Risk v Executive Reward

All this screaming about excessive incentives for risk taking.  I think it has more to do with asymmetric incentives.  If you give someone the motivation to make a huge amount of money without losing much, then you have done a poor job of incentive design.

The crazy thing about all this talk about pay design for top executives like in this WSJ article today, is that it mostly talks about the pay for the titular heads of these massive companies.  What about the people at the operating levels? And those traders that bet everday with the firms' money?  Those guys that headed the units for mortgage lending? It's the operating guys that we need to restructure pay for.  They take the risks.

Here's my suggestion:  Pay them in variable cash bonuses linked solely to the intrinsic value growth of the unit measured by economic profits in dollars (not ratios). Accrue bonuses earned in a reserve and pay 1/3 (or some fraction above a target for "normal" or "expected performance") of earned bonuses in the reserve each year.  There is then something at risk when future performance is subpar.  If they take another job, they lose their bonus reserves.  If they retire they get it.  Of course, for those of you who know me, I could not have invented something so simple but so beautiful.  No that was the invention of the smart guys like Steve O'byrne, Bennett Stewart and Joel Stern, among many others I am sure. 

Here's what Professor Murphy, the guy that wrote the paper with Michael Jensen that got much of the "structure of pay design" discussion started. 

Kevin Murphy, a finance professor at the University of Southern California's Marshall School of Business, says it is possible to control how much risk is built into pay packages. He said compensation fell sharply for CEOs of banks receiving federal bailout money last year, compared with those of other banks and non-financial companies.

Mr. Murphy says paying executives with cash bonuses, restricted stock and stock options creates strong penalties for failure. He says companies also can control risk by paying executives for longer-term, rather than shorter-term results, and "clawing back" pay when big losses wipe out prior profits.

I argue with Professor Murphy that equity in the whole company which is not bought and paid for by the individual does much good - there really is nothing at risk especially if they get paid a lot of money.  But if they earn or pay for their equity I am all for it.  How do they earn their equity?  By giving them the option to purchase it with a multiple of that cash bonus reserve we just talked about.  Or for top executives make them take loans out and buy stock.

But it is a minor argument and probably differs only with the level of executive or employee we are talking about - I am talking about the guys that take the risks - the traders, division heads, etc.  Not the CEO only.  Murphy'sbig contribution in this article though is that clawback thing - we called it a "bonus bank" at Stern Stewart.  And it is designed to mimic ownership like incentives for operating people with a much better line of sight.  They will be less likely to tank the whole company like at AIG if the risks they are taking are borne mostly by them.

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BERK