Saturday, September 29, 2012

Incentive Compensation

Incentive Compensation

Wall Street is the home of “incentive compensation,” bonuses paid for achieving certain goals: beating a certain investment benchmark, making a sales quota, or achieving a profit target.  This is a highly leveraged game because the most senior people have the biggest base salaries and are also entitled to the biggest multiples of their base salaries.  For example, a lowly junior analyst might be paid $150,000 salary and be eligible for bonus that is 50% to 100% of her base salary.  At the upper end, a portfolio manager might enjoy a seven figure base salary along with the opportunity to earn 5 or 10 times the base.

At the moment I’m not concerned about those base salaries.  It’s the incentive compensation that has me upset, because it is largely a fraud.  The theory is that bonus plans create powerful incentives to employees to achieve certain goals or targets.  In other words, if a portfolio manager is eligible to receive a big bonus, he will try harder to achieve top quartile performance (top 25% among all managers investing in a similar manner).

Corporate Ideals (1999)

There are two huge holes in this theory.  First, I have never seen any evidence that portfolio managers with bigger incentive plans work harder or do better than those with smaller incentives.  Everyone is striving (and most are failing) to beat a benchmark like the S&P 500.  Second, when the incentives are paid, a huge piece of the compensation is based on dumb luck, not skill.  The market happened to move in the manager’s direction in a particular year, or a marketer had a product that sold itself (such as an enticing track record).  Nonetheless, companies create complicated incentive plans in lengthy documents with all manner of grids, targets, and benchmarks, and hold endless meetings to explain the systems and dole out the cash.  Why?

These systems seem objective and scientific, so it appears that the big dollars are being doled out on a fair and meritorious basis.  However, if you dig into these plans, the goals are seldom objective.  In money management anyway, the benchmarks and targets are often rigged or are the by-product of political negotiations between the top portfolio managers or marketing executives and senior management.  No such luck for the rank-and-file; their bonuses are probably the result of a McKinsey consulting study.  Moreover, the measuring periods are often too short, so big dollars are paid for short-term performance even though the client’s interest is long-term.

The real reason these systems exist and proliferate is that they are a handy way of paying people huge sums of money without it appearing that the recipients earned a windfall.  The biggest beneficiaries can claim that they “earned” their bonuses, when it was good fortune that produced the bumper crop of dollars.

I’d have less concern about the Wall Street incentive compensation system, if it were confined to Wall Street.  However, these schemes are everywhere, including the classroom.  I really don’t think that a 10% or 25% bonus offered to school teachers whose students achieve certain test scores or outcomes is going to change anything in education.  Teachers are simply not in control of enough that is going on in the lives and minds of their students.  If a teacher hits the target, we’ll pay him the bonus and congratulate him on his achievement, even though the woman in the next classroom over did a better job with a much more challenged group of students.  

I find it rather ironic that people who insist that they need to make 5 and 10 times their base salaries in order to produce their financial alchemy think that a small bonus to a school teacher is going to change educational outcomes.  I suppose the teachers should be grateful because these schemes are about the only way they’ll make any more money.  We on Wall Street and in money management have our nerve criticizing a profession where a large portion of the practitioners spend their own money to meet the needs of their classrooms, while we charge every expense possible to our company or investors despite our seven figure pay packages.  We should examine our own pay practices before recommending them to others.

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