial Crisis

The causes of the GFC are multiple and the crisis clearly cannot be attributed exclusively to short term incentives.  In fact, Luci Ellis of the Reserve Bank of Australia articulated the broader causes here.  However, short term incentives clearly played a critical role in creating the risk-taking behaviour which was inherent in the financial markets at the time.

A 2011 paper by Chesney, Stromberg and Wagner cited the review of incentive compensation practices by the Board of Governors of the Federal Reserve System which stated that, “risk-taking incentives provided by incentive compensation arrangements in the financial services industry were a contributing factor to the financial crisis that began in 2007”.

In an article in The New York Times referring to financial incentives, Nassim Taleb commented that, “the greater problem is that it provides an incentive to take risks.  The asymmetric nature of the bonus (an incentive for success without a corresponding disincentive for failure) causes hidden risks to accumulate in the financial system and become a catalyst for disaster”.

Clearly traders were taking significant trading risks to meet financial targets and adopting unethical behaviour due to the ‘carrot’ of a large financial bonus.  The end result sought by the traders, whatever the means, was to achieve that bonus.  The end result for the rest of the world was the GFC.

  1. Wells Fargo

A 1998 Fortune magazine article interviewed Dick Kovacevich (then CEO of Wells Fargo) who likened bank instruments such as ATM cards, cheque accounts, and mortgages to regular consumer products like screwdrivers in a hardware store. This attitude underpinned the scandal that was to emerge at Wells Fargo when it launched its “Going for Gr-eight” initiative.  The concept was to encourage branch workers – or, as they were more aptly regarded, ‘sales people’ – and branch managers to ensure each customer had eight of the bank’s products through cross-selling.

This was based on the notion that customers with a variety of bank products were typically far more profitable for their bank than those who had, for example, just one cheque account. Sales targets were strongly reinforced by Wells Fargo management and resulted in branch staff creating accounts for customers without the customers’ knowledge.

The policy and resultant malpractice continued for years.  In fact, according to Bethany McLean writing in Vanity Fair, “Wells Fargo’s own analysis found that between 2011 and 2015 its employees had opened more than 1.5 million deposit accounts and more than 565,000 credit-card accounts that may not have been authorised. Some customers were charged fees on accounts they didn’t know they had, and some customers had collection agencies calling them due to unpaid fees on accounts they didn’t know existed”.

In the case of Wells Fargo, both compensation and performance ratings were associated with sales goals and this, along with the culture and pressure to achieve goals directly, led to unethical and fraudulent behaviour.

  1. Green Giant

The Green Giant label has been iconic in US produce for close to a century. In this relatively light-hearted example, Green Giant suffered significant brand damage a few years ago when they discovered remnants of insects in their products.  With the best intentions of eliminating the incidence of contamination, the company introduced an incentive plan which rewarded employees with a bonus for finding insect “parts”.   A number of employees responded by bringing in remnants of insects from home to “plant”, only to “find” these remnants later, thereby qualifying to claim their bonus.  A well-intentioned, but flawed, incentive plan.

There are countless other examples where poor incentive design has resulted in behaviour which is fraudulent or unethical.  Arising from circumstances of this nature, Boards today are more highly focused on the company’s exposure to reputational risk and are monitoring assessment processes which trigger the payment of incentives.

To manage risk within a short term incentive design, there are several factors to consider, including:

  1. When performance targets are created, what behaviours are being driven?  Are there any potential negative impacts of those behaviours?  If so, is the measure appropriate and/or are there safeguards (such as deferrals, caps, discretionary components and pricing control) in place to alleviate the potential negative impacts?
  2. Are standards included which relate to values and ethics (which can be measured through colleague and customer feedback) which can be linked to clearly articulated clawbacks in case of failure?
  3. Are operational controls in place to prevent manipulation of results?
  4. How is performance validated?
  5. What is the level of engagement of the Audit and Risk or Remuneration Committees (in listed organisations) in approving performance measures and outcomes?

If these factors are taken into consideration during the development of performance measures, the associated risks can be minimised and managed to win the approval of shareholders, proxy advisers and Boards.

Click here to find out more information on incentive plans.