Key Points

• Risk usually carries a cost. In free markets where participants have alternative opportunities, few will take on added risk without demanding greater compensation. The core question is who among an organization’s stakeholders can bear the risks associated with performance more efficiently and thus at the lowest cost.

• Many companies use variable pay as a mechanism for buffering bottom-line performance during business downturns. When revenues shrivel, they automatically reduce employee compensation. Alternatively, companies may rely on layoffs. Which solution is better depends in part on the relative importance of general versus firm-specific human capital to company performance.

• Investors and employees are not positioned identically to bear risk. Investors can diversify away much of the performance risk, certainly the industry- and firm-specific components, but employees cannot diversify the risks to their labor investments. This suggests that asymmetry in the way risk is distributed between shareholders and employees is often better. They should not always be placed “in the same boat.”

• One of the challenges in motivating and rewarding executives and employees is to determine which part of total shareholder return is due to their decisions and efforts and which part is due to market and industry volatility.

• Performance Sensitivity Analysis is a proprietary statistical method that identifies and measures the different sources of volatility in a company’s total shareholder return. It can identify the portions of volatility in shareholder return that are attributable to industry-driven, market-based, and firm-specific factors. It can be used to develop better risk-adjusted measures of performance for use in incentive compensation programs. The result is stronger performance incentives for employees at a lower cost to shareholders.