Radical Reform of Executive Pay

Andrew Lo has written a few guest posts here before, and now he’s back with another excellent one — so excellent, in fact, that we asked if he’d join our corps of recurring guest bloggers. Happily for all of us, he accepted.

The recent proposal by the Fed to regulate bankers’ compensation practices is understandable given the events of the past two years, but setting caps on salaries and bonuses misses the fundamental problem of compensation on Wall Street. Despite the public resentment surrounding finance-industry payouts, the fact is that no one objects to paying for performance. We just want to make sure we’re not getting fleeced or paying for pure dumb luck, and this is where the problem lies.

To correctly link pay to performance, we need two key ingredients: a reasonably well-functioning labor market for talent and an accurate measure of performance. If either of these inputs is missing or broken, compensation levels can easily get out of whack, disrupting several industries as employers and workers respond to potentially misleading wage differentials.

To see how, consider first an industry with eye-popping compensation contracts that no one seems to complain about: professional sports. The process for recruiting new talent in every major spectator sport is certainly well-organized, and the labor market for professional athletes is relatively liquid and transparent compared to other labor markets. But what about those outrageous multi-million-dollar contracts? In fact, such contracts generate little public outrage because pay and performance are so directly linked in these instances, and because performance is not only easily measured, but is thoroughly analyzed by millions of fans as well as the franchise managers ultimately responsible for justifying these contracts to their shareholders. Is Tom Brady — the 2007 NFL MVP with a career record of .787, a playoff record of .824, 197 career touchdown passes, a 63.0 percent completion percentage, and a 92.9 percent passer rating — really worth the $8,001,320 he was paid in 2008? Absolutely. There is an even more direct connection between pay and performance in professional sports: ticket sales and advertising revenues. Brady’s star power can literally be measured in dollars and cents.

Now consider financial services: the usual performance measures used to structure Wall Street compensation — investment return, stock price appreciation, assets under management, and the dollar-value of deals closed, for example — may simply be too noisy to gauge the genuine value-added of even the most talented masters of the universe. The main reason is risk.

Virtually every aspect of financial decision-making involves making trade-offs between risk and reward, and even the most savvy investor is rarely correct more than 55 percent of the time. For example, a trader who generates a profit of 2 percent per day with 55 percent probability and -2 percent per day with 45 percent probability is wrong 45 percent of the time, but over the course of a year the expected compound return of his portfolio is 65 percent! However, the annual standard deviation — a common risk measure — of this trader’s compound return is a whopping 53 percent (for comparison, the annual standard deviation of the S&P 500 is currently around 25 percent). Such a high level of risk implies an 11 percent chance that this highly skilled trader’s annual return is negative in any given year (assuming normality), and a 30 percent chance that over a 10-year period, at least two years will show negative returns.

This example illustrates the challenge of determining who has skill and who got lucky, a considerably more difficult task in financial contexts than in professional sports, manufacturing, retail sales, entertainment, and many other industries. Therefore, we shouldn’t expect the traditional employment contracts and incentives to work the same way in financial services.

Now regarding the arcane probability calculations above, the shareholders of recently failed financial firms might say that this is exactly the kind of fast talking that got them in trouble in the first place, and sadly, they’re probably right. Far too often, sophisticated risk/reward computations have been used to justify enormous payouts to those who happened to be in charge when good outcomes occurred, only to leave shareholders holding the bag when the bad outcomes came along — a case of “Heads I win, tails you lose”.

The only way to meet this challenge is to restore the intellectual balance of power between executives and shareholders by: 1) constructing new compensation contracts that are as sophisticated as the business activities of the managers being compensated, and 2) educating shareholders, auditors, accountants, and lawyers so they can make more intelligent risk-based choices. Such contracts and decisions must be based on new, more accurate and more relevant measures of performance that explicitly account for risk, incentive effects, time horizon, and the uncertainties of the performance-attribution process. One size cannot fit all, and we should expect contracts to differ according to the risk/reward profiles of different financial services and their respective shareholders’ objectives.

Radical compensation reform will be no easy feat given the complexities of most financial institutions and the politics surrounding this effort. However, it will take more than bonus caps if we ever hope to create a more stable and robust financial system that will be free from the tyranny of bubbles, crashes, and credit cycles.


Forrest

The problem is that insurance, Wall St., etc., are parasitical businesses that actually produce NOTHING and yet control the political and the economic course of the nation. It's a sort of societal cancer. And the prognosis is not good if we can't cut it out.

Michelle

Delayed compensation seems like a good idea to me. See how decisions pay off in 5 years, and then distribute the corresponding compensation to the decision-maker. Not a panacea but a good start.

Of course, the way our country used to deal with excessive compensation was with a 90% tax rate on the wealthiest. I don't think the public would be complaining nearly as much if 90% of the corporate titans' earnings were going to the government and paying for social services and infrastructure.
Not advocating that, just sayin'...

Steve

Regulating the pay of traders is ridiculous. Regulate the banks. The reason traders are paid so much is because the banks have been allowed to engage in ridiculously irresponsible business practices.

Also, comparing a trader to a professional athlete is a joke. Financial traders have the skill set of used car salesmen but are lucky enough to be in the right industry.

Rick

One addition: the government just spent over $1 trillion repairing the damage these people caused. No matter what reward system you design for the financial superstars, there should be a 50% tax off the top to repay taxpayers for all they've lost in the past. Then, once we're even, they can keep all of their subsequent gains for themselves,.

Baffled Observer

I can see paying a big salary for stellar performance. But these financial people have been paid astronomical salaries for abject failure! And as if that weren't enough, they feel entitled to more!

Completely unabashed by the events of the past year, they want to continue in the disastrous course that had to be rescued by a taxpayer bailout, and to party hearty at the taxpayers' expense as well. And to rub their luxurious lifestyles in the peons' faces, while offshoring said peons' jobs and taking away their homes. "Apres moi, le deluge..."

Don't these business schools teach history anymore?

dude

Glass Steagal is simpler and probably more effective. Separate out speculation and attempts to generate alpha from traditional banking. Limit leverage severely in the latter. In the former let them do what they want as long as they don't violate current SEC guidelines and as long as any single entity is not allowed to develop beyond a certain size. However this will have to be a worldwide regulation. Otherwise countries that don't limit leverage will outcompete, at least in the short to intermediate term.

retired guy

Andy Lo's trader (the trader who generates a profit of 2 percent per day with 55 percent probability and -2 percent per day with 45 percent probability is wrong 45 percent of the time, but over the course of a year the expected compound return of his portfolio is 65 percent! ) may not be the real problem. The problem may be the trader who earns 0.1% of his capital per day 99.9% of the time (doesn't sound like much, but would come to about 25% per year), but loses all of his capital, and then some, 0.1% of the time. This guy is a net loser, but he could go several years earning a nice bonus before disaster strikes (and when it does, he doesn't have to return any of his bonus money).

jeffreytg

It is none of the government's business. Furthermore it is no one's business but shareholders and the employee himself. Shareholders exercise their will via the board of directors. The shareholders can simply exercise the democratic process and vote for shareholders of their liking.

I know the argument- there are investment funds who own the stock and have all the votes- don't those funds want to make money? If I don't like how a corporation operates, the fact that investment funds control it, or the executives, I can elect not to work for same and not to own same. We have freedom of choice here.

How about the privately held corporations and what they pay their executives? Should the government regulate their pay also? If government pay regulation is good for public companies then why not for private companies? The only difference between the two is that there is a stock exchange involved in the former.

Corporations have no duty to society- they do not exist in order to employ people or to fill the government coffers- they exist only to bring a return to their owners. I don't go to work for the benefit of society, I go to work purely for my own selfish benefit.

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$

Wall Street Bankers typically make 10% of the deal revenues they bring in .

So for a Banker to make $1 million he has to bring in $10 Million. That is 100% risk free revenue...usually for doing a merger, IPO, or bond deal.

Many departments, divisions, or whole subsidiaries of Fortune 1000 companies have trouble making that much in profit. Wall St firms have thousands of these guys making that year in year out.

That 10% rate is the same as commission rates in high ticket real estate, boat, aviation and entertainement agents/brokers.....

Do an analysis on the Realtors who made more than $1 Million...there are more of them than Wall St. Bankers !

Mr

You cant regulate jealousy......

Andrew

The problem isn't just with the executives - it's the concept of shareholder value itself. When the average holding period for stocks is 9 months, shareholders have no interest in the long-term value of the company, and will always design compensation packages that encourage executives to seek short-term profits. The solution isn't to limit executive pay - it's to limit short-term returns to shareholders to encourage a long-term outlook.

http://akwag.blogspot.com/2009/09/banks-dont-work-in-free-markets-either.html

Rael64

Any definition of performance must include the component of ethics. Without it, performance is based on mere profit, which while nice for a few, can reap magnificent damage upon the many. In other words, if 'business' cannot change itself, cannot take of its blinders and act with the interests of the general public, i.e. the nation, in mind, then 'business' should not be allowed to function without strict regulation, strict oversight, and swift punishment and liquidation (take that to mean what you will) of those who abuse the public trust.

Johnny E

Compensation should be based on long-term results so stock-manipulation tricks will have little effect. Compensation could be based on stock-options redeemable 10 to 20 years down the road. Then if the companies go down the tubes they could renege on the agreement like they do with pension plans.

Nobody should get any compensation based on leveraged buyouts that destroy companies and jobs and put stockholders in debt.

Compensation should be distributed more equally among the workforce. Most anybody with a finance MBA could do what those banksters did. There's too much ego involved. Let them compete for their jobs. Nobody is indispensible, and any board who thinks somebody is a "star" is risking the future of their company. CEOs quit. CEOs die. CEOs go to jail. CEOs drive their companies down the drain. That's why companies have life insurance on their critical people. As DeGaulle said "the graveyards are full of indispensible men".

The companies could save a lot of money in their labor cost budgets by laying off some of those leeches. They should instead be compensated by how many jobs they create in America. The workers' productivity keeps going up yet they never get their piece of the pie. There's plenty of people who would willing to take a CEO job for half of what they're making now. Why not outsource them like every other industry. There must be a shortage or else their salaries wouldn't be so high.

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Jason

"Is Tom Brady — the 2007 NFL MVP with a career record of .787, a playoff record of .824, 197 career touchdown passes, a 63.0 percent completion percentage, and a 92.9 percent passer rating — really worth the $8,001,320 he was paid in 2008?"

Isn't there a salary cap in the NFL?

KRISTINE

I don't want a $ cap on anyone's pay . . . but I thought this is a smart idea (and simple): the CEO of a company can't make more than 200x (or 250x, etc. whatever) what the lowest paid employee (or the average of all employees) makes.

mailguy - 10/hr = 20800/yr
ceo - 1000/hr = 4.16million/yr

if you want to up your pay you up everyone's together. You want 8 mil? You find a way to double the lowest guys salary and still make money. Easy breezy.

KRISTINE

edit typo:
ceo - 2000/hr = 4.16million/yr

Valpey

Another good idea of Mark Cuban's is to reform how stock sales are taxed - inversely proportional to how long they are held. This would shift the emphasis of trading from short-term speculation to long term investment. Day trading could still be possible for the very skilled, but investors would become more focused on long term fundamentals.

LG

On the contrary, I hear people complaining about professional sports salaries all the time. I can think of two huge societal problems that result:

(1) This contributes to the progression of live enjoyment of professional sports becoming just for those with money to burn; it was not that way when I was a kid, middle class families could afford the occasional baseball or football game. I can't help but think that if the best players were getting $1M/year instead of 10x that much, surely that means lower ticket prices for us consumers, and wider potential audiences (socioeconomically, that is).

(2) The truly exorbitant salaries in sports totally warps the professional goals and academic choices of kids, who vastly overestimate the chances of success and spend too much time on football or basketball for the lottery aspect of it, instead of the sure-bet that spending the time on academics that would lead to good professions such as engineering. (i.e., spend 10 more hours a week playing football, you have maybe a 1 in 10000 chance of that being a career; spend 10 more hours a week studying things that will get you a college degree, you probably have an 8 in 10 chance of lifting your family out of poverty).

Exorbitant salaries are corrosive in any industry, and when you consider the externalities such as those above, are actually quite a big inefficiency for society overall.

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Nate

I don't know a lot about this, but executive pay packages and golden parachutes aren't just limited to the financial sector; all large companies have them, and it's the failing ones that get all the attention, so it might not be that bad.

I heard a lot of the increase in pay happened when CEO salaries were made public, and corporations enacted policies requiring executive pay to be above a certain percentile in the industry, usually something stupid like 90%. Why not tie the percentile of a banker's salary to the percentile of his performance? This would get rid of the up-and-down problem, and other things could fix the risk problem.

Steve

I doubt that there is any better rate of "successful" compensation in professional sports as there is in the financial industry. In both cases they are paid large amounts before they are measured. In sport the measurement comes at the end of the season but in banking, the decisions often can't be properly measured for years. In both cases, the obscenely high pay is given before performance is accurately measured and in both cases, compensation is usually far out of line.

Your sport example just shows someone who was successful AND was paid well. This is rare since in professional sport, there are plenty of examples of both over pay and in a very few cases, under pay.

What should be a concern is that in both industries, there are tremendous subsidies from the taxpayers for these industries and their grossly over paid employees.

In sport, its subsidies for venues and tax write offs for wealthy owners and their "toys".

In the financial services sector, its the public "insurance" of the risks they incur.

Without these subsidies, these sectors would likely collapse and the high paying positions that produce absolutely nothing of any real value, would be eliminated or severely curtailed.

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