Wednesday, 6 March 2013

Clarity on bonuses

Updated: Andrew points out that he wasn't responding to the bonus cap, it's an old piece.

Andrew Lilico has turned in a pretty comprehensive case against the bonus cap on Conservativehome here. However, I think he is wrong a lot of points, and some of what he says contrasts with pretty mainstream corporate governance thinking. So here is a response:

Argument: Bonuses create loyalty.
"Retention" is one of the holy trinity of arguments (along with "attract" and "motivate") in favour of high pay in general and incentive schemes in particular. It is also perhaps the weakest. It is routine for companies to compensate new recruits for loss of awards from their existing employer as a result of moving. This is very common practice and basically destroys the idea that incentives work to retain. Incidentally this even happens when sometimes companies make "retention awards". As the ABI executive pay guidelines say: "Shareholders believe that retention awards for main board directors rarely work. Retention concerns on their own are not sufficient grounds for remuneration to increase."

Argument: Bonuses manage risk.
I have no doubt that in the past there was a bit of truth that greater variable pay enabled firms to manage costs, and it may still be true for smaller firms. But when you look at the big banks, actually staff costs are pretty stable (as Ben Chu points out here). But in any case, what we are talking about is a bonus cap, not eliminating bonuses. This still gives banks the ability to reduce staff costs by up to 50% through changes to variable pay alone.

Argument: Bonuses allow targeted rewards.
The existence of clawback and bonus-malus policies should prove just how difficult it is to both indentify individual contributions and be sure that they were in the long-term interests of the business. But, again, the EU is not seeking to eliminate bonuses entirely, merely to cap their value as a % of salary. 

Argument: Bonuses can be aligned with particular company or individual objectives.
I think this is where we need to be particularly careful. In terms of tying bonuses to specific company outcomes, like a successful deal, this is something shareholders have generally disliked. This is because partly they think that some things that get rewarded are part of the job (I have seen bank rem policies where directors get rewarded for stuff like getting on with regulators and meeting regulatory requirements). In addition there is a danger that the particular action in question that is rewarded might look good in the year te award is made, but turns out to be a disaster. Here's the ABI again: "Shareholders do not support of the practice of paying transaction related bonuses."

On individual targets, it's unfortunate that the example given is tying sales team awards to numbers of sales made to particular customers. The FSA recently published a paper showing how difficult it was to get sales incentives right in financial services, and how it easily leads to mis-selling. Notably it was titled 'The risks to customers from financial incentives'.

Argument: bonuses incentivise effort and quality
I have dealt with these kinds of arguments a lot over the past three or four years so won't rehash them. My understanding, having read quite a bit of the literature on this stuff, is that incentive pay works best for simple and easily measurable tasks and where motivation to do the job is low. It is not clear that people at a very senior level (who, presumably, don't do simple jobs) even like variable pay that much, as remuneration consultants PwC found.

Argument: bonuses build esprit de corps
I think this may have some truth if there is a genuinely company-wide policy. But I wonder how many Barclays employees were thinking "Go team!" when they found out what Bob Diamond was getting last year. Again the psychological literature seems to show that people value fairness, or reasonableness, in rewards, and will even incur a bit of a loss to punish others who they see as taking too much. In a sense, the whole argument about bankers' pay is, as someone on Financial News wrote a whike back, a big version of the ultimatum game. The banking lobby has said for years that we have to pay them a huge amount, or they will leave the UK taking tax revenues with them. What we have seen in the past few years is public opinion harden to the extent that - offered that ultimatum - they will reject it, even with the threat of losing out personally.

Bonuses as contractual entitlements
Some people suggest that not paying bonuses would somehow breach contracts. I can only speak from my own experience here, but I have read quite a few executive director contracts (not bankers though) to get to the bottom of exactly this point. In almost all of them the language relating to bonus and incentive schemes wav very vague, and many said that awards were at the discretion of the remuneration committee. Notably this point was proven in the row over Stephen Hester's bonus last year.

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