Wednesday, February 11, 2009
Compensation Observations
It is a fact of life that incentives matter. The way you structure incentives are critically important in how people will behave.
One of the observations that I have about incentives is that equity incentives are notoriously bad when it comes to promoting long-term health of the firm. The reason is simple. Once the larger management team has accumulated a bulk of vest stock options over the years it is very difficult for them to take a long-term view of the firm. The classic theory so goes that if the long-term story of the firm is safe, the stock will rise in the long run. But as Keynes shrewdly observed over half a century ago - in the long term, we are all dead.
The truth also is that the stock performance is largely a function of the larger economic situation over which an individual firm, and lesser the individual has any control. So once the accumulated stock sits in the demat account, the tendency of managers is to maximise the same over the 'short-term'. I believe that rare is the soul who will say that i will take hard but necessary decisions which i KNOW will impact my stock (and hence my wealth) in the short term but MAY only increase in value over the long term. I am not saying that people are children and they cannot delay gratification. However, it is extremely rare that business outcomes can be predicted with absolute certainty in the long run whereas it can be predicted reasonably accurately in the short term. Look at what happened in the recent economic crisis. An yearly bonus is a poor way of rewarding when the bets taken can turn out to be very risky over the long term. The problem is that what exactly is the long-term ? A trader can show gains over a given period of time but only time will tell whether the bets placed were 'smart and successful' or 'risky or stupid'.
Unfortunately there is no clean solution here of builidng ownership. In business, one takes bets which one hopes will lead to success in the long-term. However, there is no 'perfect' period over which success of an individual can be predicted.
Ditto is the case with benefits. Look at GM and their very generous benefit schemes. When they came out, they were heraled as the new benchmark for corporate citizenship. However, 30 years later, the same strategy proved to be their undoing. The manager in 60s was convinced that the decision taken was a wise one but over thirty years that very tactical compensation decision brought the biggest company down on it's knees.
