Risk-reward horizons in short term incentive (STI) schemes

Risk-reward horizon mismatches were a problem in financial services remuneration around the time of the GFC. Deferring portions of STI rewards to reflect the risk horizon was one response. Deferral is good, but not necessarily the answer. STI schemes typically feature a mix of financial and non-financial performance measures. Financial measures are often underlying measures, which can include Deus ex machina actions by the Board to remove one-off items that impact on the reported results. Transaction bonuses are a good example to study. CSL acquired Novartis’ influenza business in FY15. The costs are removed from underlying NPAT (CSL also uses uNPAT on a constant currency basis) in the STI scheme but the acquisition itself is rewarded via the non-financial measure ‘Achieve leadership in influenza’. In your investee companies, look out for STI schemes adjusting the numbers for completing transactions (removing the costs associated with the transaction) while rewarding completing the transaction via the non-financial performance measures. It might just be a risk-reward horizon problem in the making.