The Law of Unintended Consequences

By: Paul R. Dorf, APD

Upper Saddle River, NJ - July 28, 2009 - It happened again, as it always does.  “The Law of Unintended Consequences” has again thwarted the good intentions of the government.  Putting controls on how much money the “greedy executives” of Wall Street make should certainly bring smiles to the faces of the people (including voters) who have lost their jobs, their homes, and all or much of their life savings.

The unfortunate truth is that creating laws that are in conflict with existing regulations and sound business concepts may probably cause more damage than good.  Few would disagree with the need to reel in the excessive compensation that has become the norm on Wall Street and the banking industry.  Putting arbitrary caps on what executives and “heavy hitters” can make has just caused those companies to increase the base salaries for these individuals in an attempt to recruit and retain them with no commensurate change in scope of responsibilities.  We need to remember that base salary is a guaranteed level of pay that an individual receives regardless of performance and is counter-intuitive to the concepts of a performance-driven culture. 

What lessons can be learned from the government relative to executive compensation and pay plan designs?  A company's emphasis should continue to be placed on creating variable pay plans that are based on an individual’s performance and what they are able to contribute.  "Success" should be defined and measured on the quality of work, in combination with quantity produced.  Stock brokers should not be paid only on how many stock and bond transactions they are able to generate, but their pay should consider the performance of the portfolios that they sell.  In the same way, bankers should not be rewarded for the number or value of the loans and mortgages they sell.  Instead, they should be rewarded on the value of “good” loans that they generate, measured over an extended period of years.  No one would argue high levels of executive compensation if their performance contributed to increased and maintained shareholder value.

Most incentive plans require, but few have, some type of check and balance.  Referred to as “Circuit Breakers”, these specific performance measures prohibit payment of any incentive awards unless certain underlying performance levels are met.  These could include a combination of financial and operational indices, such as achieving sound financial results, avoiding bankruptcy, maintaining accreditation, etc.  Setting the standards and requirements beforehand, and not to pay out awards if they could possibly be compromised later, avoids issues with “Clawbacks” resulting from uncovering issues after the fact.  Thoughtful plan designs, through appropriate performance measures, checks and balances, and commensurate rewards, equate to overall compensation that should satisfy executives, their Boards, stakeholders, and the outside world alike.

How, then, can you avoid these unintended consequences?  The bottom line is this:

1.       Review all new initiatives from the standpoint of what could possibly go wrong.
 
2.       Include Circuit Breakers in the plan design to focus attention on the right results.

3.       Continue to emphasize pay based on results, but make sure the results are clearly and carefully spelled out and consistent with the company's business and strategic plans.

Expect that the "Law of Unintended Consequences" will wreak havoc on the unwary.