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There is no doubt that a solid compensation philosophy must
address issues of equity and justice, both from an internal
perspective and an external perspective. As such one must be
very aware of the causes of inequity but also be much attuned to
the relationships, internal and external, that promote concerns.
A strong compensation program, driven by a philosophy of
justice and equity, can define and placate problems before they
occur.
Required Reading:
Please refer to the Activity Resources section of each activity
for the required readings.
Assignment 4 Equity: Internal and External
As an HR professional, it is important to thoroughly understand
the concept of internal and external equity in terms of pay and
benefits. For example, you will need to understand how to
answer the following questions. How is the concept of internal
and external equity similar or different in discussing pay versus
benefits? In the struggle to recruit and retain productive and
motivated staff members, is it better to design and promote a
compensation and benefit program that focuses on external
market competitiveness or that is structured to promote internal
equity? How does one articulate the concept of just and
equitable within a compensation structure? Activity
Resources:
HYPERLINK
"http://proxy1.ncu.edu/login?url=http://search.ebscohost.com/lo
gin.aspx?direct=true&db=bth&AN=44900327&site=ehost-live"
Earle, J. E. (2009).
Main Task: Analyze Issues of Internal and External
Equity Write a paper analyzing the concepts of internal and
external equity and apply these concepts to an examination of
pay versus benefits in organizations. Include in the analysis, a
comparison of the advantages and disadvantages in designing

compensation and benefit programs that focus on external
market competitiveness or that are structured to promote
internal equity. Support your analysis based on current research
incorporating three journal articles or publications into your
response. Support your paper with minimum of five (5)
scholarly resources. In addition to these specified resources,
other appropriate scholarly resources, including older articles,
may be included. Length: 5-7 pages not including title and
reference pages Your paper should demonstrate thoughtful
consideration of the ideas and concepts that are presented in the
course and provide new thoughts and insights relating directly
to this topic. Your response should reflect scholarly writing and
current APA standards. Incorporate reference page number
within the context of the paper. Use current day examples to
substantiate your research. Submit your document in the
Course Work area below the Activity screen. Learning
Outcomes: 3, 4
Assignment Outcomes
Analyze the importance of balancing internal and external
pressures and effects of external competitiveness in designing
pay structures. Assess the role of performance measurement in
compensation decisions.
The Evolving Role of Risk Management in the Design and
Governance of Compensation Programs
James E. Earle
Historically, “risk management” and “compensation” were
separate and dis- tinct disciplines within most companies. The
economic meltdown that began inside the financial services
industry, however, has launched a new social discussion that
will cause these two disciplines to become intimately linked
going forward, and as a result will likely forge new ways of
thinking about the design and governance of compensation
programs.
How is it that a compensation plan can pose risks to a
company’s business? What kinds of risks are associated with

compensation plans? What steps can be taken to mitigate those
risks? These are the questions that this article explores.
Risk management is normally associated with the process for
identifying, assessing, and prioritizing business risks as part of
a sound business management practice.1 The purpose of the risk
management process is not to eliminate risk from the business
model, but to help the company make sure that it appropriately
takes risk into account in its business strategy. This is
especially true in the financial services industry, which is in the
business of pricing risk with every loan made.
The types of risks that are the focus of a company’s risk
management routines will vary by industry and company
specifics. In the financial services industry, the Basel II Accord
focuses on three key areas of risk: credit, operational, and
market risk.2 Operational risk, in particular, is a very broad
concept that includes any kind of risk arising from a company’s
business functions, such as failed internal processes, fraud,
legal and compliance risks, etc.3
Risk management attempts to not only identify business risks,
but to assess the degree of risks by attempting to quantify both
the
Mr. Earle is a partner in the Charlotte offices of K&L Gates.
Mr. Earle’s practice involves counseling publicly traded
companies and other complex employers on matters related to
executive compensation. Clients include financial services
companies, hedge funds, large national retailers, manufacturers,
and service-companies with global operations.
BENEFITS LAW JOURNAL 44 VOL. 22, NO. 4, WINTER
2009
Risk Management in the Design and Governance of
Compensation Programs
likelihood of occurrence and the severity of loss. After
identifying and prioritizing risks based on this assessment, the
risk management process considers potential risk management
plans to avoid, mitigate, or otherwise address the key risks.4
But what does all of this have to do with compensation?

Although there is room for debate, there has emerged a general
public consensus that compensation practices in the banking
industry played a role in the credit market meltdown that has
been at the eye of the current economic storm. Consider some of
the following quotes.
The Financial Stability Forum, comprised of a group of G20
financial industry regulators (including representatives from
the US Federal Reserve), had this to say in their April 2009
report on compensation practices:
Compensation practices at large financial institutions are one
factor among many that contributed to the financial crisis that
began in 2007. High short-term profits led to generous bonus
payments to employees without adequate regard to the longer-
term risks they imposed on their firms. These perverse
incentives amplified the excessive risk-taking that severely
threatened the global financial system and left firms with
fewer resources to absorb losses as risks materialised. The lack
of attention to risk also contributed to the large, in some cases
extreme absolute level of compensation in the industry.5
The U.K.’s Financial Services Authority (FSA) expressed a
similar view in their March 2009 proposal on reforming
compensation practices in the financial services industry:
Although it is hard to prove a direct causal link, there is wide-
spread consensus that remuneration practices may have been a
contributory factor to the market crisis. Practices in common
use during the period leading up to the crisis, mainly but not
exclusively in investment banking, tended to reward short- term
revenue and profit targets. These gave staff incentives to pursue
unduly risky practices, for example by undertaking higher risk
investments or activities which provided higher income in the
short run despite exposing the institution to higher potential
losses in the longer run. In many cases, remuneration practices
were running counter to effective risk management, in effect
undermining systems that had been set up to control risk.6
Finally, here is what Gene Sperling, Counselor to the Secretary
of Treasury, had to say in his opening remarks this past June

before the House Financial Services Committee:
2009
There is little question that one contributing factor to the exces-
sive risk taking that was central to the crisis was the prevalence
of compensation practices at financial institutions that
encouraged short-term gains to be realized with little regard to
the potential economic damage such behavior could cause not
only to those firms, but to the financial system and economy as
a whole.7
KEY INITIATIVES
This consensus view has resulted in a number of legislative and
regulatory initiatives, both here in the United States and abroad,
that will require banks and other companies to develop better
risk management practices regarding the design and governance
of compensation programs. The following highlights some of
these key initiatives.
Emergency Economic Stabilization Act of 2008
The Emergency Economic Stabilization Act of 2008 (EESA)8
required compensation committees, with input from the
company’s senior risk officers, to review compensation
arrangements covering the company’s “senior executive
officers” (SEOs) to ensure that the arrangements do not
encourage “unnecessary and excessive risks that threaten the
value of the financial institution.”
American Recovery and Reinvestment Act of 2009
The American Recovery and Reinvestment Act of 2009
(ARRA)9 substantially revised the executive compensation
provisions of EESA and expands on themes about risk in
compensation programs. The compensation committee must
meet at least every six months with the senior risk officers to
discuss, evaluate, and review:
• Whether compensation plans for SEOs encourage unneces-
sary and excessive risks;

• Whether compensation plans for all other employees pose
unnecessary risks; and
• Whether compensation plans for all employees encourage
manipulation of earnings.
ARRA requires greater disclosures about these review
activities. A narrative discussion must be included in the
Compensation Committee Report in the annual proxy statement.
ARRA also requires an annual certification by the CEO and
CFO that these review activities (as well as compliance with all
other executive compensation requirements under ARRA) have
taken place.
2009
• • •
Properly measure and reward performance; Are structured to
account for the time horizon of risks; and Are aligned with
sound risk management.
Securities and Exchange Commission: Proposed Disclosure Rule
Changes (July 2009)
The EESA and ARRA requirements apply only to Troubled
Assets Relief Program (TARP) recipients. The Securities and
Exchange Commission (SEC), however, has proposed new
disclosure rules, potentially to be effective next proxy season,
that focus on risk management issues for all public
companies.10
Like ARRA, the SEC proposal looks beyond executive officer
compensation plans.
The proposal would require discussion in the Compensation
Discussion & Analysis section of the annual proxy statement
about how the company’s overall compensation policies for
employees cre- ate incentives that can affect the company’s risk
and management of that risk (to the extent such risks are
material).
Financial Services Authority (U.K.): Update to Its Regulatory

Code
In August 2009, the FSA updated11 its regulatory code to
establish a new general requirement for certain larger financial
companies covered by the U.K. code: “Remuneration policies
must be consistent with effective risk management.”
It includes eight “evidentiary principles” to prove whether the
general requirement has been met. These evidentiary
principles include features related to both the design and
governance of compensation programs.
Corporate and Financial Institution Compensation Fairness Act,
H.R. 3269
The Corporate and Financial Institution Compensation Fairness
Act, H.R. 3269,12 was passed by the House on July 31, 2009.
Section 4 of the Act would require certain “covered financial
institutions” to have compensation structures that:
TWO MAIN TYPES OF COMPENSATION RISK
What kinds of risks can compensation programs pose to a
business? We think there are two key risks, which are
thematically reflected in
2009
the various legislative and regulatory initiatives described
above. They are: (1) “short-termism” and (2) manipulation.
Short-Termism
“Short-termism” results when a compensation program
encourages too much focus on short-term results to the potential
detriment of long-term value creation.
Examples of the potential for short-termism include:
• A compensation mix focused very heavily on annual cash
bonuses. This has been a prevalent practice in many lines of
business in the financial services industry, and the primary
source of regulatory criticism. The concern is that the perfor-
mance generating the annual cash bonus, such as the closing of
a loan portfolio, the generation of a securitized transac- tion, or

the origination of a number of mortgages, does not adequately
consider potential future losses as a result of the transactions.
The individuals are paid for front-end produc- tion without
having to accept risk for back-end losses.
• The use of performance metrics to determine incentive com-
pensation that do not adequately reflect company-wide risk
considerations. This concern is closely related to the concern
about overemphasis on annual cash bonuses, and is an
especially tricky topic that we will discuss further below.
• A heavy focus on stock options or other forms of equity
compensation that do not require holding periods or that include
accelerated vesting at termination of employment.
Perhaps New York Attorney General Cuomo captured the
essence of short-termism in the title of his July 30, 2009, report
on bank compensation practices: “No Rhyme or Reason: The
‘Heads I Win, Tails You Lose’ Bank Bonus Culture.”13
Manipulation
Manipulation is the risk that a compensation program could
encourage individuals to manipulate data inputs to the
compensation process or information about the company in a
way to increase compensation results.
Examples of the potential for manipulation include:
• Annual bonus programs based on a single financial metric.
• Compensation decision-making processes without meaning-
ful engagement by independent control partners.
2009
• Heavy use of equity compensation without holding period
requirements. One recent example of manipulation in this
context is the option back-dating scandal.
TWO KEY RISK MITIGATION STRATEGIES
How can companies mitigate against the risks that their
compensation programs might result in short-termism or
encourage manipulation? The mitigation strategies can

generally be lumped into two categories: (1) design and (2)
governance.
Design
The design of compensation programs covers a potentially wide
array of considerations. Many companies consider the design of
their compensation programs to be a market differentiator. For
financial services companies operating multiple lines of
business, there can literally be hundreds of different
compensation programs within the company, each tailored to the
needs of a particular business unit. There cannot be a “one size
fits all” approach, which makes the consideration of design
issues especially complex.
Some of the key considerations when addressing risk issues in
the design of compensation programs include:
• Mix; • Metrics; • Deferrals or bonus/malus; • Equity
design; and • Clawbacks.
Mix
What is the relative level of fixed versus variable pay? As the
FSA has noted, if salary is too low it may be difficult to operate
a “fully flexible” bonus program—that is, a bonus program
where no bonus is awarded if there are losses.14 If salary is too
low, this can also put undue pressure on the achievement of
annual bonus results, which can encourage manipulation.
For variable pay, what is the relative mix of annual versus long-
term incentives? The historic practice at most large US financial
services companies was to focus on annual incentives, but to
deliver a portion of the annual incentive in a deferred stock
award. Some companies also provided higher level employees
with stock options as part of their total compensation package.
Having a balanced compensation
2009
package with elements that focus on longer-term performance
can be one of the best ways to address short-termism.

There are a growing number of examples of changing market
practices on mix of compensation. A number of banks,
including Citi and Morgan Stanley, have announced an
increased percentage of salary as part of the total compensation
package.15 Morgan Stanley also announced for 2009 a new
long-term compensation award that becomes earned based on
return on equity and total shareholder return results, against
both internal targets and results relative to peers, over a three-
year performance period.16
The executive compensation restrictions under EESA and ARRA
for banks that received financial assistance include a
prohibition on most bonus payments, other than certain long-
term restricted stock (LTRS) awards worth no more than one-
third of total annual compensation. In response, several
companies have announced a new compensation mix made up
of cash salary, stock salary, and a LTRS award. The LTRS
award vests over two to three years and is subject to transfer
restrictions linked to repayment of TARP funds. Figure 1
illustrates this compensation mix announced by Wells Fargo and
AIG for their respective CEOs.17
Metrics
What metrics are used to determine variable pay? Do the
metrics take into account the quality and sustainability of
earnings? One criticism of historic compensation practices,
especially in the investment banking industry, was that annual
bonuses were based primarily on a single metric—typically, a
percentage of revenues. In contrast, the FSA advocates that
bonuses be based on a balanced scorecard of metrics, including
the net income of the company as a whole and the business unit,
but also taking into account more subjective considerations
such as a demonstrated commitment to compliance, teamwork,
and other individual factors.18
One of the trickiest topics in this area is whether performance
metrics should be “risk-adjusted.” The concept is simple
enough: All income dollars are not the same. For example, a
dollar of income generated by making loans, requiring the

deployment of company assets,
Figure 1.
Pay Element
John G. Stumpf, CEO, Wells Fargo
Robert H. Benmosche, CEO, AIG
Cash Salary
$900,000
$3,000,000
Stock Salary
$4,700,000
$4,000,000
LTRS
$2,800,000
$3,500,000
Total
$8,400,000
$10,500,000
2009
which could be subject to future losses, is arguably not as
valuable as a dollar of income generated by a one-time fee for
services. However, the mathematical process for deriving the
risk-adjusted return for a particular activity can get very
complicated and may not work well for all business activities.
The complexity involved in deriving a risk- adjusted return can
make the incentive compensation process more opaque to the
participant and therefore less effective as an incentive. This is
an area where the risk management and finance functions can
help to determine whether a risk-adjusted metric might make
sense.
Deferrals or Bonus/Malus
Given that risk-adjusted returns can be difficult to apply in
practice, what other techniques can be used to mitigate against
current performance that leads to future losses? One approach,

already common to the banking industry, is to have a portion of
the annual incentive delivered on a deferred basis, say over
three years. Often the deferral is delivered as restricted stock,
the value of which arguably depends on future performance—
that is, stock price (although some naysayers contend that stock
price alone is an insufficient performance indicator because of
the variety of factors, such as macroeconomic changes, that can
impact stock price). The deferred portion of the compensation is
also usually subject to forfeiture in case the employee resigns,
is terminated for cause, or engages in some form of detrimental
conduct.
We will discuss more about equity design below. How much of
the bonus should be deferred? That probably depends on the
employee’s role and compensation level, although the FSA
advocates a deferral of at least two thirds of the bonus.19
Another spin on the deferral design is the so-called
bonus/malus. Under this design, a portion of the annual bonus
each year is deferred. The collective amounts deferred are then
subject to offset in future years if there are losses or other bad
behaviors (the malus). The offsets can be based on objective
measures (such as portfolio losses) or more subjective
determinations about performance, such as misconduct, failure
to observe risk management requirements, etc. One recent
example of this kind of design is the new UBS “cash balance
program.”
Under this program, two thirds of an employee’s annual bonus
is deferred to be paid in later years and subject to reduction for
certain “malus” events, including:
• A large financial loss (firm-wide or business unit); • A
large balance-sheet adjustment; • Misconduct on compliance
issues;
2009
• Breach of risk parameters; and

• “Non-adherence to other quantitative and qualitative core
objectives as expressed within individual target agreements and
performance measurements.”
Figure 2 illustrates how the UBS program is intended to
work.20
For any deferral or bonus/malus program, careful attention
should be given to potential state wage and hour act issues.
Most states pro- hibit amounts “earned” from being subject to
future loss or forfeiture. Deferral or bonus/malus programs
should be carefully worded and communicated to make clear
that the portion of the annual incentive award that has been
deferred is not earned until all conditions to the award have
been met.
Equity Design
Equity awards often provide the most direct means to align the
interests of key employees with those of long-term
shareholders. However, the effectiveness of this alignment
depends on the details of the equity award design. An award
that may be cashed in at any time or that can become fully
vested upon termination of employment might arguably
encourage a short-term focus on increasing quarterly results for
short-term gains.
To address this concern, most large public companies now
require executives to hold a certain minimum level of stock
ownership (often expressed as a number of shares or a multiple
of base salary). Another related technique growing in popularity
is to require executives or other key employees to retain a
significant percentage of their equity awards after vesting or
exercise (and after covering taxes and the cost of exercise). And
yet another technique requires executives to hold their shares
not only until termination of employment, but for an additional
year or two after.
Rather than fully vest and pay equity awards at termination of
employment (such as termination due to severance without
cause

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