In the midst of the financial sector meltdown, directors and executives are asking innumerable questions. One, in particular, seems central: “In our quest for pay for performance, have we—boards, executives, and shareowners alike—created pressure points that influence risk-taking behaviors in unintended ways?”

Risk is one of our favorite—yet most feared—topics. For starters, risk is not a bad thing. Taking risks and getting paid is at the heart of business. But to state what should be obvious, that is only true if we are taking known and intended risk. Therefore, the first question, even before you get to the nexus between executive compensation and risk, is the most fundamental: How can we know the inherent risks in a company’s strategy? Unknown risk is always unintended risk; known risk can usually be mitigated by management execution.

Unfortunately, strategic risks are likely to vary from company to company and industry to industry. Still, there are universal preventative actions you can take. Think of it as driving along a mountain road: The curves, drops, falling rock zones, and other hazards of each road are different, but good brakes and alert driving can help in any situation.

The first bit of preventative maintenance is for boards and executive management to distinguish between strategic risk-setting and tactical execution. Let’s give a common example. If your company decides to source (or sell) overseas, then there are clearly execution risks, such as whether you buy (deliver) the right SKUs in the right volume and how will you deal with logistics such as longer lead times. Those are serious management challenges, but they don’t require boards to set risk limits.

However, there are other inherent risks in the strategy, about which execution simply cannot be judged absent strategic direction from the board. Some are obvious: if you’re increasing your overseas sourcing (sales) what is your currency hedging program? A strategy needs to be in place to define what the program is trying to achieve. Are you looking to take risk so as to profit on exchange rates, or are you looking to decrease risk and hedge? If you’re looking to hedge, is that at the lowest out-of-pocket cost or are you trying to minimize volatility, even if that results in a higher out-of-pocket cost?

Sure, the example above is simple and commonplace, but how many companies have you seen which blame unexpected profit or loss on hedging issues? Are the people in charge of the Southwest Airlines’ hedging program that much better than their competitors at hedging the price of oil, or has Southwest simply done a better job of understanding one of the basic strategic risks of running an airline and made an explicit decision about its risk tolerances?

The second task is to ensure the board can understand the strategy-specific risks. That means directors need: (a) some level of domain expertise; (b) enough time to review strategy and its implications; and (c) the desire to do so. Former SEC Commissioner Harvey Goldschmid relates how senior financial executives blame “those MIT kids” for the unprecedented credit crisis. While raising the specter of some type of financial engineering nerd concocting all sorts of strange instruments in the basement may be designed to shield boards, it also says that the boards neither had sufficient domain expertise nor the willingness to gain that expertise.

Third, a board needs good sources of information. The use of different “lenses” (such as environmental liability or reputation management or regulatory analysis) to analyze strategy can be helpful in getting different takes on the risks inherent in the strategies.

Just completing that three-part task, however, is akin to giving management a well-tuned car, a map, and a destination on the other side of the mountain. What’s missing is some sense of how fast management will drive. How far above or below the safe limit? How close to the edge? How long before taking a needed break to rest and recalibrate location? In other words, how much risk are we allowing our driver to take? Too fast and we may crash and burn; too slow and we may be overtaken by the competition. Speeding down a curved 17-degree incline at 80 mph is different than driving at 40 mph or crawling along at 5 mph.

Boards typically set a speed limit by limiting the capital exposure of the company; virtually every company has some type of capital commitment process which prioritizes projects, sets hurdle rates, and so forth. In the process, we effectively say how much of a company’s balance sheet we’re willing to risk on any specific project.

The question is how do you get management to drive along at the speed specified by the board? How does a board encourage appropriate risk-taking?

What we propose is that boards “risk-adjust” the familiar pay-for-performance paradigm. Is $1 billion in EBIDTA earned without risk to the balance sheet the same as $1 billion earned by putting the balance sheet at risk? Of course not. This type of risk-adjustment is well known and understood in the investing world, where returns are normalized for volatility or for leverage. And make no mistake about it; putting the balance sheet at risk is economic leverage. So why not adjust executive compensation performance targets to take risk into account?

Admittedly, this is easier said than done. If, for example, a financial institution wanted to limit its exposure to the structured credit business to 10 percent of its balance sheet, that would raise a host of measurement issues. Ten percent in what type of scenario? By what valuation methodology? Over what time frame? Is it 10 percent on a stand-alone basis, or 10 percent in combination with related risks? Yes, there are myriad questions, but they are answerable. For our purposes, the point is that to align executive compensation with the risk appetite of the board, the board first must define its risk tolerance and then link performance bonuses to it.

Unless we do that, we give the CEO an asymmetric option. If a CEO speeds and arrives early, he gets his maximum bonus and, likely, a new contract with a higher bonus. If, on the other hand, he winds up crashing the car, he gets zero, whether that crash occurred at high or low speed. To the CEO, the speed is irrelevant on the downside. To the company, its shareowners and creditors, however, a high-speed—or high-leverage—crash is much more damaging.

That’s not to say some CEOs don’t have skill navigating the twists and turns of business. They do. And boards should recognize that by allowing skillful management teams to employ more risk than average or poor teams. But in all cases, the amount of risk anticipated—the potential harm allowable to the balance sheet—should be explicit in the annual- and long-term incentive compensation programs. EVA or CFROI calculations back into these issues by accounting for the cost of capital. By making adjustments specific for risk, the board can make the appropriate linkages more direct.

Finally, remember that using economic leverage always magnifies both risk and return, but the risk may not be immediately apparent. If a car speeds unsafely on a mountain pass but doesn’t crash, it doesn’t mean the driver isn’t taking risks. It’s just that they may not be felt until the next curve. Then they may be fatal.

Which leads into another issue: Time frame. Realized risk is not normally distributed over time. Actions taken today may seem to have little risk for months, or even years, and then explode; that is exactly what happened with the sub-prime crisis. Yet we tend to award executive compensation on a time-certain basis, mostly on a relatively short-term basis, with the annual compensation and one-third of a typical stock-based incentive plan vesting within a year.

So how do we deal with the issue of submerged risk that may surface long after the expiration of the pay period in which it was created? That answer is actually pretty simple: Through claw-backs. Of the 30 companies in the Dow Jones Industrial Average, 28 have claw-back policies to reclaim compensation awarded as a result of performance, which later needed to be restated. Similarly, we believe that if submerged risk surfaces years later to blow a hole in a corporate balance sheet, then executive compensation should be subject to a claw back.

Do all that—analyze the inherent strategy risks in your businesses, risk-adjust your executive compensation plan, and institute claw-backs —and chances are good that your board will navigate that mountain pass safely. You might even enjoy the scenery along the way.

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