The Bonus Culture: what’s it got to do with accountants?

Introduction

It is impossible to read a newspaper, watch the television and listen to the radio at the moment without being aware that there is a problem with bankers and their bonuses. Actually there is a general problem with bonuses but it is the bankers who are getting it in the neck at the moment.

At the emotional level, everyone thinks that bankers and their bonuses are bigger than Saturn and more deadly than the bubonic plague. Nevertheless, the most powerful politician on the planet is reported as having said that a return to pre credit crisis bonus levels for bankers is not acceptable but when pushed recently on what he had done about it all, replied: what about the bankers? If we hit the bankers, what about silicon valley and ... so, no help there then!

Some Background

Sir Fred Goodwin is the UK’s most famous bonus baddie was hounded by press and public alike and even had his home and personal possessions vandalised. Why? Because he presided over the near collapse of the RBS and yet took home a bonus and pension settlement that was worth around £700,000 a year to him ... for life ... and he’s still only 50 or so years old.

There is the old chestnut that these bankers are taking large risks on behalf of their shareholders and everyone knows that there is something called the risk v return trade off. OK, but whose risk is it? How many of these bankers have really and I mean really risked anything? There is a merry go round that even Sir Fred Goodwin will get back on before too long on which these very senior managers spend their lives. Did these men (I don’t know of any women, sorry) stake any of their personal wealth as they took all of this risk? How many shareholders in RBS as their share prices slid were happy with the amount of the losses that ensued taking the mother of all risks as they poured wasted billions into buying ABN Amro Bank?

There is also the chestnut that these bankers are paid very large salaries in order to attract and retain the best people for the job. Sir Fred Goodwin was the best man for the job then? The global financial crisis was nothing to do with these highly rewarded bankers then? Come off it. I always say, if that’s true and if a banker is given a pay cut, let him go and find a similar but more highly rewarded job. On average, I doubt that will be possible.

Very rarely do any of these executives think of paying back their bonuses when the downturn arrives.

I’ve got a solution for all of this nonsense, by the way and I am calling it The Williamson Solution. I have shared this solution with no one until now. Well, I told my neighbour the other day but he seemed distracted as I told him!

Share Options: the long and short of it

One of the key problems with the financial world these days, apart from the guaranteed bonuses that Lehman bankers were re employed on following their previously untimely demise, is the one of short termism. Living for the short term and being rewarded for making short term profits only to find that these profits and bonuses were sub optimal for the long term success and viability of the organisation is seen as being a key problem.

One solution to the problem of short termism is to create such things as share options and deferred bonuses. This means that rather than being paid in cash on the basis of this year’s profits, executives and others are given three year, five year or longer term share options. At the end of the three years or so they then have the option of exercising their options if it is in their favour to do so.

The argument with share options is that if the company does well, the share price will rise and the executives then DESERVE their bonus and they can take it. So, short term profits are proven to have been sustainable in the longer term and no one can complain.

Alfred Rappaport complained: he more than astutely noticed that the price of a share in the open market often has nothing whatsoever to do with managerial performance. After all, inertia and inflation are usually driving the market indices higher. The pay off here is that all the executives have to do, potentially, is nothing and the share price will rise. As long as nothing bad is happening and the business is ticking along, the share price will rise.

Where’s the incentive there then? I prepared a PowerPoint presentation a couple of years ago on this aspect of executive pay and have included a copy along with this essay.

You will see in the PPT presentation that I mention the alternatives as Economic Value Added (EVA) and Shareholder Value Added (SVA). For me, those alternatives are rather academic; but many consultants and practitioners respect and use them. I wrote in a study I did of Marks and Spencer that a valid way of assessing performance is to use the Balanced Scorecard or a version of it.

The Kaplan and Norton Balanced Scorecard is seen by some as the most important thing that has ever happened to them and by others as a plague on all their houses. However, take it calmly and most people should agree that by taking a more holistic view of the organisation, everyone will benefit and, of course, everyone can share the bonuses.

The new CEO of RBS is being rewarded partly on the basis of share options!

Why only the Executives?

I think there is a very fair question to be asked at this stage too: why is it that only the senior executives are being paid these bonuses? After all, without the cleaner, the shops would be filthy and without the people on the tills, they could not sell anything. And so it goes on.

Yes it is true that good and honest executives are more likely to be working 60 – 100 hours a week as they dash here and there. It’s the senior people who understand their business, their markets, set the strategy and so on. Without all of these things and their management of cash flow and the accessing of the capital to keep the business alive, the cleaner would not need a job and the people on the tills could stay at home.

Some companies, such as the John Lewis Partnership reward everyone in the organisation when things go well.

The G20 Summit in Pittsburgh

At the time of writing, the G20 summit is about to be held in Pittsburgh and bankers’ bonuses is on the agenda there. What are they likely to say and do?

In late August, 2009, French President Nicholas Sarkozy proposed bonus caps for individual financial executives and a mandatory deferral of payment on 50% of such bonuses. While Sarkozy has implemented these proposals in France, he was rebuffed by the Finance Ministers of the G20 in early September. They favour a proposal to limit the total amount of bonuses paid by a bank to a fixed portion of its income.

In February of 2009, Congress adopted legislative limits on bonuses of senior executives at financial institutions receiving federal assistance (Assisted Institutions). In specific, Congress limited their annual bonuses, or any other type of incentive awards, to grants of restricted shares of Assisted Institutions not exceeding one third of annual compensation.
Reference: Bob Pozen

Pozen then reports that:

These legislative limits on individual bonuses have already led to much higher annual salaries at Assisted Institutions. For instance, Wells Fargo raised the base salary of its CEO from $900,000 to $5.6 million. More broadly, Morgan Stanley increased by 250% the base salaries of its four top executives just below its CEO.

Moreover, to echo a point I made earlier, Pozen also says:

In a profitable bank, the portion of income going to executive bonuses comes from the pockets of its shareholders. As long as the bank fully discloses the amount of these bonus payouts, shareholders can decide whether these payouts represent a reasonable allocation of the bank's income. Shareholders have been willing to invest in a bank with relatively high bonuses if they see significant earnings growth   the pie is expanding for everyone.

But then as if no one has read and learned the lessons from Rappaport, Pozen concludes with this:

I would recommend that the unprofitable bank distribute modest cash bonuses now to top executives, together with large awards of restricted shares that will vest over the next few years if the bank returns to profitability. In addition, to avoid massive increases in base salaries for many employees, there should be limits on overall compensation for unprofitable banks   based on their revenue since their income is negative. [sic] This combination would incent [sic] talented executives to stay and turnaround the bank, while protecting the interests of the government insurance fund and the bank's investors.

At the end of that online article they ask, what do you think of this idea? Why not click on the link at the end of this essay and let them know?

What Happens Elsewhere?

American Football

So far I have concentrated on bankers and senior executives and so, essentially, is the G20. How about American Football players? They seem to have a funny system. In the English football leagues, successful teams tend to reward all of their players handsomely. Whilst individual players for a successful team might earn 10%, 30% and even 50% more than some other players in the same team, £60,000 versus £90,000 a week doesn’t seem so bad. Moreover, long term success means that all players can aspire to such earnings.

In American Football apparently, the major players in a team can be paid a massive salary yet the minor players are paid whatever is left over from the salary pot. Does this guarantee success: by making sure the big tacklers and the longer runners are given massive incentives to work hard? Read on!

Kevin Gray calls that the star system. Gray then says the New England Patriots follow the no star system:

The result: Few players have stellar individual statistics, but the team overall has two of the longest winning streaks in National Football League history. And it has won three Super Bowls in four years.

Now, you might be like me and wonder why on earth men in huge padding who take many hours to play a 90 minute game that can use up to 90 players in a game (I think that’s right but please feel free to correct me)  is anything to shout about but that’s not the point. There are two reward models being operated on and on the basis of a sample of one, the alternative model is proven to be more effective.

I won’t give you any more from this article since it is unintelligible to me because I don’t understand what a quarterback sack is nor do I appreciate rushing the offensive backfield too quickly. Except to say that Gray regales us with this:

...the Los Angeles Raiders thought veteran wide receiver Randy Moss was washed up, slow and grumpy. Then he moved to the Patriots in 2007 (for less money) and set the all time NFL single season touchdown receptions record (with 23).

Health Care

Let me stick my neck out here and again be prepared to be corrected but Kevin Gray now reports on health care industry incentives and one of the models he refers to seems to me to be a balanced scorecard type of system.

Gray reports on health care in the North Shore Long Island Jewish Health System in New York and Long Island: 14 hospitals and 5,000 beds to service the 5 million people with 38,000 employees.

The federal  Centers for Medicare & Medicaid Services (CMS) launched the study to determine if economic incentives were effective at improving the quality of patient care. And officials at North Shore health system signed on for two reasons: to win funding, sure, but primarily to see if they could make their already top notch patient care even better.

The rules were strict. The staff was given 30 measures to assess the treatment of thousands of patients. Heart attack victims, for example, had to receive aspirin within two hours of arrival, beta blockers at discharge and smoking cessation counseling. Pneumonia patients required flu screening and an assessment of the amount of oxygen reaching their blood. And surgery patients required antibiotics one hour before the first incision. The hospitals were graded on each criterion and given bonuses based on their performance.

“If you came in with a heart attack and you got an aspirin, but you did not get advice on quitting smoking when you left, then you didn’t get any credit for that case,” says Karen Nelson, the health system’s vice president of quality management. “It was all or nothing.”

Accurate and complete documentation was the key to this new system.

Gray went on to report:

In mid August, the CMS awarded North Shore $750,000 for raising its quality of care for the fourth year in a row.

Moreover, the American Football example was based on a sample of one, in this case, though:

The results weren’t unique to North Shore, either. All told, 275 hospitals are taking part in this national study, the Hospital Quality Incentive Demonstration. The Premier health care alliance, which is running the whole thing with CMS, analyzed data from 1.1 million patients and estimated that this single pay for performance study had saved the lives of 2,500 heart attack patients in its first three years.

Even with such results, critics exist who assert that such incentives distort the efforts of health care workers, putting a premium on paperwork over the often immeasurable causes and effects of proper care giving: in effect, “teaching to the test.”

Finally,

North Shore’s chief medical officer, Lawrence Smith ... “If all hospitals nationally were to achieve the (study’s) three year mortality improvements across the project’s five clinical areas, 70,000 lives per year could be saved,” ...

American Airlines

I mentioned above that bankers and executives are being awarded bonuses for things they cannot control: the behaviour of the stock markets being one of them. Here is a story that addresses that issue: what happens when a company moves from a system in which employees cannot control the processes underlying their bonus payments to one where they can control such things.

When American Airlines launched its Annual Incentive Program for employees in 2003, it overlooked a crucial factor: bad weather.

The airline had gone through a painful restructuring and, as a way to make up for painful pay cuts,  decided to reward each of its 72,000 rank and file employees with up to an extra $80 a month if they could improve customer service and on time performance ...

When it came to on time performance, employees found themselves in the tail wind of things beyond their control. Specifically, the government data that is used to measure an airline’s on time performance factors in weather and air traffic troubles, elements workers are obviously powerless over. As a result, workers became frustrated and a well intended bonus system backfired.

“There are a lot of things our employees control to give customers a great experience at the airport and in the air,” says Mark Mitchell, who managed American’s operations in Los Angeles and in New York City for several years. “Mother Nature is not one of them.”

Mitchell stepped in to try to figure out ways to improve the system and help morale. In 2007, the airline tapped him to run a newly created Customer Experience Team. His group began tying specific metrics to the incentive plan to make it, in a sense, more scientific. On the customer service front, adding clear cut metrics helped make the monthly bonuses less subjective. The staff was given certain requirements: greeting first class passengers by name, for example. Bonuses varied depending on the marks the team received in customer satisfaction surveys.

Conquering the problems with on time performance took Mitchell longer. In fact, by early 2008 American had one of the worst on time records in the industry, ranking last out of 19 big carriers, with only 63.4 percent of its flights arriving on time, according to the US Department of Transportation ...

In the first six months of this year, American’s on time rate soared to 78 percent, an improvement of more than 14 percentage points over 2008. Here, too, several factors came into play, such as a change in flight schedules. But all those involved agree that fixing the bonus plan helped. “Employees now feel directly empowered, for the boarding process, the loading of baggage and cargo, the upkeep of the aircraft,” says Mitchell. “We’ve made it more real. So they can say, ‘I know what I can do.’ It’s smaller bites of an apple and thus it’s more effective for everyone.”

The benefits became clear in June. Thunderstorms across the country wreaked havoc on air travel. Overall industry on time performance averaged just 68 percent that month, the worst since wintery December; and American scored a disappointing 60 percent by government standards. However, under its employee specific metric, American clocked 77 percent, just three points shy of its target of 80 percent. Sure, the workers didn’t get their full bonus for July, but at least they couldn’t blame the unfairness of the system.

Short or Long Term Problem?

The next thing is to ask whether the arguments surrounding executive remuneration is a short or a long term problem: will we be visiting this [roblem again and again? Of course the answer has to be yes; and here is why.

In an article in the Economist 19th – 25th September 2009, they talked about some of the things that have happened and are happening in the world of Executive remuneration. They say on the one hand, in contradiction of my assertion that executives are the T Rex of the salary cheque in that they are the biggest in the field and they are free to roam and feed off what the heck they like:

SHAREHOLDER revolts, like the one in May over the fat pay packets of Royal Dutch/Shell’s bosses, are rare. More than half of the investors at the company’s annual general meeting, led by Standard Life, an insurer, voted against what they saw as the flouting of agreed performance measures in setting top executives’ pay. A normally routine measure on remuneration backfired badly, among accusations of greed and underhandedness ...
Investors frequently reap nothing but frustration when they seek to restrain the financial aspirations of corporate bosses. Many don’t even try. For all the public outcry over soaring bank bonuses, for example, the British government, the controlling shareholder in the rescued banks RBS and Lloyds, has not dared to rock the boat by curtailing them explicitly. The latest revelations about the so called Phoenix Four, the consortium that bought MG Rover Group in 2000 for £10, have stoked public outrage over the perceived greed of some bosses still further. According to a government report published on September 11th, by the time Rover filed for bankruptcy in 2005 the four had paid themselves around £36m in salaries and special dividends, all sanctioned by auditors and lawyers. Around 6,000 workers lost their jobs.
The Economist could have gone on to say that the Phoenix four have not only stashed away those millions for themselves but there are clauses in contracts waiting to be triggered that will unload further millions on them.

Back to my thesis, though, of the status quo ante:

Executive pay in Britain, as in America, has risen sharply. The average pay package of the chief executive of a FTSE-100 company, including his pension and long-term incentive plan, increased from £1m in 1998 to close to £4m in 2008, on figures from MM&K, a remuneration consultancy (see chart 1). In 1998 the average FTSE boss made 47 times as much as a typical employee; in 2008 he earned 128 times as much ... long-term incentives tend to be a bigger part of the British package (see chart 2).

One reason for rapidly rising executive pay is globalisation. Top bosses offer themselves for hire from Sydney to Frankfurt and a salary offered in one big city sets a floor in another. A second is the incentives offered by private equity funds to keep executives at firms when they take them over, or to motivate new ones.
That latter point, involving private equity funds was echoed by a Banker speaking on the Today programme on BBC Radio 4 just this morning.
In a sense, in support of Alfred Rappaport’s point, above, the Economist then says:

Paying top executives a conspicuous bundle might be justified if it meant that a firm was much better managed, but the connection is often weak. And at a time when taxpayers are underwriting bank profits, lavish pay deals in that sector strike many as just plain offensive.

So what is happening then? After all, none of this is new, the Economist again:

Various bodies are seeking ways to align pay more closely with companies’ longer term fortunes. In Britain, the Financial Services Authority, which worries that some bonus deals encourage reckless risk taking, says it may force banks that dish them out to hold more capital. Two government sponsored reviews, one by Sir David Walker, a former central banker and another by the Financial Reporting Council, an accounting standards body, are likely to demand that shareholders police pay more effectively.

In the end does anyone really care about any of this? Sir Fred Goodwin’s case gets in the newspapers and we are all aghast and against it. Jonathan Ross’s reported £16 million three year contract becomes public knowledge and we are against it. We then find that relatively lowly people are paid yearly multi million pound salaries and we are all aghast.

However, London, Birmingham, Manchester, Edinburgh, New York, Paris, Bonn, Singapore, Sydney, Johannesburg, Hong Kong, Tokyo and a great many more places across the world are littered with massive estates and houses that were built 600 years ago, 500 years ago, last year. As the title of a novel by Malcolm Macdonald has it, The rich are with you always.

Conclusions

It strikes me that politicians are the last people on earth and in the universe who should be holding anyone to account. At the end of it all, these people are subject to enormous pressures from people who know how to play games far better than they do. Moreover, companies bring jobs and any politician who says let them all hang could well be sounding the death knell of an entire community. Look at Thatcher’s Britain where, for good or ill, entire mining and steel making communities were decimated as a result of political decisions. The pay off for Thatcher’s Party is that they have been in Opposition for 12 years now and counting.

Someone has to act, though, because there are already serious rumblings from Wall Street and the City of London that the bankers are back: we are only three months away from the annual bonus season at the time of writing.

The Williamson Solution

What about my solution then? My solution is this: anyone who is likely to be paid a significant bonus (amount to be agreed) as a result of working to an incentive scheme has to attend a meeting of members of the public, shareholders, customers and others (to be decided) and convince at least 75% of the people in the room that they deserve their bonus. Less than 75% and they get nothing, say.

A far fetched solution? Not so, there is the case of the Detroit based car company executive who installed a system that came to be called strategic budgeting in which he gathered all of the managers of discretionary expenditure in that company and told them that with immediate effect all of their budgets were being cut by 50%. He then said, we’ll come back in a week and anyone who thinks they need some or all of that 50% back has to argue their case in front of everyone ... Overall, he saved 38% of all discretionary expenditure in that first year.

References

Alfred Rappaport (1999) How to Link Executive Pay with Performance Harvard Business Review March April

Robert S Kaplan and David P Norton

• 1996 Balanced Scorecard, The: Translating Strategy into Action Harvard Business School Press
• 2000 Strategy Focused Organization, The: How Balanced Scorecard Companies Thrive in the New Business Environment Harvard Business School Press
• 2004 Strategy Maps: Converting Intangible Assets into Tangible Outcomes Harvard Business School Press
• 2006 Alignment: How to Apply the Balanced Scorecard to Corporate Strategy Harvard Business School Press
• 2008 Execution Premium. Linking Strategy to Operations for Competitive Advantage Harvard Business School Press

Bob Pozen Should the G 20 Adopt Bonus Limits? 21st  September 2009  http://blogs.harvardbusiness.org/cs/2009/09/should_the_g20_adopt_bonus_lim.html?cm_mmc=npv _ TOPICEMAIL _ SEP_2009 _ FINANCE2

Kevin Gray

• Got Superstars on Your Team? Great. Just Don’t Pay Them Like Superstars Undated http://www.bnet.com/2403 13059_23 344823.html?promo=713&tag=nl.e713
• Can Pay For Performance Work in Health Care? You Bet Undated http://www.bnet.com/2403 13059_23 344827.html
• Don’t Let a Bonus Plan’s Goals Exceed the Employees’ Grasp Undated http://www.bnet.com/2403 13059_23 344821.html

Executive Pay: Maligned or Misaligned? The Economist 17^th September 2009

© Duncan Williamson
23rd September 2009 updated 25^th September 2009