Responsible Incentive Compensation

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Thursday, I criticized AIG's new bonus pay plan. Although a ratings-based system can be a great way to ensure that your employees deserve the bonuses they receive, I was less than impressed with AIG's particular version. But since I like to be constructive, I thought it might be nice to explain an incentive compensation system that could do better.

Preliminary Considerations

Before getting into specifics, let's go through a few general requirements. First, any good incentive compensation system should pay primarily shares of company stock. That stock should also take several years to vest. That way, the employees have greater reason to target long-term profit: if the stock price plummets in a few years, so does the value of their bonus.

Next, most, or all, of that stock should also be subject to being clawed back if the something goes terribly wrong. The easiest example here is if a trader's long-term positions go bad. Then, any bonus he received based on earlier gains should be seized to cover those subsequent losses.

The System

Grades

The actual details of the system could vary a bit, but here's one format that I think would make sense. All employees are graded on a numerical system, 1 through 5:

5: Best score, 10% of employees
4: Very good score, 40% of employees
3: Good score, 40% of employees
2: Needs improvement, 5% of employees
1: Unacceptable (Probation), 5% of employees

In any given year, a firm should probably shed approximately 5% of their worst performing employees. Some companies already do this. Unless all of a firm's employees are truly incredible, I find it hard to believe there aren't a handful that are expendable.

Timing

I would do reviews twice each year. That way, anyone scoring a "1" can have the opportunity to improve. If the employee remains at this level for an entire year, then he should be dismissed. This also balances out the grade if considered twice a year, with the grades averaged.

Bonus Pool Distribution

So what about actual pay based on those grades? That can be determined on a firm-by-firm basis. But I would suggest something like:

5: Share 20% of the bonus pool
4: Share 45% of the bonus pool
3: Share 35% of the bonus pool
2: No Bonus, potentially claw back
1: Claw back past bonus

Obviously, this would be more complicated in practice, but you get the general idea. Past performance gone bad would also count. During really bad years, more employees could end up with a "2" or "1" for that reason, if more claw backs are necessary.

Bonus Pool Formation

But what makes up that bonus pool? For example, in a year the firm posts a loss, do employees still get bonuses? It depends. If clawing back employee bonuses who are responsible for that loss can more than cover it, then other employees might receive bonuses. But it is possible that even well-performing employees would suffer due to poor overall firm performance. More on objections to this in the next section.

Covering Losses

Let's think about the financial crisis. Who profited due all the bad bets that were made on Wall Street? Obviously, the bonuses soaked up some of the profit, but not all of it. Banks also divvied up billions in dividends to shareholders during the housing boom, and some of that money surely came from all of the gains on bets that eventually went bad. So I'm not convinced that shareholders should be shielded from claw backs either.

What I'd envision is dividends needing to vest as well. If employees shouldn't receive profits on bets that go bad, why should investors? All dividends could be subject to claw backs for several years before investors can fully realize those gains. However, even if investors sell the stock between the time the dividends were accrued but before vesting, they would still be entitled to collect once the waiting period is over.

I also think that higher-level management should be graded on a stricter scale than other employees. The buck stops at the CEO, for example. If losses occur under management's watch, then they should be subject to substantial claw backs.

Benefits

The most obvious advantage to a system like this is that employees would be much more careful to strive for long-term profitability. They could still make gobs of money in the long-run, but not by taking bets that only look good in the short-run.

This system would also have a nice additional consequence: it would help solve the "too big to fail" problem. Let's say you work in mergers and acquisitions at a bank like Citigroup. You don't want to worry about a situation where those crazy mortgage bankers overheat the housing market, and you consequently lose your bonus if the bank suffers a loss due to their shenanigans. Instead, you would prefer to work for a smaller, boutique firm that specializes in M&A. That way, there's a much better chance that your compensation will be based on your performance, instead of irrelevant external factors.

Finally, since shareholder profits would also be held back, and could be seized to cover future losses, this system would also encourage investing based on a longer-term view. In a well-functioning market, you want investors who care about what happens to a company over the course of several years, not several months.

Considering Some Predictable Criticisms

One obvious criticism is that the good performing employees will be penalized for the actions of bad ones. But I already explained why that's actually a positive above: it will discourage a firm from growing so large that its right hand doesn't know what its left hand is doing. The leadership of a firm of a manageable size should have a good understanding of what all divisions are doing. As former Treasury Secretary Hank Paulson admitted last year, that's not always the case in big firms like Goldman Sachs.

Another complaint might be that firms will have to hold an awful lot of money back, and that would be unproductive capital. I have a solution to this. Any money held-in-waiting for distribution could count towards capital requirements. The reason why capital requirements exist in the first place is to pad potential losses. But that's exactly the function that this held back bonus money is meant to serve. As a result, firms would actually have even more capital they could use for investment, since their deferred compensation pools would constitute a large portion of their capital.

I would not, however, advocate the government require such bonus plans. I'm not a fan of regulation that heavy handed. As a result, I see getting most firms to agree to adopt incentive compensation systems like this as the biggest obstacle. If entire industries don't develop plans like this, then talent could just flee to the firms where they can get their money immediately, rather than wait patiently for their shares to vest and worry about long-term profitability.

But that's where I think shareholders and boards of directors should come in. A system like this would be prudent. It should ensure that big, catastrophic losses are rare. And when they do occur, the firm could handle the blow by clawing back previously promised compensation. That's why I think it would take shareholders to demand a system like this put in place. And if some firms did adopt such practices, I think investors would find their equity far more attractive than that of others that continue to allow wild short-term profits that endanger long-term viability.

So there's my thought experiment on incentive compensation. Feel free to share your thoughts or comments below!

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.
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