Wednesday, February 25, 2009

A Modest Proposal to Reform Management Compensation

Nassim Nicholas Taleb has a post on incentive compensation in Financial Times which describes the problem with the typical bonus plan. Here’s an excerpt:

Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses. As you do not disgorge previous compensation, the incentive is to engage in trades that explode rarely, after a period of steady gains.

Taleb’s solution is radical:

We trust military and homeland security people with our lives, yet they do not get a bonus. They get promotions, the honour of a job well done and the disincentive of shame if they fail. Roman soldiers signed a sacramentum accepting punishment in the event of failure. This is prompting me to call for the nationalisation of the utility part of banking as the only solution in which society does not grant individuals free options to look after its risks.

I like the military analogy, but I think Taleb goes further than needed in eliminating bonuses entirely, and I think he doesn’t go far enough when he limits the proposal only to banking. Here is what I propose for all managers of public companies (or private ones which rely on public support, for example, a privately held bank).

1) Your base pay is limited to it’s military equivalent:


2) The rest of your compensation is in the form of whatever bonus your company thinks is appropriate – no mandated limits or performance criteria. However, the bonus must be paid in cash, and it gets paid into a federal trust fund.

3) After five years, the trustees compare the shareholder equity for the year the bonus was paid with current shareholder equity. If equity is the same or has increased, the bonus is paid. If shareholder equity has declined the bonus is forfeited and used to offset costs of administering the trust and then for some good purpose (education, or unemployment benefit funding). You don’t have to stay at the company to get the bonus.

This approach will cause managers to be thinking about values five years out, which should be a long enough horizon to avoid the problem Taleb describes. It also encourages managers to control employees engaging in risky actions (e.g., traders), and to move on if they think the company is taking excessive risks.

There are plenty of potential objections, but I think the most serious one is that some risk taking often produces real long term rewards, and this approach will dampen productive risk taking in public companies. That’s true, but I think it’s mitigated by the fact that private companies and partnerships will still be around to take big risks, and to provide opportunities for those who can’t wait five years for their reward.