Executive Pay Caps and Bonus Hocus-Pocus

When young people are faced with a vexing problem or frustrated by a situation that is seemingly out of their control, they sometimes lash out at anything near, even though it may not be the cause or solution to the problem.

Most mature adults know better. They have learned to accept responsibility for the harsh realities that sometimes confront them, and diligently seek ways to identify the core problem and find ways to solve it. But bureaucrats – particularly the government variety – do neither. They are well practiced at the political version of “problem solving” which is easily summed up as follows:  “If you make a mistake, blame someone.”

That’s exactly what we are witnessing in Congress. Elected officials and bureaucrats, frustrated by their inability to resolve the financial crisis are lashing out at the compensation of executives running these problem companies. No matter how abusive these compensation plans may have been (and many were) they did not, in and of themselves, cause the financial meltdown and demonizing them will not solve the crisis. And putting an artificial “cap” on executive compensation is an especially foolhardy notion.

Creating a brouhaha over executive compensation and bonuses accomplishes nothing except to divert attention from the real problem while allowing the bureaucrats to escape the blame for their own failures. Sure, putting a cap on executive compensation and bonuses might make us feel better and it provides mesmerizing grist for the news pundits, but this approach is pure hocus-pocus and will not make the financial crisis disappear any more than it will make a rabbit jump out of your hat. In fact, such a diversionary approach may delay a solution or even exacerbate the problem.

The poster-boy for this bureaucratic approach to problem solving is Congressman Barney Frank (D-Mass). The Honorable Barney Frank is a loud-mouth, disingenuous demagogue who is probably more at fault for the financial crisis than any of the executives with their big bonuses. It was Congressman Frank, after all, who was at the vanguard of those pushing sub-prime mortgages and relaxation of controls over financial institutions. Now that the error of this approach has come home to roost, like any good bureaucrat he is lashing out to blame others for his mistake.

There is no doubt that many of these executives gave the bureaucrats the whip with which they are now being flogged from talk show to committee meeting. And there is no doubt that many of these executives deserve to be flogged, but we must be careful not to allow our frustration over the financial crisis to evolve into treatment that will make the cure worse than the illness.

What must be recognized is that we are dealing with two intertwined yet different problems – abusive executive compensation plans and inappropriate actions on the part of financial companies as it relates to risk management. While the executive compensation plans and foolish corporate actions can be linked – each one making the other worse – they require a distinct approach to finding the solution for each problem.

The purpose of this blog is to isolate the compensation issue and suggest steps that can be taken to improve the situation. If the right actions are taken with regard to bonus plans, then the motivation of executives to take risky and inappropriate actions can be virtually eliminated.

To begin, put me in the camp that believes executive bonus compensation should be unlimited, not capped. It is not the bonus concept that is bad; it is how the bonus concept has been abused that is bad. It is the old cliché, “Don’t throw the baby out with the bath water.” Or as Rob Cox wrote in the The New York Times (Feb. 3, 2009), “The critics should be careful. The bonus is a pillar of the meritocratic capitalist system, which, despite its many recent failures, has mostly served democratic societies well.” Mr. Cox continued, “The prospect of rewards for exceptional performance drives ambitious people to new heights of hard work and innovation. A bonus system is a great tool to help prevent workers from losing interest in their job. If structured properly, a bonus system binds workers to larger corporate objectives.”

The last point made by Mr. Cox – a properly structured bonus – is the most cogent as it applies to the current problems. Clearly, the fact that these large bonuses, in effect, paid for poor performance proves that they were not properly structured and out of whack with intent and reality.

Why Bonus Systems Fail

There are three conditions when bonus systems fail to achieve their objectives:

1) The bonus becomes viewed as part of basic compensation and becomes an entitlement,
2) The bonus is based almost totally on short-term results, and
3) The bonus plan is structured from the top down instead of bottom up.

When we witness large bonuses being paid to executives of companies delivering poor performance – and we’ve seen a lot of that lately – it is a clear indication that the bonus has lost its meaning and has simply become an entitlement. The properly structured bonus system would never allow this to happen. In defense of their actions, the executives of the poor performing banks and investment firm argued that – despite the poor performance – if they did not pay bonuses then all the good people would flee to companies that did pay an annual bonus, regardless of performance. (I always love those, “Well everyone else is doing it,” arguments.)

The abusive bonus systems that have been exposed were based almost exclusively on short-term results, despite the fact that actions taken to garner the bonus had potentially damaging long-term impact. It is like holding a mile race and awarding the medals at the end of the first lap. If the runners are encouraged to focus all their efforts on the first lap only, it is likely the results at the end of the mile (if they even make it that far) are going to be disappointing. It is fine to be in the lead as the race progresses, but the real winners are those who lead at the end, and that is when they should be rewarded.

A bonus plan that emanates at the pinnacle of the company in the CEO’s office and trickles down the organization is, by its nature, inequitable and offers the likely potential that it will become abusive. Such a philosophy in bonus payments is the type of plan that can pay the CEO $20 million and the mail room manager $200, if anything.

What Is To Be Done?

The first step is to redefine the concept of the bonus. A bonus should not be considered “compensation,” but rather an incentive to share in value that has been added to the organization by the work of the employee. Compensation is what an employee is paid to do their job. A bonus should be an incentive that encourages employees to go beyond their job and add additional value to the company. A bonus should never be based on salary or seniority, but rather on the specific additional value an individual adds to the company.

A bonus should never pay for the same work twice. What that means is that once a bonus has been paid for value added to the company, then the new value should be the benchmark moving forward. Unless there is additional value added, the bonus should not be repeated. When the bonus becomes part of compensation for a given job, the company ends up paying for the same value over and over, without any incentive to do better. Only new value added should be rewarded, not just maintaining existing value.

Any bonus plan should be simple, easy to understand and transparent. (Clearly an oxymoron for most plans in place today.) A bonus plan must be based on specific performance that adds value to the organization. Most importantly, the bonus plan must be based on specific targets the participant feels they can impact. For example, a bonus plan that is based on stock price or current earnings is not effective, because the majority of individuals in a company don’t believe their individual efforts will impact these type of targets. On the other hand, if the bonus plan is tied to the specific actions the employee can control, then real incentive is created.

Finally, and most important, for a bonus plan to be effective at creating incentive to add value to the organization it must start at the bottom of the organization and work its way to the top. To often in today’s world the CEO and executives are paid large bonuses, while most employees go wanting. Instead of the CEO being the first to receive a bonus he/she should be the last one to benefit. And, the CEO bonus should be a factor of what others have been paid.

And The Moral Of The Story Is …

The concept of a bonus that rewards exceptional performance is an incentive tool that has proven effective at encouraging those who have the ability to add value to an organization to do so, because they recognize the opportunity to share in the value added. However, a bonus plan that is not properly structured is virtually guaranteed to be abused and be ineffective.

We have a right to be outraged by the obscene bonus payments that have been granted in poor performing companies, but it is wrong to blame the vehicle rather than the abusers. The properly structured bonus plan is at the very heart of the entrepreneurial culture and concept that has created the most powerful and democratic economic system in the history of the world. To eliminate or restrict its proper use, just to lash out in frustration at those who have abused the concept, is to damage – if not destroy – future economic growth and vitality. And, that is no hocus pocus.

(This blog does not allow for a full discussion of a specific compensation and bonus program that will incent people to do the right thing in the right way. If you would like to read more about developing effective bonus plans I encourage you to get a copy of my book Beat The System and going directly to Chapter 10 – Sharing Wealth Increases Wealth.)