Executive Pay for Sustainable Performance

The recent financial crisis has exposed financial services companies that have not effectively managed risk. Bear Stearns, Merrill Lynch, and Lehman Brothers, three titans that had weathered the Great Depression, World War II, and September 11, could not survive the current economic turbulence. In the aftermath of 2008, survivors must redesign risk management and employee rewards to ensure sustainable performance. Investors will increasingly require that executive pay be tied to sustainable performance measured by economic profit to take account of both total capital deployed and risk.

Despite unprecedented fiscal and monetary interventions by governments and central banks, the global economy remains highly volatile. Uncertainty in markets persists because investor and creditor trust has been breached in a way that has not been experienced in generations. While governments, central banks, and regulators have taken aggressive actions to combat the painful symptoms of 'frozen credit' and 'toxic assets,' they are reactive, insufficient, and have long-term inflationary consequences. Resolution can only occur by addressing the root causes of the breach in trust.

A concentration of risk

Although the current financial crisis may be the broadest and most severe in many years, financial emergencies requiring government intervention have been a pattern in the sector. In the recent past we have seen Russian and Latin American sovereign debt defaults, the reinsurance spiral and Lloyds of London failure, the collapse of Long Term Capital Management (whose principals were supposedly the experts on risk!), and the US savings and loans debacle. The common factor in these crises was the concentration of risk in a few areas that appeared to be producing high returns, without providing adequately for the possibility of a disaster. The concentration of risk often has been disguised by the recycling of the same risks among industry players. Reward programs that pay out a substantial proportion of nominal profits (or even of revenues) have operated to encourage this process, as short-term revenues and nominal profits tend to be highest from the highest risk investments – for so long as the risks do not materialize. Even companies that recognized the risks were afraid to change their reward systems for fear of losing out in the war for talent.

The transparency challenge

Post 2008, investors are demanding from management greater transparency, accountability, and long-term performance sustainability than ever before. But transparency in financial services is a difficult goal to attain. Financial instruments are pioneered daily, and it is difficult to adequately describe the complexities of a single transaction, let alone a diverse global portfolio. The credit default swap market illustrates the problem, as it took the dramatic and sudden decline in the housing market to expose the riskiness of the assets. Timeliness is challenging (as we witnessed in 2008) because asset values change on a tick-by-tick basis. Determining the impact of a single change in the bid/ask spread of a highly leveraged asset can be misleading if not presented with great care. The continuing debate on marking to market centers on this issue, and is further complicated by the significant claims attached to any one asset at any point in time.

Finally, the issue of risk-adjusted performance in financial institutions is difficult since there are three categories of risk in financial institutions – credit, market, and operating risk. While Basel II has provided a useful standard for 'value at risk' and 'risk-adjusted return on risk-adjusted capital,' even the savviest investors can find these calculations difficult to interpret. Furthermore, transparency and timeliness are critical to these measures having any utility at all from an investor perspective. For example, highlighting in the 2009 Bear Stearns annual report that the company was overly leveraged by credit default swaps would not be of much use.

Keeping reward in context

Reward systems have certainly contributed to the problem and need to be radically overhauled. However, changing reward so that executives suffer if there is a financial crisis is not the whole solution. Financial crises are infrequent, so they only affect the executives in place at the time; they are also generally (almost by definition) not anticipated, so the possibility of a collapse tends not to affect executive behavior. Therefore, in addition to changing rewards:

• Financial services companies need to improve their risk assessment and to ensure that they are not betting the company on a single investment or on investments that are likely to be correlated in an economic or financial crisis. Given the long timescales, this has to be a governance and regulatory responsibility, not driven by reward - although part of top executive reward should be for doing this well.



• Companies also need to build up reserves against the inevitable losses from time to time, as insurance companies do. Arguably the excess of the risk-adjusted required return over the risk-free rate is an 'insurance premium' that should be reserved against future losses, not paid out in bonuses (or dividends).

Achieving risk-adjusted reward

Executive rewards must be based on measures of corporate performance that take account of the risks to shareholders' capital inherent in the business strategy. Notwithstanding complexity, investors will no longer be satisfied with the 'too complicated' excuse on risk-adjusted performance management.

Corporate performance must be assessed based on a broad framework of interrelated metrics that influence current expectations. To succeed, the framework must first and foremost be economically sound. The 'performance mathematics' must ensure that as levers are pressed, expected values are achieved and perceptions influenced accordingly. Second, it must be comprehensive and balanced. As Drucker reminded us, 'we manage what we measure.' History is replete with pay-for-performance issues stemming from improvement in 'measured' revenue growth offset by 'non-measured' expansion in assets or risk. And finally, it must be easy to implement. If it cannot be readily understood and tracked by all stakeholders, it will not work.

The two measures that should be used to tie executive pay to performance are total shareholder return (TSR) and economic profit (EP). TSR is the best de facto measure of long-term corporate performance, despite the difficulties of defining a peer group to measure relative performance and the potential impact of short-term price fluctuations.

EP is fundamentally the return on capital deployed net of its risk-adjusted cost. It is an essential measure because it ensures that return is calculated in the context of both the scale of capital deployed and its inherent riskiness. While this is a more complicated calculation for financial services companies since these companies are essentially 'spread' businesses, EP is superior to other metrics like earnings per share (EPS) and earnings before interest, tax, depreciation and amortization (EBITDA) since these do not consider risk and capital deployed.

However, TSR and EP must be managed through a performance framework. Exhibit I is an illustrative example of a performance management framework that connects TSR and EP with actionable enterprise operating metrics. From a board and investor point of view, the framework provides a holistic approach that enables effective assessment of 'performance' in the context of executive pay.

While this approach is not immune from the aforementioned issues of comparability and complexity, it is a useful paradigm for establishing a standardized approach to performance management. Investors made their voices clear in 2008 and a failure to tackle the problem will no longer be tolerated. The restoration of trust begins with executive pay for sustainable risk-adjusted performance.

Exhibit I. Performance management framework (illustrative above)