Incentive Pay for Execs Is Overrated

Have you tuned out the shrill, interminable debate about incentives for executives in banks, from CEOs down? It's an ill-informed and increasingly misdirected and distracting hubbub.

We are told short-term incentives promoted foolish risk-taking, causing financial crisis. Ridiculous. Angelo Mozilo's drive to achieve a 30% market share in mortgage originations wasn't fueled by desire for immediate financial rewards. He was the longest of long-term investors, starting in 1984 or earlier. Likewise, Joe Cassano at AIG "earned" $280 million over a period of eight years by selling what proved to be disastrous credit-default swaps. He didn't have his head turned by one year's bonus calculation. The same was true for Wamu: Kerry Killinger is reported to have received $88 million from 2001 through 2007. So, let's skip the simplistic claptrap.

A green beacon shines from On High: Charlie Munger (Warren Buffett's partner) asserts repeatedly that incentives have a huge influence on employee accomplishment. So, we are doomed to go on yammering about three- to five-year plans, clawbacks and their endless variations.

I bow to the authority of Charlie's age and particularly his wealth. But my view is different. Excepting only lone-wolf salesmen, I haven't seen incentives improve anyone's decisions and accomplishments within a large organization. Monetary incentives never made me work harder, or smarter.

Charlie's favorite example is itself antique. He says workers at FedEx performed better when sent home after finishing the day's parcels (whether few or many). Should we try that on bank employees working item processing volume? These people aren't unionized either. But overtime has to be paid under state wage and hour laws. And we actually have more work for these employees, beyond the day's volume of debits and credits.

Paying fixed compensation for fixed hours of work was neither obvious nor an inspiration. At the beginning of the Industrial Revolution in England, people who had previously done piecework at home were hired into textile mills and allowed to come and go as they pleased, to meet output quotas. Chaos ensued.

The notion of working and getting paid for an eight-hour day came later. And circling back to doing white-collar work at home, even empowered by the most modern technology, has nearly always failed — despite the savings in occupancy and commuting cost. We need fixed hours and fixed pay at the workplace. Without that, we lose both work discipline and financial discipline.

I know managers who started handing out $20 and $50 gift cards at the end of a productive day. That didn't cut much ice, or at least not for long. Employees become inured to it quickly, attaching low value to highly uncertain winnings. If this can't motivate them, how could longer-term rewards? They don't: The longer the wait, the less you care about the bonus.

In a good workplace, good workers want to keep their jobs — at least until offered a better one. With visibility and prompt, clear feedback, they respond to direction. How to be efficient, compliant and productive is not something they can figure out for themselves, no matter how glittering the rewards.

Executives are allegedly smarter and more motivated. How do incentives impact them? If rewards are based on bottom-line results (EBITDA, stock price), then payout will be determined primarily by external events — the economy, competitors and the stock market. Demoralizing, demotivating.

Basing bonus on performance versus competitors rather than on absolute performance foments exactly the downhill race to perdition seen in mortgages. A few irresponsible competitors magnetize others to do likewise in order to avoid losing market share and hence share of industry profits.

Could we have incentivized a CEO who produced terrible mortgages in 2006 to pull back instead until 2013, when (at the earliest) the housing market might conceivably become healthy? Or would he have counted on making big money in 2009 by being less bad than his rivals? No.

What we have now is an illusionary system where CEOs hire compensation consultants at corporate expense to devise and "justify" maximum possible payout via imaginative incentive formulas. Other CEOs on compensation committees, together with less-sophisticated directors, happily say grace over this — and their own compensation rises. Subordinate executives are accorded bonus triggers and scales that often assure almost maximum payout for most of them no matter what happens.

Let's pay people what we think they're worth, rain or shine. Cut the management incentive travesty, at least in banks. If it's complicated, you can game it. Today's incentives cover a disguised escalation of what is essentially fixed pay, wafting the whole compensation structure upward. Dependence on supposedly contingent payout for a large fraction of the compensation accorded executives and managers is an unsafe and unsound practice. The prudential regulators should rein it in.

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