February 3, 2012 8:36 pm

Bonuses of contention

The corporate pay culture is the focus of unprecedented fire
pfeatures Office Buildings at Canary Wharf

Sky high: office buildings in Canary Wharf, the financial district in east London. More than three years after the collapse of Lehman Brothers, banks are still struggling to restrain incentive pay-outs

Charles M. Schwab was a pioneer of pay for performance. The US steel magnate was also, in the words of Thomas Edison, a high-living “master hustler” who won notoriety by supposedly breaking the bank at Monte Carlo during a wild holiday in 1902. Twenty-nine years after cleaning out the casino, he and his management team found themselves accused of cleaning up at Bethlehem Steel, the Pennsylvania company he headed. Shareholders sued when it was revealed that his innovative bonus plan was turning his lieutenants into millionaires – at their expense. Amid widespread concern about executives reaping excessive rewards as the US plunged into depression, Schwab cut the bonuses.

It sounds familiar. President Barack Obama vowed in last month’s State of the Union speech that banks would never again be allowed to make “huge bets and bonuses with other people’s money”. This week Stephen Hester, Royal Bank of Scotland chief executive, agreed under public and political pressure to waive his £963,000 bonus for trying to revive the state-controlled institution, as the media focused on his multiple properties and love of fox-hunting. In a symptom of mounting anger about all rewards for high-level executives, Fred Goodwin, who led the bank into near oblivion in 2008, was stripped of his knighthood.


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FROM Andrew Hill

In the trial of capitalism, the bonus culture stands accused as an accomplice to crimes against the global economy. Mihir Desai of Harvard Business School writes in the March issue of Harvard Business Review that market-based compensation in the US – stock-based pay and bonuses for corporate executives and incentive-based contracts for fund managers – inflated “a giant financial-incentive bubble”. Such “remarkable” windfalls “have given rise to a sense of entitlement that burdens us still and that will be hard to reverse”.

Yet, while much research suggests ill-conceived bonus and incentive plans can be counterproductive – and that managers underrate old-fashioned positive feedback and fair treatment – monetary reward remains the carrot of choice for companies worldwide and in many sectors. According to figures collated in 60 countries by Mercer, one of the largest remuneration consultants, 85 per cent of Latin American senior corporate executives re­ceived short-term incentives in 2011 – just ahead of North America.

How did this “bonus culture” become so deeply embedded; and can it – should it – be unpicked?

Bonuses emerged in the early 20th century as owners delegated the running of companies to managers. But while factory workers’ output could be monitored easily, it was hard to tell whether a chief executive was doing what was required. Properly structured, bonuses – paid for exceptional work – and performance pay distributed on the basis of meeting future expectations could help align shareholder and manager interests.

The most famous breakthrough in incentive theory came in 1990, when academics Michael Jensen and Kevin Murphy set out how stock ownership could galvanise executives. The use of share options to encourage managers ballooned, inadvertently assisted by US legislation that in effect capped executives’ cash salaries at $1m.

There were two snags, says Raghavendra Rau of Cambridge university’s Judge Business School. First, many companies implemented the Jensen-Murphy theory clumsily. Second, options attracted the wrong type of executive – risk-takers who “buy companies more frequently and they try to grow much faster”, says Prof Rau. As a result, his research shows, US companies run by these executives have done worse than companies run by managers with lower incentives.

Companies did rein in executive rewards after the collapse of energy trader Enron 10 years ago. Boards also reshaped the form of incentives, paying more bonuses in restricted stock that can be sold only under certain conditions. But overall amounts offered to senior executives have since risen. In the US, as a proportion of the value of publicly listed companies, overall rewards are returning to levels of the 1930s and early 1940s. Critics point out that public companies’ obligation to declare executive pay has merely helped compensation consultants set benchmarks, ratcheting up pay at the highest levels.

In the process, everything from property prices to luxury car sales is affected by the size of bonuses, particularly of those in finance. Prof Rau, who worked for Barclays Global Investors (now part of BlackRock, the asset manager) in San Francisco, recalls that in “bonus season” – January and February – the pay-out “was pretty much the only topic of conversation”. The same is true in London, Europe’s leading financial centre.

. . .

More than three years since the collapse of Lehman Brothers, banks are still struggling to restrain incentive pay-outs. Josef Ackermann, Deutsche Bank’s outgoing chief executive, said on Thursday that the bank had reduced its bonus pool by 17 per cent in 2011, but this followed a 42 per cent decline in annual pre-tax profit at the investment banking arm, where the biggest bonuses are paid. According to a US federal audit of the bail-out of seven companies – including insurance behemoth AIG; financial services giant Citigroup; and General Motors – the Treasury approved pay packages of $5m or more for 49 executives since the president himself promised a $500,000 salary cap in 2009. The companies “really showed little or no appetite for reforming compensation practices or cutting pay on their own”, according to Christy Romero, deputy inspector-general for the troubled asset relief programme.

Even in good times, bank chiefs say, they learn not to expect gratitude from recipients of big bonuses. “In bull-market days you lose sight of context and perspective,” says Simon Hayes of Peel Hunt, a City of London broker and adviser. “With very few exceptions, no one ever dared to say ‘thank you’.”

This sense of entitlement reached its fullest expression in the “guaranteed bonuses” offered to new staff in the financial sector even after the crisis had broken. But while few executives defend this contradiction in terms, they do worry the campaign against a bonus culture will go too far. One chairman of a blue-chip UK company says: “The government is gunning for us in a way that is unhealthy. It will make young people not want to go into business, and we are creating the wrong sort of environment. If we don’t want wealth creation in the UK, there are plenty of other places that do.”

Mr Hayes argues that tailored and targeted bonus plans are vital for motivating his staff, but they have to offer the right “mixture of incentivisation, reward and a sense of equity”.

Others defend the right to contractual payments. “I have materially hit my targets, so I’d expect the bank to honour the commitment to pay me 100 per cent of my entitlement,” says one senior investment banker.

In angry exchanges in the UK parliament this week, David Cameron, prime minister, argued that to abolish almost all pay for performance would deny “people working in factories, offices and shops” the opportunity to win bonuses, which he described as “pro-aspiration”.

Historically, in developed countries the desire to curb bonuses has reached its peak when shareholders are unhappy and economic conditions dire. Sir Philip Hampton, RBS chairman, told the BBC on Friday that pay was “a straightforward business issue, with too much money not going to the right place. Shareholder rewards have not been sufficient”. As western economies recover and dividends and stock buy-backs resume, investors’ concerns may dissipate.

Something else has changed since the last peak of concern over pay inequality in the 1930s: executives now compare their rewards with those of their global counterparts. Robert Swannell, chairman since 2011 of Marks and Spencer, the UK retail group attacked two years ago for the pay package awarded to its new chief executive, argues that incentives must be framed in this context: “A unilateral act in one company could be to the disadvantage of shareholders, if you expose your best people to being hired [elsewhere].”

Much of the world is only now catching up with the US and UK. The Federation of Indian Chambers of Commerce and Industry has estimated that Indian chief executives on average receive only one-hundredth of the pay of western counterparts. Some have spoken up about how little they are paid relative to those in the west.

This global market for executive talent is far from perfect. As Ruth Bender of Cranfield School of Management has pointed out, companies benchmark themselves against “a limited population of elite salaries”, usually chosen by their pay consultants. But as companies in fast-growing economies extend their reach – and compete for senior staff with multinational experience – upward pressure on incentives to attract and retain top executives may increase. Charles M. Schwab died bankrupt in 1939. But for all the political and public fuss over excessive pay, the bonus culture he helped foster seems likely to receive a new lease of life.

Additional reporting by Elizabeth Rig­by, James Lamont and James Wilson

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