Incentives: Ensuring Sustainability in Program Changes

January 2, 2018

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    Incentives have been top of mind for the financial services industry for over a year now. Many changes have already taken place while simultaneously considering where to focus going forward. By now, most financial institutions have placed significant resources toward assessing and adjusting, as necessary, their incentive programs. While this effort likely started with branch sales practices, it may have been extended to the following areas, among others:

    • Marketing (in many cases a “second look” at add-on products)
    • Underwriting
    • Customer Service / Cross-Sell
    • Collections

    For each of these areas, the goal is the same – minimize the chance that an incentive program drives undue risks or inadvertently causes customer harm. To mitigate these risks, two main actions are generally required: (1) changes to the incentive program structure and (2) enhancements to the monitoring of the incentive program.

    Changes to Incentive Programs

    Incentive program changes can range from minor tweaks to full scale overhauls, depending on potential risk. First, the most fundamental question is whether a current incentive program is truly achieving the benefit or intended results. If not, adjustment is likely needed. Many groups review return on investment (ROI) or level of uplift in a key performance metric to determine this. Once the intended result is defined, a new program can be developed, but it must be built with consideration for the potential compliance, regulatory and reputational risks.

    More specifically, guidance has been shared by multiple regulatory bodies to help navigate incentive-based compensation. Joint recommendations from the OCC, Federal Reserve, FDIC, NCUA and FHFA applies to all banking organizations regardless of the organization’s size. The three main principles from this Guidance on Sound Incentive Compensation are:

    Principle 1

    Incentive programs should appropriately balance risk and financial results in a manner that does not encourage employees to expose organizations to imprudent risks or cause customer harm

    Principle 2

    Risk-management processes and internal controls should reinforce and support the development and maintenance of balanced incentive compensation arrangements

    Principle 3

    Banking organizations should have strong and effective corporate governance to help ensure sound compensation practices, including active and effective oversight by the board of directors

    These principles from the regulatory guidance should be kept front of mind for adjustments to all types of incentive programs.

    As incentives have evolved, these risks have led to today’s programs placing a greater focus on customer service, product usage and growth (i.e. quality, not quantity) and direct customer feedback. Plus, there’s also been an overall reduction in variable incentive-based compensation (i.e. higher % of compensation coming from base salary). That said, this greater focus and scrutiny on incentives doesn’t mean the end of sales goals, but they should be monitored more closely as part of a robust Compliance Management System.

    Monitoring of Incentive Programs

    Incentives in today’s environment can still be effective in achieving intended results when appropriately controlled. This means having processes in place to quickly identify when an incentive program is leading to an undesired result, and taking immediate corrective action. Examples of additional monitoring that has been (or should be) put in place include:

    • Tracking complaints back to specific processes and escalating complaints when trends are identified
    • Monitoring incentive programs for unusual upside and downside staff performance trends (i.e. did contact rate improve dramatically? Is one manager’s group significantly outperforming others?)
    • Testing – including transactional testing – and auditing practices to determine if potential harm to protected classes or inconsistencies among employees exist
    • Enforcing incentive knockouts and disciplinary action on all fraud abuse (i.e. zero tolerance policies) – these should be supported by defined procedures when a fraud abuse is identified

    An appropriately designed incentive program, coupled with controls and monitoring that is effective and aligns with the existing risk and control frameworks, helps place financial services firms on track to focus on growth and achieve future sustainability.

    Making Sure it “Sticks” – Keys to Sustainability

    Much of what has been described above has likely taken place with most financial institutions and a majority of organizations are now ensuring these changes are sustainable. True sustainability involves a robust understanding of all incentive programs that exist across an enterprise; proper oversight to ensure compliance with enterprise objectives/policy; and an appropriate level of risk-based monitoring. Recommended activities to achieve sustainability include:

    • Inventory all active incentive programs and prioritize them by risk level
      • This should include third-party incentive programs
    • Develop a roles and responsibilities matrix for each active incentive program
      • Ownership of the program
      • Applicable compliance requirements
      • Policies and procedures
      • Training
      • Controls and monitoring
      • Complaint handling
      • Resolution and cause analysis
      • Human resource actions
      • Communications and escalations
      • Frequency that the program is required to be re-evaluated
    • Ensure ongoing horizontal risk assessments to assess how programs “interact” and any potential upstream/downstream impacts that may not be identified by evaluating a program on its own
    • Establish a strict no tolerance policy for any unfair, abusive, or deceptive techniques across all programs
    • Develop MIS- and board-specific reporting, track Key Risk Indicators (KRIs) at the corporate level for each incentive program, and implement a formal communication and escalation policy

    We anticipate that dedicating time to these types of critical sustainability activities will be what enables firms to shift future focus to other more strategic matters and reduce the risk of future regulatory actions.