Last week, the president of the New York Federal Reserve understandably warned banks to continually assess their incentive compensation structures. He said, “If the incentives are wrong and accountability is weak, we will get bad behavior and cultures.” Those responsible for designing incentive compensation structures may be tempted to focus on anticipating perverse employee behaviors – and rooting them out through ever more specific plan precautions. Unfortunately, hindsight is often more valuable when it comes to discovering abuses. In more practical terms, the best answer to providing the “right” incentives likely comes from greater use of performance-based deferred compensation.
There is nothing new here. For years, and increasingly, long-term incentives have been subject to varying forms of vesting, such as “bonus banks” with forfeiture risks, and other upside or downside adjustment factors tied to future corporate, divisional, or individual performance. In the wake of executive pay abuses, many cry for clawing-back amounts already paid. That is another losing proposition, because over a decade of experience has shown that clawback policies and Sarbanes-Oxley rules generally work only in the most extreme, egregious cases.
Overall, those who design incentive compensation should consider shifting significant portions of annual incentive pay into deferred compensation that has a “tail” vesting period for payout. In this way, they will avoid having to chase down every potential for employee abuse in annual incentive structures. Careful documentation is needed, of course, in order to comply with laws ranging from state and federal wage protections to ERISA to Code Section 409A. That will be a small price to pay, however, for incentive pay that truly encourages employees to achieve productive, long-term corporate goals.