Czar czaps pay

Kenneth Feinberg, who has the ignominious title of U.S. pay czar is zapping the pay of firms receiving U.S. government monies. To me this is exciting news. For over a year I have been waving the flag of salary and incentive compensation reform. Thankfully the egregious and unwarranted size of executive pay is no longer a secret. So what’s the czar up to?

Salaries at firms such as Citigroup, Bank of America, AIG, GMAC, etc. who are or have received government aid are being slashed by 90% on average. The number of employees affected is around 175. The largest pay package will be at B of A but is going to be less than $10 million. Wow! This is a radical reduction.

Much of the lost compensation is being turned into long-term stock grants – something I have been calling for (!). It’s my deeply held belief that the time horizon for incentive compensation is unnecessarily short. That causes financial decision makers to try and hit home runs each year rather than singles and doubles. Why? Because the potential payouts are huge and if you fail the losses are not your money. And most importantly, if compensation is based on one year’s performance then the “clock” gets reset after a year’s time anyway.

This is like in sports. If you lose one game football game 48-21, that loss is negated by the next game even if you win 7-6. The net loss of the two games is huge, but because the clock at Wall Street firms is reset there is always the potential for a big gain next year. I would expect big noise out of the 7 firms affected by the czar’s decision. In fact, there has been a lot of rumbling. Wall Street firms counter that employees who lose them money lose their jobs.

Yet imagine the likely scenario. A trader at a Wall Street firm has an outstanding year in which she/he makes the firm a lot of money. The firm is emboldened by the “brilliance” of the trader. Next year they are given even more capital to play with. The trader has a difficult second year and loses the firm a lot of money. You are the decision maker at the firm, what do you do? Most likely you still have in your mind that great first year and so you give the trader another year to re-prove themselves. If that third year is also miserable then you have 2/3 of the trader’s tenure that stinks. How could a hero turn out to be such a zero?

Maybe the trader and her/his skills work well in a particular type of trading climate and not so well in others. But you don’t know this until after the fact. Maybe the trader actually has no skills at all and instead got lucky. Who knows? But imagine if the trader were awarded compensation based on performance over 3-5 years? The way you would reward the trader after that great first year is with a slightly increased salary and with restricted stock of the firm. The stock is essentially held in escrow until 5 years after the fact. If the trader continues to do well then it’s likely the firm does well. That means that in 5 years the stock will be worth much more and will be proper reward for that first year’s performance. But if the trader after 3 years has lost the firm a lot of money then you fire the trader and they do not collect the stock. The loss to shareholders is thus minimized. Not only that, but the trader has a deep incentive to make prudent choices over the course of five years. Duh!

Some of you may be curious as to how I was compensated during the course of my career. I was awarded a base salary that increased only slowly. However, if I performed well, as measured by investment returns relative to my peers and benchmarks (the S&P 500) over three years, then I received a large bonus. Additionally, I received the equivalent of stock options that were not redeemable for three years after the date they were earned. And lastly, shortly before my retirement I was made a (very) minor partner at Davis Selected Advisers. Profits of the partners were also tied up in forms of long-term, deferred-type compensation. So the overwhelming majority of my compensation was long-term in nature. And yes it did affect my behavior and choices. Duh!

At this juncture we have Wall Street’s spoiled babies having to confront the “grim” prospect of having to actually earn money by thinking long-term. To my thinking this aligns employee behavior with what is good for shareholders. Go Czar Feinberg!

Jason