Compensation 101

Maybe one’s background determines how one feels about those AIG bonuses. Passing a special tax to make those executives and derivative traders pay back the total of what they were awarded, with a special income tax just for them, seems rather odd, even if it is, for many, emotionally satisfying. It also may be illegal – you cannot pass revenge laws like that, and that’s in the constitution.


But to some of us, the whole thing seemed kind of stupid, and that may be a matter of personal experience.


If you’ve ever worked in HR Systems for a large corporation – not that many people have – you find yourself forever doing pay equity studies. It’s not just that you want to make sure you’re not inadvertently paying people in those protected classes – minorities, women or whatever – less for the same work, you also want to make sure you are offering competitive wages and benefits, so key people stay, knowing they won’t do any better anywhere else. And you want to attract the productive new employees you need. You pay what it takes to lure them in. Out here, back in the eighties, everyone said Disney paid absurdly low wages – well below the market – on the notion that people would accept low pay for the privilege and joy of working for Walt and Mickey. That probably wasn’t true – no one is that dumb. People would walk. A financial analyst knows cash flow and receivables are what they are – the cash that flows in from a happy theme park is much like any other cash. Mickey has nothing to do with it.


So you build your tables – consulting firms and research houses will sell you data on the going rate for people who do this or that, broken down into geographic subsets, or subsets relating to experience or education or age or most anything else – and you plug in your positions, the people in them, their characteristics, and plot all that against the market information – and you see what you have. Then you report any problems – underpaying Jane or Fred, or wasting far too much money on Clyde – to management. They know what to do. The appropriate adjustments are made, save for the inevitable favoritism, grudges and gleeful sadism. You’re dealing with people, after all, not a rationalized display of data points.


And once a year it gets really hairy – everyone gets an annual performance appraisal and, against a fixed pool of money set aside for raises, promotions and bonuses, management digs in and tries to figure out who should get what, and why, or who gets nothing. You want to reward the best performers, and the temptation is to use your limited portion of the corporations fixed pool of money, set aside for this effort, to give them big raises, and just screw everyone else. That somehow seems fair, and what incentive is all about. On the other hand, you don’t want to demoralize the good people who do all the reasonable, if unexciting work, who keep everything running. That’s most of your department. You don’t want them to walk. That would be a disaster. So the other temptation is to give everyone a small raise, everyone getting the exact same percent. Solidarity and having a happy, functioning team is important too.


Those of us in HR Systems knew what came next – requests from management for custom applications that, through some sort of regression analysis or other magic, might square that circle – so that with a set amount of resources, as there would be no additional money allocated, there would be some way to reward the stars and also keep the good worker-bees from being massively discouraged. Those applications were fun to write – and, in a giant aerospace corporation, appreciated by the brilliant engineers who managed the young and even more brilliant engineers. But they were nonsense. These guys still had to make very human and quite difficult decisions – and what they decided would have human repercussions. Building cutting-edge commercial communications satellites, and advanced military satellites that no one could even discuss, was far easier than any of this. They hated it.


And it got even more complicated with pay-ranges for each position. Say a systems engineer of a particular type was, according to the market tables, to be paid between X and Y, depending on his or her education, skills, experience and performance. You had your quite specific pay ranges and pay-grades. That’s fine, and a lot of research – and far too many meetings – went into getting all that just right. You had to get that right to stay in business. But then there was this guy who had been doing his systems engineer job magnificently for many, many years, and was at the top of his pay-grade, which this particular year meant you could not pay him any more than what he was earning. He’d hit the ceiling, the top of the range. But the problem was you couldn’t promote him to the next highest pay-grade, where he’d be in the first quartile and eligible for big bucks. What was one step higher was management, and this guy was a complete jerk. The idea of him managing others was appalling. And he didn’t want to do that anyway. He was a brilliant, and eccentric, systems engineer – he had no interest in managing budgets and people. He liked what he did. But if you didn’t reward him for his hard and inventive work someone else would. He’d go down the street to your competitor. So, if you could allocate the cash, you paid him a big bonus, in lieu of a raise. But he asked you why he wasn’t getting a raise. Drat.


This was the compression problem – where human factors slam up against systematic thinking. Of course the solution was to create a new pay-grade that pays as much as the one-higher-up management pay-grade – a parallel success track for socially inept introverts, who you need to keep doing what they do. A few tech companies finally figured that out.


But, in short, human factors slam up against systematic thinking all the time. Most of compensation is like that. You say you pay for performance – that’s what you do and nothing else – but it’s never that simple.


And the AIG business, take the bonuses away by taxing them all away, isn’t that simple. Of course, one of Andrew Sullivan’s readers thinks it is:


It’s stupid, and probably unconstitutional, sure. But it’s great because it gets us past what is, in the big picture, a trivial issue. If the bill becomes law, Americans can feel like the government did something to get their money back and we can move on to dealing with real problems. A lawsuit challenging the bill will follow, and in a year or two, it will get struck down, and no one will care, because we’ll either be on our way to a recovery, or so deep in shit that we’ll have much bigger problems on our mind.


Sullivan adds this – “That sounds about right to me.”


But the House bill, which may well die in the Senate, makes things a bit more complicated, to make the thing look less like an illegal post facto law or a bill of attainder to punish certain parties. As written, the tax would apply only when an entity has taken more than five billion dollars in government relief, and apply to only certain people who receive bonuses – those whose base salary is greater than a quarter million a year. Anyone who makes less than that can get a retention or performance bonus – no problem.


Nate Silver, the master statistician, says that’s nonsense:


The government has dictated that nobody at anybody of these companies is deserving of incentive-based compensation, unless their household income is less than $250,000 per year.


Just think about some of the implications of this. A senior engineer at General Motors, who shepherds the production of a new hybrid vehicle that will turn out to be a best-seller, shouldn’t get a bonus for that. Really?


And the Nobel Prize winner, the economist Paul Krugman, is unhappy Obama isn’t calling out this foolishness, and that the treasury secretary, Tim Geithner, isn’t objecting much at all:


This was bad analysis, bad policy, and terrible politics. This administration, elected on the promise of change, has already managed, in an astonishingly short time, to create the impression that it’s owned by the wheeler-dealers. And that leaves it with no ability to counter crude populism.


You don’t protect the bad guys, but you don’t support nonsense. They did both.


Some see the structural problem here. Federal Reserve Chair Ben Bernanke says something is really wrong with Wall Street’s pay structure:


“Poorly designed compensation policies can create perverse incentives that can ultimately jeopardize the health of the banking organization,” Mr. Bernanke said during a speech in Phoenix to the Independent Community Bankers of America. “Management compensation policies should be aligned with the long-term prudential interests of the institution.”


Well, no kidding. But fair compensation is hard to manage.


Still, the reason we are told these people got their bonuses in the first place does raise some question about who knows what about how and why you pay folks what you pay them. Simon Johnson doesn’t exactly buy the AIG line of thinking, which seems to be what Tim Geithner thinks too. Johnson puts it this way:


…in every crisis I’ve ever seen, the (banking/corporate/government) insiders responsible for major problems always want to stay on – arguing that they have unique skills and can sort things out better than anyone else. Countless times around the world I’ve heard some version of, “it’s very complex, no one else can figure it out, and you’ll lose a lot more money unless you keep us on.”


Yet, whenever possible, it’s better to clean house and bring in new talent at all levels to wind down bad business and more generally clean up/recapitalize/re-privatize the financial sector.


Still, that begs the question Bernanke raises, of what compensation system would line up prudence and reward. And Matthew Yglesias comments:


There are two kinds of issues here. One is what should the government do (or have done) with “normal” financial institutions. In this case, I don’t think it would be appropriate for government to step in and try to tell firms how to pay their traders. But Ben Bernanke and other regulators, charged as they are with prudential oversight of the financial system, could certainly make known to the public their view that certain firms have a compensation structure that does not seem consistent with the long-term prudential interests of the institution.


But Yglesias sees that’s a bit irrelevant now, as what to do with government-controlled or government-dependent enterprises is the real issue:


Here the case for forthright action is pretty clear. It’s our money, so we should insist that it be given to managers who are compensated in a way that’s aligned with long-term prudential interests. That would mean relatively low salaries and long-term equity in the firm so that you can strike it rich if and only if your work actually pays off well over time.


That’s easier said than done. But Brad DeLong, the Clinton economist up at Berkeley, may be onto something. AIG and the rest should be run like the chip makers:


The engineers of Silicon Valley startups are significantly smarter and work a lot harder than do the traders of Wall Street. Some of the engineers of Silicon Valley make fortunes: they are compensated with relatively low salaries and large restricted equity stakes in the startup businesses they work for, and so if the businesses do well they do very well indeed – in the long run, in the five to ten years it takes to assess whether the business is in fact going to be a viable and profitable going concern. And the engineers of Silicon Valley have every incentive to use all their brains and all their hours to make their firm viable and successful: they get their cash only at the end of the process. They don’t get big retention bonuses if they stick around until the end of a calendar year. They don’t get big payouts if they report huge profits on a mark-to-market basis.


But the big financial service firms just don’t work that way:


The traders of Wall Street, by contrast, get their money largely up front. If the mark-to-market position is good, they get paid – even though it is almost surely the case that nobody has tried to actually sell the entire position to somebody else. If the strategy produces short-run profits, they get paid – even though not nearly enough time has passed for anybody to be able to assess what the risks involved in the strategy truly are. They get “traders’ options” – we claim that we have made you a lot of money, we claim that the positions and strategies we have left you, the stockholders, with are sound, we claim that we have correctly managed our risks – but we are not interested in putting our own personal money where our mouths are but instead we insist on getting our fortunes up front.


The major institutions of Wall Street did not adopt Silicon Valley compensation schemes (SVCS). They went the other way, even if that bothered DeLong and the other economists at the time:


The strong view was that the venture capitalists of Silicon Valley knew what they were doing and were acting as prudent and responsible agents of their investors when they insisted on SVCS for their startups. So why didn’t the shareholders of the major banks do the same with their traders, quants, and strategists?


The decisive argument in regulatory and policymaker bull sessions about this issue was that this was the shareholders’ business – that if the shareholders of these companies thought that there was good reason to elect board members and CEOs who did not impose SVCSs, the government should be cautious about stepping in. And the argument that “maybe the shareholders know of some good reason not to adopt SVCSs” no longer applies: we are the shareholders, we know of no reason, and we see no reason not to align the interests of our employees at AIG and at TARP-receiving companies with the long-run interests of the U.S. Treasury.


So DeLong is fine with “punitive taxes on excessive immediate cash payouts paid by TARP and other government financial commitments.” But he thinks from now on, run the place like Silicon Valley was run:


Traders and financial executives who are willing to work very hard for what are now government-owned enterprises should be offered the carrot of long-term restricted equity stakes: that if they do their jobs well and if the government makes a healthy return because of their skill, forethought, and diligence, they should make healthy returns as well.


And those returns should not be taxed punitively – that would be dangerous too. So, all together now, everyone sing a chorus of Do You Know the Way to San Jose?


But human factors slam up against systematic thinking all the time. That may not work either. This will take a lot of thinking.


About Alan

The editor is a former systems manager for a large California-based HMO, and a former senior systems manager for Northrop, Hughes-Raytheon, Computer Sciences Corporation, Perot Systems and other such organizations. One position was managing the financial and payroll systems for a large hospital chain. And somewhere in there was a two-year stint in Canada running the systems shop at a General Motors locomotive factory - in London, Ontario. That explains Canadian matters scattered through these pages. Otherwise, think large-scale HR, payroll, financial and manufacturing systems. A résumé is available if you wish. The editor has a graduate degree in Eighteenth-Century British Literature from Duke University where he was a National Woodrow Wilson Fellow, and taught English and music in upstate New York in the seventies, and then in the early eighties moved to California and left teaching. The editor currently resides in Hollywood California, a block north of the Sunset Strip.
This entry was posted in AIG Bailout, AIG Bonus Scandal, Compensation Theory and Practice, Rewarding Dangerous Risk-Taking, Rewarding Incompetence, Rewarding Prudence. Bookmark the permalink.

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