There's no incentive in bonus

I've been blessed enough to see a big bonus and cursed enough to see the smallest.  The problem is, neither of them affected my motivation -- and not because I'm such a dedicated worker.

When I got a big bonus, I felt good of course.  The next day, the same problems confronted me, and I didn't work any less or more hard to solve them.  You can't make your brain pump out more than what it does, or come up with more innovative solutions suddenly.  The best I could have done was maybe type a little faster.

When I got a small (ahem, zero) bonus, I was very unhappy of course.  But a guy that I enjoyed working with expected me to deliver some code by the end of the week, and I spent the rest of the day dedicated to fulfilling my commitment.  That guy didn't affect my bonus one way or the other, so why should he suffer?  (Another demonstration that friends at work contribute significantly to your job enjoyment.)

The kicker is that my own productivity was one of the smallest factors.  Much bigger: profitability of the company, industry trends, macro-economic conditions.

In good years, a few people felt good, but most had mixed feelings.  After all, most people view themselves as above average, but most will receive an average bonus.

In bad years, everyone felt bad: people that had worked hard felt cheated, and those who didn't were upset just out of disappointment.

So, on net, bonus day as practiced on Wall Street is typically a mixed to negative experience.  It's supposed to reward and thereby encourage performance, but it's so weakly related to performance that it's more like a lottery.  This is the mechanism setting the culture at all these financial institutions that are too big to fail?

50% tax on bankers, US

I didn't think we'd see it, but someone will actually propose a 50% tax on banker bonuses. 

Rep. Peter Welch (D., Vt.) introduced legislation Tuesday to slap a 50% tax on bonuses in excess of $50,000 paid to employees of any bank that received bailout money. The proceeds would be lent to small businesses struggling to find loans from commercial banks.

I give this no chance of passing, if for no other reason than it's too late in the cycle.  The bonuses are practically out the door.  You don't want a situation where you have to clawback the money, or if it's the banks that would pay, they have a big unexpected bill suddenly due. 

But, I'm still surprised to see it raised as a possibility. 

Lawsuits to rein in bonuses

You know things are a little whacked when your own shareholders sue you over bonuses.

Goldman Sachs Group Inc is being sued by an institutional investor who claims the firm is preparing to pay out improper bonuses.

Naturally, shareholders want more, but in this case, they believe they deserve it.  According to an article last month:

Despite record net income and compensation at Goldman as markets rebound and the firm outmuscles weakened rivals for business, analysts expect its 2009 earnings per share to be 22% lower than in 2007 and roughly equal to its 2006 earnings...  The decline is caused by issuing more than 100 million shares in the past year to bolster Goldman's financial position and capital.

The article raises the question about whether Goldman changed the way it accounts for consultants in order to make the average bonus look lower.  The conclusion seems to be that no change occurred, but questions like these will continue when 1) you faced death and survived due to help from the government, wealthy friends, and shareholders, who allowed getting diluted due to the circumstances, and 2) you played accounting games before.

In fact, given the disappearance of the worst month in its history (thanks to the accounting games), these bonuses may indeed be improper.  Including December, this is most definitely not a record year and therefore not deserving of record bonuses.

Bonus culture has ended its usefulness.

50% tax on bankers

A short interruption as we barrel toward bonus season here in the financial industry.

A fifty percent tax on bonuses over ~$40k would certainly get bankers' attention.  Britain and France both signed up, but other countries, including the U.S., have backed away.

At first, I doubted the wisdom of it, but after some thought, I find myself agreeing with it more.  (Needless to say, my banker friends would kill me.)

 The common arguments against aren't that strong, frankly:
1. it's politically motivated?  Uh, every law that gets passed fails that test.
2. it will drive people to work in other cities?  One time events don't have a big impact on behavior.
3. it will drive people to work for other companies?  See #2.  A couple years from now, this will have zero impact on people's work decisions. 

The bottom line is, we can dismiss this one-time tax as an extraordinary event, just as we justified bailing out the events because of the singular nature of the bubble collapse.

The strongest argument against it is that it can be circumvented, through delays or payments of other forms.  Very difficult to enforce.  But most people aren't making that argument.

As an issue of fairness, I see nothing wrong with it.

Bonus season begins

I'll be following how the bonus season plays out this year.  Most banks will apparently have huge bonus seasons.

Goldman, doing the best, will pay the biggest bonuses.  Back in August, the CEO told staff to refrain from ostentation. Didn't really work: bankers and traders are making giant purchases, just with lowered voices.

I'm reminded of the movie Goodfellas.  The guys pull off the biggest heist in history, and DeNiro (Jimmy Conway) tells everyone not to spend the money until the police heat turns down.  Instead, the next day, one guy shows up in a new pink Cadillac, the next guy's wife has a new mink coat. 

The most interesting aspect will be how the public responds.  Some predict public outrage, but I think it will brief and muted.  The Wall Street show will roll on.  Only strict regulatory overhaul has a chance to change things.

In Goodfellas, recall, the only thing that stopped the lavish spending was Jimmy Conway killing everyone off.

Long-term gains

After I work out / swim, I feel great.  Yet, before I work out, I have difficulty starting and think of dozens of reasons why I can't.  Why is that?

Sleeping feels great also.  So great that, like lots of people, it's not easy to drag myself out of bed in the morning.  Yet, at night, when I should go to bed, other things that I could or should do seem to proliferate, and I constantly go to bed late.  Why is that?

I believe the answer also explains why bonuses fail as an incentive practice.

All the satisfaction from the workout and the sleeping come at the end.  Meanwhile, there are other activities that offer more immediate rewards.  Sometimes, as in the case of working out, the activity itself requires exertion, and just sitting and doing nothing can feel more satisfying, in the very short run.

Frequently, the only thing that gets you to do the "right" thing is discipline.  Tricks can help, too, like telling yourself, "If you work out, you can have dessert."  But that's discipline in another form, because you can obviously do what you want.  Automatic withdrawals from your paycheck into your 401k is another form of discipline -- actually, another example of a very beneficial long-term goal that we wouldn't have a chance of fulfilling due to so many short-term alternatives, without the aid of another trick: "out of sight, out of mind".

Similarly, if you work hard over the course of the year, you increase your chance of getting a good bonus.

Of course, that assumes that you work in meritocratic organization, one which has strong capabilities in tracking productivity and achievement, and finely calibrating bonuses accordingly.  It further assumes that you can ignore the fact that the company's performance, which you have little effect on, overwhelmingly impacts your bonus more than any of your personal accomplishments.  If any of this was not true, then clearly the possibility of the bonus would have little part in your decision to do a good job.

But, even assuming all that, how likely is it that your decision in April to put in extra effort, give up your weekend, risk making a fool of yourself, and wear yourself out, will be affected at all by some additional dollars later that year?  It's a struggle just to stay focused on the positive incentive of a work out an hour from now!  The benefit of a full night's rest just a few hours away, all of which accrues to you, is too far off to affect your decisions now!

The bonus is classic example of a long-term gain.  I might further contend it does more damage than good, but at the very least, it clearly has no impact on productivity and personal incentives.

Shrink the beast, part 2

Some recent analysis suggests that the financial industry needs to shrink a lot to bring it back in line. Starting in the eighties, the industry exploded. As a result:

Roughly speaking, though, the securities sector still needs to shrink by a factor of about five before they get back to the size they should be.

With all that growth and money running through the industry over three decades, it's no wonder 1) everyone at the top looked like a super-genius captain of capitalism, and 2) super-sized compensation culture became the norm.

Added value vs upside

How do people get paid? Often, the notion of added value comes up. Here's a classic description:

What you’ll find is that as you offer more “value” to the company, the more valuable you become. As a result, you’ll be the one most likely to get that promotion and/or receive higher compensation.

That's from an article about getting wealthy, which is ironic because I think that's exactly the wrong way to think about it. If a bigger paycheck is the goal, then you need to distinguish between "added value" and "upside".

Added value is backward looking. It's what you've accomplished. If you added value -- brought a project in under budget, on time, or with better features -- you will be paid an average salary plus compensation for the value you added. Therefore, it's true that the more value you add, the more you'll get. But, the company will pay you, by definition, only the amount that you added. Value out = value in.

Upside is an entirely different equation. That's because upside is forward looking. It's what you might accomplish. Since no one knows what that is, someone who thinks you have a large upside might pay you many times over what much you eventually add in value.

Here's some real-life differences between upside and added value.

Upside: 1st round draft pick. AV: 4-year steady veteran.
Upside: coding starts on new app. AV: 4 weeks after app delivered.
Upside: growth stock. AV: value stock.
Upside: MBA student graduating next year. AV: MBA who graduated last year.
Upside: first kiss. AV: marriage.

The hope that the big draft pick could be the next Michael Jordan always results in crazy money being thrown at him, even though its more likely they'll fizzle out. Similarly, dot-coms didn't have to have any earnings to have astronomical stock prices. And try getting a big bump in salary based on the MBA you got last year; the degree starts losing value the minute you get it, like a new car being driven off the lot.

In other words, people will pay based on speculation, until they know what you can do, and then you're capped.

Show me the... something else besides money

Do you think CEOs need the incentive of a big payout to do a good job? How about the tier of highest wager earners, which includes CEOs, who collectively took home 33% -- 1/3! -- of all wages in 2007? Do you think a big performance bonus helps them do better?

The evidence shows that people who do creative work actually perform worse when a financial incentive is dangled in front of them.

Dan Pink describes the economics in this short video. The short story is that financial rewards only work well under simple rules to achieve a clear goal. The reward narrows our focus.

Meanwhile, creativity requires a broad view. Bending the rules to uncertain ends. A narrow focus is a results killer.

Given that companies are constantly trying to lower costs, why wouldn't senior management of companies that give annual performance bonuses follow the evidence and get rid of them? Here's some possible reasons:

1. It's a setup that enables them to pay themselves generously.

1a. Particularly because it's so easy to game the results.

2. It forces workers to stay the entire year, until bonus season.

3. In theory, it allows cutting back bonuses if the company is not profitable. Given the bonus shenanigans during this financial meltdown, that's a hard argument to make.

4. It takes far more effort to create a company that motivates employees in other ways. Aka, management for dummies.

What does Dan recommend instead of financial rewards? Watch the video. (Via Bruce Eckel.)

Bailout bonus culture

The numbers in this study speak for themselves:

From 2006 through 2008, the top five executives at the 20 banks that have accepted the most federal bailout dollars since the meltdown averaged $32 million each in personal compensation.

That's each. And don't forget that includes a couple years where some CEO's paid themselves very little because, well, their companies were facing bankruptcy. Imagine the payday if they had actually done a good job!

Because large numbers can be difficult to grasp, the writers of the study provide some context:

One hundred average U.S. workers would have to labor over 1,000 years to make as much as these 100 executives made in three.

With that kind of example at the top, the result can only be car salesmen culture. Yes, some car salesmen take a long view and don't try to sell you something inappropriate, but they are clearly the exception. Nobody sends their grandmother by herself to negotiate a car purchase.

The bankers dress nicer and have larger vocabularies (some of my good friends are bankers!), but the result is the same. That doesn't make them evil, that just makes them people who behave according to the incentives provided by their companies.

Shrink the beast

If you want to stop excessive pay in a swollen financial sector you have to reduce the size of that sector

That's the head of Britain's financial regulation authority. Hopefully this means the conversation is moving in the right direction. It should start with this premise and see where it goes. Here's where it takes him:

[You can] apply special taxes to its pre-remuneration profit. Higher capital requirements against trading activities will be our most powerful tool to eliminate excessive activity and profits. And if increased capital requirements are insufficient I am happy to consider taxes on financial transactions – Tobin taxes."

These are fairly aggressive suggestions, and reasonable people might disagree on whether they are the right specific measures to take. However, they are absolutely at the right level: broad-based and sweeping, not trimming at the edges. I would add severely limiting the use of leverage near the top of his list.

And before you dismiss this as socialist craziness, don't forget that Britain is the second largest financial center in the world, so they have a huge stake in the game.

Via Kevin Drum.

Starve the beast

Pay is strategic. How a company pays its executives, and everyone else, says a lot about what kind of company it is. Many companies don't think a lot about it, and that says something about them, too.

These days, we hear lots of talk about whether the government should cap executive pay at the companies we bailed out. We want these companies to be different, and so controlling the pay at the top seems like a good lever to use.

But putting shackles on just these companies would be the kiss of death for them. More importantly, there's a much more effective way to deal with pay at financial companies: starve the beast.

The term applies to politics, but the strategy can work very well right now with the financial industry.

Pass a few laws: ones that we need anyway to keep these financial companies from threatening our global economy again, such as limiting leverage, regulating or outlawing some products, and separating some businesses. The result: the industry will shrink naturally, eventually fitting in like a regular citizen with the other sectors of the economy. The longer term result: salaries will normalize, and fall in line with jobs in other fields.

Some people will still make a lot of money in the financial industry, and this plan won't address the universal problems we have with executive compensation in the US. But this one beast will become tamer and thinner.

Watchmen

How people get paid drives much of a company's culture.

Despite requiring taxpayer bailouts, Citi's CEO earned $38mm last year, according to Bloomberg. That only made him 3rd on the financial service. Number one was the CEO of Goldman, another taxpayer bailout recipient, at over $42mm.

CEO compensation, as a process, is fundamentally broken.

The reason my boss doesn't pay everyone who works for her enormous amounts of money is because she's on a strict budget. Her budget is set by her boss, who received a number from his boss. And so on, until you get to the top, where the executives act as "the watchmen". They decide what's right for everyone else.

At the top, the CEO gets a number from the board. Boards only have incentive to raise, and not rein in, CEO pay. Why would you want to upset your CEO? And who's watching them anyway?

Government controls and independent board members can't solve the problem. They have the wrong incentives.

I think the only thing that might work is shareholder approval of CEO pay. I might go farther and say shareholders can also make proposals for CEO compensation, as they can with other corporate resolutions. Shareholders are the only ones whose incentives are perfectly aligned to paying the executives correctly. Too little, you'll end up losing your CEO; too much, you're taking money from yourself.

Supposedly, shareholders get their say by electing board members. If you own stock, can you even name any board members of any companies you hold (excluding CEO + Chairman title holders, which of course only exacerbates the problem)? How are you therefore supposed to know which ones are doing a good job in general, much less what their involvement is in executive pay?

However, you probably know most of the CEOs. And you probably have a strong opinion about the job their doing.

Let's hope companies give shareholders a chance.

Return of the bonus

After all the recent talk about remaking Wall Street and changing the culture of greed, the bonus claws back.

[Goldman Sachs], which nearly halved its compensation last year, set aside $4.7 billion for worker pay in the quarter. If that level continues all year, it would add up to average pay of $569,220 per worker — almost as much as the pay in 2007, a record year.

Not to pick on Goldman -- they're just the example -- but crazy, out sized bonuses create the wrong incentives. Especially in a culture of money, they distort the entire system.

Yes, these people work hard, and they generate a lot of money for their companies. I call that having a job. The vast majority should get a reasonable salary and then a very modest bonus. Then, by all means, give a bigger bonus to reward the high producers to separate them from the middle of the pack. But the middle of the pack guys make huge money. That makes no sense.

According to the article above: "Historically, investment banks have paid workers about 50 cents for every dollar of revenue." If that doesn't shock you, then nothing I could say could change your opinion.

Just keep in mind that the bankers in Iceland didn't do anything worse than what happened here in the U.S. The only difference is, their economy wasn't large enough to bail out their financial industry. So, before we return to "normal", don't forget how bankers are viewed in Iceland!

How compensation can be strategic

Every company pays people. How strategic can it be?

One strategy: pay everyone a lot of money. In theory, money buys the best talent. In practice, it may just buy expensive talent. What kind of people does a company with huge pockets attract? (And don't forget: Amazon.com's Jeff Bezos says frugality helps to drive innovation. For my money, Amazon.com is the most innovative large company today.)

Lots of Wall Street firms have paid lavishly for short term results. What kind of behavior did such a pay system encourage?

Many companies just pay people the going rate when they're hired, and then hope to keep raises down. Eventually, current workers can earn more money by quitting and applying for the open positions. What kind of people stay at a company that pays them less than new hires, who know less than they do?

As I've written about before, a system like Fog Creek's tries very hard to signal that merit will drive all pay, by being as explicit as possible about the differences between levels. Everyone makes the same as everyone else who works at the same level. What kind of incentives are created when a company focuses so intently on merit?

At companies like Google, the differences in levels may not be as specific, but in order to get to the next one, employees have to "apply" for it. This involves writing a resume and gathering letters of recommendations from others in the firm. Anyone can nominate themselves, and one's manager cannot prevent it. What kind of message does the company send to its employees about who is responsible for their career? What kind of people would be attracted to such a system?

In the end, a company's strategy relies on having the right people to identify, develop, and execute it. To tweak an old saying, a company full of guys carrying hammers will see everything as a nail. A company's compensation system attracts people with certain tools in their toolkit.

Big companies with few compensation levels?

In my last post on Fog Creek's 9 compensation levels (everyone in the company makes one of 9 numbers), I said that a bigger company would require more levels, which complicates the whole matter.

What about big companies that seem to defy this rule? Goldman, Sachs, for example, proudly has only about 3 titles. Google is another big company with a flat hierarchy. Both companies are hugely successful.

If a company grows but keep only a few number of levels, then it needs to offer big bonuses. Big bonuses are a back door way to differentiate compensation while maintaining a simple base structure.

Goldman, Sachs has done this for years; there aren't many promotions, but bonuses vary wildly. Google provides big bonuses through stock options.

Joel alludes to "a generous profit-sharing plan", but offers no other details. Does everyone get the same share of the profit? Or everyone at the same level? If not, are the bonus numbers still made public like the salaries? How does the size of the bonuses compare to base compensation? Answers to these questions make all the difference.

Then, the bigger question remains: what happens when profits slow down? If the company is bonus dependent, sometimes looked like an "incredible company culture" disappears along with the profits, and just as quickly. GS is about to find out; super-sized paychecks have gone the same way as trans fats at McDonald's. Google is about to find out; while they already repriced everyone's underwater options, stock market doldrums means compensation will basically be declining.

When the bonus pool runs dry, people start wanting more explicit ways to estimate their annual income, and managers need new tools to differentiate the strong from the weak. All of which means more compensation levels.

Bonuses bonus

I was done talking about bonuses, but the subject refuses to go away.

I'm not outraged by AIG's bonuses mainly because Merrill's bonuses outraged me far more. (Apologies to my friends at Merrill.) But, getting them back wouldn't bother me either.

One person on my trading floor said, upon reading that a bill would be passed to tax the bonuses at 90%, essentially clawing them back, "It's the end of capitalism. Some of these guys work 100 hours a week."

These guys do work hard, but I hardly think capitalism is at stake. I once worked over a 100 hours a week, including shifts that exceeded 30 consecutive hours, over a summer for an average of $7.50 an hour. If anything, capitalism will be healthier if we have a smaller range of salaries.

While many of the people who will be giving their bonuses back did not cause the problems, their bonus guarantees were probably born of continued expectations of fat profits through financial derivatives.

Not causing the problem is not really the issue, though, is it? What if developers started a job and refused to fix bugs because "I had nothing to do with the creation of those problems"?

More importantly, at the end of the day, everyone should be expected to work hard. While I will say, having worked with both bankers and software developers, that the former work much longer hours on average, a good percentage of highly-skilled developers work 60 hours as week (and, of course, some work more). They might earn between 100 and 150k. Does working another 50% more hours justify 1000 to 2000% the salary?

Bursting any bubble hurts. Right now we're witnessing not just the burst of the housing and financial markets bubble, but also financial industry salaries. Ouch.