Wikipedia defines moral hazard as "the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk". In an article focusing on moral hazard in executive compensation, Frederic Cook discusses how this can play out when executive teams are "rewarded for the positive outcomes of good investments, but insulated from the negative consequences of investments that turn sour".
A timely topic given the focus on executive incentives, by our representatives in Washington and the public at large, and their potential role in the credit crisis.
In the article, Cook provides a thoughtful examination of the concept of moral hazard in executive compensation. He walks us through the ways that some of the more common executive incentive devices may fall short in mitigating potential moral hazard, and offers some "thought starters" to business leaders interested in avoiding this pitfall in their own compensation design and governance efforts. I encourage you to read Cook's brief article in its entirety to check out all his ideas; here, however, are a few that make a whole lot of sense to me:
Pay modest or no severance for failed performance. Senior executives could be subject to two tiers of severance benefit – one, a higher tier, for "no-fault" terminations; the other, a lower tier, for "good reason" terminations relating to failed performance that fall short of "for cause" definitions. The public simply cannot understand why boards allow executives to receive multi-million dollar settlements when they are fired for leading the company to failure. It undercuts public support for good executive compensation practices and contributes to public perceptions that the game is rigged in executives' favor. Prohibit "flipping" of option gains. Require executives who exercise valuable options to hold a portion of the after-tax profit shares. For example, requiring executives to hold 25-50% of the net after-tax profit shares remaining after covering the option exercise price and taxes for one year after exercise is not onerous. It would function as a form of "claw back" if the executives exercised at a high point and the stock subsequently declined because of poor performance. Sound ideas from one of the premier experts in the field, and a reminder to any of us involved in executive compensation design: While we must keep in mind the need to attract and retain the executive talent required to lead our organizations in these difficult times, we must also ensure that the pay programs we implement reflect a responsible and sustained balance between the interests of all affected parties.
Image: Creative Commons Photo "Hazards! Ahead!" by Podknox
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