In the panic and chaos surrounding the financial melt-down, common sense and reason have been unceremoniously dumped in favor of a carpet-bombing of accusation and blame. As everyone from executives to regulators to investment managers to government officials emits fusillades of covering fire in hopes of deflecting in-coming criticism and responsibility, the real culprits get obscured while effective business practices get trashed as collateral damage.
The latest victim is the "management bonus" and even President Obama himself is getting in on the public ridicule and scorn. Obama wants to talk to Wall Street executives about a report indicating payments of over $18 billion in bonuses as the economy was in virtual free fall. "It is shameful," Obama said from the Oval Office Thursday calling these bonuses "the height of irresponsibility," Vice President Joe Biden spoke even more bluntly, saying "I'd like to throw these guys in the brig," in an interview with CNBC.
While I have written extensively on my disgust with excessive executive pay (See, Note to Congress -- Convert Executive Pay to Loans, I Admire His Pluck -- But His Timing is Deplorable, and John Thain, Poster Child of Excess), I want to be careful to point out that it is not the practice of paying bonuses or incentives per se that is the culprit, but rather their abuse. It would be foolhardy and narrow- minded to assume that because the same culprits who trashed our economy were paid with incentives, that all incentives are therefore evil, ill-conceived, risky, dangerous, and unsavory. Nothing could be further from the truth. This would be like saying we should do away with mortgages because they were the financial vehicles that created this mess. We still need mortgages just like we still need incentives. The difference is they need to be properly designed, properly administered, and properly managed.
I have personally seen the effect this kind of hysteria and paranoia can have on a business. One of my clients (who shall go unnamed for obvious reasons), until recently, had a Board Chairman who earlier in her career personally observed the wreckage that an ill-conceived incentive plan had on an organization she worked for. From that moment on, she vowed that no company she ever controlled would use incentives or bonuses again. And she adhered to this rigid doctrine for the next 30 years. Her myopic edict did not, however, release her from the realities of the pay market. So in order to compete for talent and retain top executives, she was forced to rely strictly on base salaries. As a result, while all of her competitors had 30% to 50% of pay at risk and could flex their cost based on company performance, she was compelled to guarantee all pay in the form of base salaries. These salaries got paid every year regardless of performance. As performance began to slip, she continued to pay top dollar. Eventually all her best executives departed, seeking positions where they were rewarded for their personal contribution to organizational success. Ultimately, she was left with an expensive leadership team comprised of people who were risk averse, timid, and overly conservative. That organization is now teetering on the brink of failure. Of course, there is much more to their collapse than the absence of incentives, but it definitely played an important role.
So, while government regulators clamor for caps on executive earnings and the abolition of incentives, don't get caught up in the hysteria. If the people who are saying these things knew what they were doing, they would never have let this mess happen in the first place. Instead, remember that well designed incentives are a key part of the solution, not part of the problem. They provide clarity and transparency by revealing what a person is expected to do, and what they will earn when they do it. They protect against windfalls and focus on outcomes that are controlled and influenced by each individual. If you doubt that I am right, ask yourself this simple question -- would you rather the head of your favorite corporation earn all his money as a guaranteed base salary and receive it regardless of what he does or how well he does it, or would you prefer he was guaranteed only a small amount and had to earn the rest by actually performing. I think the answer is clear. The challenge is to properly define "performance" and establish reasonable and appropriate payouts when the performance is achieved.
So, when you hear that incentives are being abused and misused, blame the leadership teams and Board Compensation Committees who created the incentives, not the incentive plan itself. After all, if someone walks up to your car and smashes your windshield with a hammer, do you blame the hammer?