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.

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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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