A couple of months ago I described why all the hysteria about management bonuses was a smokescreen and a red-herring (pick your annoying anachronistic metaphor). Now, I am compelled to weigh in again in light of recent developments.
This time, the spotlight of shame has shifted from the ex-Merrill Lynch CEO (John Thain) to the villains at AIG. Their decision to pay $165 million in bonuses, most if not all of which will come out of TARP funds, has cast them in a very poor light. And as often happens when hysteria permeates public opinion, people aren't interested in being confused with facts when it is so much more fun to vilify and accuse. After many months of being blamed for all the problems, Congress is thrilled to have someone else to blame. Listening to them pontificate about waste and excessive spending is as comical as it is pathetic. Policymakers can always, it seems, be counted on for meaningless posturing when serious action is needed. And the public will respond in kind, fixating on inconsequential and superfluous details
How best to summarize this mess? Well, consider this. Incentives are not extra pay, they are merely another part of pay. And they happen to be the part that a person actually has to earn. Unlike base salaries which are paid merely because a person is able to fog a mirror, you actually have to do something to earn an incentive.
Now if you believe that AIG's incentives were paid to individuals who did nothing to deserve them, then your beef is with the people who designed the incentives, not the people who received them. Conversely, if you believe the recipients of the incentives did something worthwhile, then your beef should be with all the other people who did nothing to deserve a bonus and got paid anyway. Get the point?
So rather than vilify incentives, we should be begging for them. Incentives are contracts that only pay out when the recipients deserve them. Rather than guaranteeing 80% to 100% of a person's pay in the form of a base salary and paying it out for nothing, shouldn't we be guaranteeing far less and demanding performance for far more? Imagine a world where executives and managers received 20% of their pay in the form of a guaranteed base salary, and had to deliver specific measurable results to earn the remaining 80%. I am willing to bet that the same AIG employees who earned $165 million in incentives, earned close to a billion in base salary over the same period. They had to do something to earn the $165 million. They did nothing to earn the billion.
So now congress, in its infinite wisdom, is capping salaries at $500,000 and taxing incentives at 90%. Consider what this means. The executives that the taxpayer is counting on to dig us out of this mess show up to work every day guaranteed to earn $500,000 whether they perform or not. Wonderful. And if someone actually wants to link their pay to actual results, there is no way to do it. Not even the circus would make such a foolish mistake -- at least the lion tamer has a little bag of treats he can give to the animals to keep them from chewing his head off.
My great fear is that incentives will take such a PR hit from all this bad press, that boards and CEOs will shy away from them in the future. This would be a grave mistake.
So, as I said back in February:
...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. 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?