We normally think of incentive planning as a process that falls squarely in HR’s domain since incentive plans are an element of the compensation policy used to motivate and retain employees. However, another group of people is often interested in how HR designs and implements incentives: risk management.

Concerns about incentive plans are particularly prevalent in financial services, where risk management teams often study where inappropriately high payouts could incentivize bad behavior.

One reason incentives can create poorly controlled risks is because the quantity and complexity of incentive plans can gradually expand to the point where no one team of professionals can effectively maintain them. A large financial institution, particularly if it has made some acquisitions, can end up managing hundreds of plans. There’s no guarantee that these plans are all well-designed and governed.

Appropriate risk design

Here are some ways to implement appropriate risk design:

• Ensure roles are designed in a way that individuals cannot take risky actions independently (i.e., make a large investment).
• Avoid an over-reliance on a single measure that might not fully reflect business results.
• Where possible, tie incentives to profitability rather than revenue.
• Where situationally appropriate, base incentives on team and corporate performance, not exclusively on individual performance.
• Be wary of uncapped upside on incentives.
• Include management discretion in judging performance (and hence incentive payout) to discourage risky behaviors.

Getting incentives under control

If your incentives are out of control, then you should do two things in parallel. First, reduce the number of incentive plans as quickly as possible. There will often be numerous similar plans you can consolidate. As the number falls, figuring out how to control risk gets easier. Identify the highest risk incentive plans (e.g., high payout and poor design) and address those right away.

Adding governance to incentive plan design

When the quantity and complexity of incentive plans in your organization have gotten out of hand, it’s wise to examine how the bloating happened. The most likely cause is a lack of a strong, central team overlooking the creation of plans. Suppose senior managers across the organization are designing and tweaking plans with HR only approving what they have asked for. In that case, it’s easy for the number of different incentives to get out of hand.

The group governing incentive plans needs enough subject matter expertise to understand the risks involved. For example, if a financial professional working in derivatives has an incentive plan, then there need to be people on the governance team who understand the hidden risks involved with derivatives. They also need to have the authority to say no when an influential leader pushes for an inappropriate incentive plan.

This governing group needs to monitor incentive plans across their organization, ensuring that it isn’t falling into bad habits or endlessly designing new incentive structures to maintain.

Conclusion

It is a good exercise for compensation professionals to look up from their spreadsheets and think about the broader issues surrounding compensation for their business. Risk is often one such overlooked issue. If a compensation pro can get involved in the risk assessments of incentive plans, the experience will provide an interesting and valuable change in their perspective.

More broadly, it’s an example of the importance of “teaming” for the compensation professional. Compensation is so important that there needs to be a collaboration between HR, finance, and, as we’ve discussed, risk management. Taking a multi-disciplinary approach will ensure your organization achieves better business outcomes while building goodwill and a reputation for excellence.   ⬤