What is a Compensation Risk Analysis?

There are at least two major lawsuits currently in the United States courts that could have been avoided with a proper compensation risk analysis. But avoiding litigation is only half the benefits they offer.

A regular risk analysis of your incentive compensation program can also help identify which business units are overproducing or lagging, and where inefficient processes are causing costly bottlenecks.

Here’s a quick brief on this challenging but highly beneficial corporate governance process.

What is a compensation risk analysis?

Since 2009, the Security Exchange Commission (SEC), which oversees public corporations in the United States, has required public companies to review their pay policies and practices to determine whether

“The features of a company’s compensation policies and practices have the potential to incentivize its employees to create risks that are reasonably likely to have a material adverse effect on the company.”

Companies must disclose the results of this risk assessment in their annual proxy statement.

Although your Compensation Committee may oversee the process, ideally, a risk analysis should be performed by an independent third party.

Why do companies perform incentive compensation risk analysis?

Employee and executive compensation make up a huge chunk of most sales organizations’ spending — anywhere between 10 and 30%. How that money is managed has a huge impact on the whole organization.

A compensation risk analysis is supposed to prepare the company for any risk created from extreme or outlier outcomes of the sales comp plan or to identify any areas that might inadvertently encourage employee misconduct or excessive risk-taking.

What types of risks are there?

A compensation risk analysis aims to identify which risks your incentive program is most vulnerable to. We talked about some of the risks above, but there are too many to cover here. Instead, here are the categories that these risks fall into to guide your assessment.

1. Financial Risk — Your incentive plans could place an undue financial burden on the company or fail to motivate the right behavior, impacting financial success.
2. Operational Risk — Your processes around the governance and administration of compensation may increase the likelihood of errors or miscommunication and misconduct, or negligence.
3. Talent Risk — The design of your compensation plan or your ability to execute it could result in a loss of critical talent and failure to replace it.
4. Reputation Risk — The design of your comp program could attract negative attention from the company’s investors and customers, impacting performance.

There are many quantifiable and qualitative risks that exist within each of these umbrella types.

When Compensation Risk Goes Unanalyzed

It’s often difficult to assess how much risk exists within each category because there isn’t a universal definition of risk. How each risk is quantified and mitigated will depend solely on the company and its exposure to the risks and outcomes identified.

These outcomes could be market events, unplanned “windfall” transactions, or random global events like COVID-19.

In one recent example, a cleaning product sales executive took his employer to court for withholding the commission on sales related to the leap in demand in Q2 & Q3 2020.

In another, a medical call center employee took their employer to court for refusing to compensate for the huge leap in referrals that came about because of COVID-19.  

As unlikely as this scenario may have seemed during planning, there were certainly some safeguards that could have been put in place to prevent legal action.

Other risks could include unrecoverable commissions paid for large deals that fall through or fines and litigation that comes about as a result of criminal conduct by employees. Neglecting to analyze uncapped commissions properly and getting stuck in frustrating lawsuits happens a lot more than people realize.

The Problem with Most Sales Compensation Risk Analyses

The problem is that the SEC only requires detailed disclosure of the risks if they are believed to exist. So, most companies tick this box by simply saying they have performed the assessment and do not believe there is a significant risk. At most, they may include details of the method of evaluation.

No public company has ever reported their incentive policies might have an adverse impact. But there are numerous examples where a significant risk did exist, wasn’t identified or reduced, and ended up causing a material adverse effect on the company.

We mentioned a couple of the most recent cases. There are dozens more related to poor risk management practices and a lack of investment in this critical aspect of corporate governance in the last decade.

Enabling Compensation Risk Analysis in Your Enterprise

One of the biggest risks enterprises face comes from a lack of time and resources to perform a proper risk analysis. Far too many companies tick the box and hope for the best.

Organizations should be reviewing the incentive plan design and performing a compensation risk analysis on an ongoing basis. Sales compensation is a moving target, and what works yesterday won’t work today. New risks and opportunities arise rapidly, and the companies that are agile enough to react to them ultimately win.

The manual overwork involved in compensation administration is a large part of the problem. There is little time to invest in analyzing performance and risk when there’s a stack of manual data validation to perform.

Investing in sales compensation automation and validation systems will unlock a huge swathe of time for things like risk analysis. Improving the integrity and reliability of your data will also make analyzing risk against historical performance possible as part of the cyclical planning process.

Some Risk is Unavoidable

Remember that the analysis isn’t about eradicating all risks from your compensation program. That’s not possible, and you wouldn’t want that anyway. A compensation risk analysis aims to understand and actively balance the risk and reward presented by the plan.

To learn more about performing a complete compensation risk analysis for your organization’s incentive compensation plan, reach out to one of our sales compensation experts here.