How Risk Is Allocated

In principle, all the stakeholders in an organization can bear risk to a greater or lesser degree. Stockholders bear the risks of volatile share prices, which rise and fall in response to both company performance and external factors; they sometimes are subject to changes in dividend payments as well. Customers bear risk through changes in prices or service and/or product quality, which vary in their predictability. For this reason, branded companies can extract a premium for maintaining high levels of predictability in both of these dimensions of exchange. Vendors and suppliers bear risk through variability in the security of their relationships with customers. Demand may fluctuate. Contracts may be canceled. Customers in adverse circumstances may pressure them for price concessions as a condition for maintaining the business relationship. All these are forms of risk that manifest themselves in day-to-day transactions.

Employees feel the sharp edge of risk through their paychecks and their jobs, as is shown in Figure 10-1. Many companies manage fluctuations in company performance by adjusting employment—the quantity of the workforce—and its related expenses. When revenues fall, some workers are furloughed, partially buffering the effects of declining revenues on the bottom line and on the company’s share price. This practice has been widespread mostly among unionized companies, which traditionally use “last in, first out” policies to determine whose jobs will be eliminated even though the people with the greatest seniority may not represent the greatest value to the enterprise. More modern forms of quantity adjustment include contingent staffing, such as part-time and temporary employment, and the use of contract employees. Those employees are like a reserve army, that adjusts quickly to changing business conditions and requires less of an investment to maintain. Like the low-seniority workers of yesteryear, they serve as a kind of release valve, absorbing the vacillating pressures of business risk.

Figure 10-1: Risk And It’s Allocation 2003, Mercer Human Resource Consulting LLC

Many companies, particularly nonunionized firms that rely on so-called knowledge workers, increasingly are opting for variable pay as a mechanism for buffering bottom-line performance from business downturns. Variable-pay programs help companies protect the bottom line by automatically adjusting labor costs to changing market conditions. By adjusting the price of labor, they remove some pressure to reduce employment, at least in the short term. This can help a company retain the human assets on which smooth-running operations depend, something that is more important for some organizations than for others. It also preserves investments in training that otherwise would be lost through layoffs.

Many employees now are compensated through plans that guarantee a certain level of base pay supplemented with a variable component that is linked to one or more measures of performance. Thus, a middle manager may be given a base salary of $60,000 with a stated opportunity to earn upward of another $15,000 if company, department, and/or individual goals are met. In this case one-fifth of the middle manager’s annual compensation is at risk. Senior managers in the same company usually have a larger percentage of their potential compensation—half or more—at risk. That arrangement appears to make sense since senior managers presumably have greater control over corporate outcomes.

Interestingly, variable-pay programs seldom are introduced explicitly as instruments of risk sharing even though they inevitably have that result. Instead, they are instituted as incentive mechanisms that are designed to improve performance by tying rewards to business results. Such programs have exploded in recent years under the banner of “pay for performance.” Particularly in the United States and among many companies in Europe and Asia, more and more employees, regardless of level or occupation, find that a portion of their pay is tied to some measure of group or organizational performance. Those incentives come in the form of annual bonus compensation, productivity gain-sharing, or profit-sharing programs.

For many companies during the 1990s the preferred vehicle for delivering incentives was stock or stock options. That certainly was the case for American executives. Spurred in part by new restrictions on the tax deductibility of base compensation over $1 million, compensation committees began to rely heavily on stock options as the basis of executive pay. Stock options confer the right to purchase company stock at a set price—the exercise price—during a specific period of time, usually 10 years. The purported benefits of stock options are twofold: The fortunes of shareholders and employees are linked directly, and the value of compensation is adjusted automatically to meet market conditions. Everyone has a piece of the action, and why not? Isn’t this a logical way to motivate executives to increase value for shareholders? Isn’t this form of pay for performance a perfect counterpart to a management creed that exhorts employees to be “results-oriented”?

Although the logic behind incentive compensation seems compelling, the record suggests that incentive programs are among the most problematic of all human capital practices. In the meta-analysis reported in Chapter 1 it was shown that financial incentives had by far the greatest variance in impact on performance outcomes. In some cases performance improved dramatically after the introduction of an incentive program, far more than was the case with any other intervention. In other cases the effects were negative. No other intervention tracked in the companies studied posed the risk of actually diminishing performance.

There are also serious questions about the efficacy of stock-based rewards. The collapse of the Internet bubble and retrenchment in the stock market overall have decimated the stock-based programs of many companies. Stock options for executives in those companies are deeply “under water,” and the wealth accumulated during the 1990s generally has evaporated. Many executives have gotten the sudden, sobering news that their rewards have less to do with their own performance than with Alan Greenspan’s.

In our view these problems reflect a failure by compensation committees or others in charge of incentive design to account for the role and costs of risk. Whatever their intent, incentive compensation and variable pay always involve two transactions:

• They price and allocate labor services.

• They price and allocate the risks associated with performance fluctuations.

Effectively addressing these two transactions with a single instrument is a major challenge. For those who view the world strictly through the motivational lens, it is easy to focus on the first transaction and neglect the second. Those people forget that if the second transaction is not managed appropriately, the results can be costly. Worse, the results can even undermine the motivational value of the supposed incentives. Indeed, when the efforts of employees are neutralized by environmental factors outside their control, those employees often cut back on their efforts. How well an incentive program balances both objectives ultimately determines its effectiveness.

Incentive schemes such as variable pay and stock options are based on the assumption that alignment between employee and shareholder interests is best accomplished through a symmetry of risk, that is, by putting both parties into the same boat. When one wins, according to this reasoning, so does the other. When one loses, others do as well. Basic economics indicates, however, that effective alignment sometimes requires an asymmetric allocation of risk for two reasons:

1. Under incentive compensation, performance volatility produces reward volatility even though performance volatility may be the result of random, external factors.

2. Shareholders and employees are not positioned equally to deal with risk.

To understand these positions more fully, it is necessary to dig deeper into the concept of risk.