Bonus Bitterness Backfires

By Daniel Indiviglio

The Wall Street Journal reported late last night that Citigroup and Bank of America will soon be raising the salaries of their investment bankers, just like Morgan Stanley announced last week. The idea is to have higher salaries with lower bonuses, which will help retain their best employees who might otherwise flee to banks without government-imposed bonus restraints. While their desperation is noted, their idea is terrible.

The WSJ also reports that JP Morgan and Goldman Sachs might follow, though "people familiar with the matter" swear otherwise. The article quotes compensation consultant James Reda:

"This could give an advantage to the company paying the higher salary, and that creates a market," he said. "I think eventually J.P. Morgan and Goldman Sachs will need to adopt the same changes to compensation."

This all resulted by the government imposing limits on bonus compensation. That occurred through popular outrage that investment bankers get such gigantic bonuses, particularly at a time many think they deserve a jail cell instead. Anyone familiar with investment banking compensation, however, knows that the very term "bonus" is a misnomer.

For well-compensated bankers, the base salary has traditionally been a small fraction of overall compensation. After two to three years experience, salary is about 50% of compensation and decreases steadily from there. By the time a banker achieves the esteemed level of Managing Director, salary is almost certainly less than 20% of total compensation.

The idea was that the major portion of compensation being in the form of a bonus would create greater incentive for hard work and innovation. In good years, bonuses would soar; in bad years, bonuses would deflate. As the past few years have shown, however, while bonuses do go up in good years, in bad they seem to stay up -- at least by the average American's standards. That made people angry, especially Congress and the President.

So raising salaries seems to be Wall Street's brilliant solution. Here's the problem: it doesn't solve anything. The eye-bulging compensations that the general public objected to will continue -- all that changes is that the proportion of guaranteed salary becomes a larger part of the pie. If before total compensation was a pizza and only a slice was salary with the rest bonus, now only a slice is bonus and the rest is salary. The size of the pizza hasn't changed.

But that's not the real problem. Critics of the traditional investment banking bonus scheme argue that bankers are compensated for short-term gain, resulting in risky and negligent behavior. Yet, paying high salaries also fails to provide incentive for bankers to seek long-term profit. Indeed, a high salary does not really provide incentive to do anything other than the status quo.

Instead, banks should try to be more creative and devise a compensation scheme where short-term gain is not rewarded as greatly, while providing greater incentive for long-term gain. Here are a few sample proposals, all of which would be better than merely increasing salaries:

Option #1: Award bonuses using a three year rolling-average based on each business unit's performance the prior year, current year and following year. That means each year, the bonus awarded is actually the prior year's reward.

Option #2: Defer compensation in such a way that, if a business unit's profit turns out to be short term, the accrued future compensation is reduced. Each employee could have a compensation pool with various vesting points in the future, the value of which changes each year, based on performance.

Option #3: Use very little cash to pay bonuses, but instead pay in firm stock or options that take several years to vest. That way, if the firm does poorly in the long-term, the banker fails to see the compensation.

Of course, Option #3 is not that different from what happens currently. That's why most bankers are significantly poorer than they were three years ago. Some may have been lucky enough to get rid of their holdings of their bank's stock or options before share prices plummeted, but most lost hundreds of thousands or millions of dollars. Either Congress failed to understand this when they created the new compensation restraints, or it just didn't care.

Bankers earning higher salaries is not a solution to the problem. I'm not sure why a better solution hasn't been sought. Surely, banks want to attract the best talent while also creating greater incentive for long-term profits. It's not that hard to think of better ways to do so. After all, I just thought of three in approximately as many minutes.

This article available online at:

http://www.theatlantic.com/business/archive/2009/05/bonus-bitterness-backfires/18349/