These days it seems that almost everyone has a proposal for changing the way executives are paid, especially at financial firms. Recent scandals—notably the bonuses that went to employees at AIG’s infamous credit default swap factory and the last minute bonuses at Merrill Lynch—have infuriated the public and policy makers, and inspired an urge to reform and restriction compensation.
Unfortunately, most of the compensation reforms being considered are inspired by a bad idea—that compensation should very closely mirror a firm’s performance. This is taken for granted by would-be reformers, but it is actually a recipe for disaster.
Let’s back up. Right now we’ve already got some temporary stop gaps in place. The Obama administration and Congress acted to limit pay at firms that took bailout money. But those limits are widely viewed as relatively toothless and Wall Street is already at work evading them. So people are searching for a more permanent regulation of pay that won’t be easily avoided.
The new proposals span a wide gamut, including claw-backs of past pay, restricted stock awards, retroactive tax penalties, bonuses paid in shares of special purpose entities that hold assets mirroring the company’s balance sheet and accrual pay accounts that can’t be tapped for years. What all of these have in common is an attempt to tie compensation to long-term performance.
In the latest issue of Portfolio, Jesse Eisinger describes how Credit Suisse addressed the compensation problem. It awarded its employees compensation with toxic assets that the bank was holding on its books. But because the bank valued those at 65 cents on the dollar, Eisinger thinks it still overpaid. He would have preferred the assets to be given out at 100% of their original value, so that employees would have to “suffer the whole pain” by taking 100% of the losses.
That sounds like an admirable goal, and many of the ideas floating around have their merits. But advocates of performance compensation like Eisnger go too far when they try to make sure that employees should suffer all of the pain when a company’s business doesn’t pay off, its investment assets decline or its stock price drops precipitously. It’s actually a very bad idea to try to make employees feel all of the pain for failure.
The liability of employees for losses needs to be limited because this actually aligns their interest with that of shareholders. An employee who knows that all or substantially all of his compensation can be forfeited if his company looses money, will be overly cautious about the business. Instead of seeking to maximise shareholder value, the employee will be likely to seek to minimize his risk of having his compensation reduced. Shareholders who have outside sources of income and for whom a company performance results in an investment gain or loss, would have a much greater risk tolerance than an employee for whom company performance closely determines his income. The attempt to align the employee’s incentives with those of shareholders, actually builds a chasm between them.
Oddly, tying pay for performance also breaks down the alignment of shareholders and employees in the opposite direction. At money losing companies, employees will be incentivized to take huge risks in order to recover the possibility of being paid. When losses have guaranteed that pay will be low to zero, those employees will have very little to lose by gambling with the firm’s performance. This means that their risk tolerance will be far greater than those of shareholders.
Another problem with the idea is that most employees cannot affect the performance of anything but a small portion of their firm. But the pay for performance idea creates an incentive for them to attempt to involve themselves in operations outside their assigned areas. This winds up breaking down the internal division of labour and responsibility, which can make a company more inefficient.
Financial firms may be an exceptional case, however, and perhaps closely tying pay to performance makes sense if we think shareholders of financial firms tolerate or even demand too much risk. There’s ample evidence for this, and it’s likely to continue since the bailouts have taught shareholders that their downside is even more limited than holders of other types of equity. There may well a strong case to be made that financial firms should be forced to become more boring, with their appetite for risk more closely controlled by regulation than by markets. A few years ago the idea that the government was a better judge of risk than markets would have been startling. But that was then, and this is now.
So by all means, go ahead and link compensation to performance. But be careful not to take the idea too far. Like most medicines, it can be poisonous if taken beyond the recommended dose.