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It’s Time To Challenge Bonuses

December 13, 2009

I must admit that I do not understand why those in the financial services industry need such large bonuses. I am not alone in struggling to grasp what they do that offers such tremendous social benefit (indeed, a report in today’s Financial Times claims that “Top Bankers Destory Value” for society). No one has explained what unique talents or education these financial experts bring to their work.  I am unclear what loss there would be if they were no longer bonused in this way and felt ‘obliged’ to move to alternative careers. Indeed, if they are so talented, then perhaps those alternatives would be of greater social benefit. And if they are not so talented, perhaps they would simply remain in their current jobs anyway.

I am steadily becoming more convinced that bonus schemes cause undesirable distortions in many areas of our economy – including the world of contracts. It will come as little suprise that, in IACCM’s survey on ethics earlier this year, one of the main concerns expressed by members was the extent to which sales staff are incented to exaggerate commitments.  Many contracts and purchasing professionals wrestle with the mismatch between sales’ promises and contractual limitations. This is often the cause of mistrust and of the battle over risk allocation that distorts many negotiations.

As a specific example, last week I was talking with a senior governemt official about the public procurement requirement to avoid direct discussion with individual suppliers. We discussed the fact that open forums prevent suppliers sharing new ideas and describing possibilities for differentiated solutions – a factor that some of my senior contacts suggest is significant in the frequency of project failures. The official agreed, but explained that the policy cannot be breached due to the propensity of suppliers to take legal action when they lose. And he suggests a major factor is the distortion caused by short-term bonus schemes – the severity of personal loss that results from failure to win a major bid.

In a simpler world of product sales, where force majeure was an accepted principle, bonuses perhaps made sense. But today, in a complex global environment, they cause distortions that generate unacceptable risk. For all of us in the world of contracts, perhaps the time has come when we should consider becoming advocates for a new approach to reward systems – an approach that would be more consistent with the ethical standards of contracting and the delivery of value.

A good start would be for us to start sharing information  about some of the distortions we observe that result from the behaviors induced by bonus and other incentive schemes. Any initiative for change must start by illustrating the damage that is done by the current approach. Do you have examples?

10 Comments
  1. Mike Wall permalink

    My understanding is that the bankers have contracts with targets to drive performance. If they meet or more specifically exceed these targets they get their bonus. So either change the targets or the structure under which they get huge bonuses. Like most companies that have a large incentive schemes they claim the base salary doesn’t reflect the risks they take. Not that I condone the large bonuses, I don’t, but this is how the industry has evolved to be one of the best financial institutions in the world bringing into the UK lots of investment!!!

    • Mike, my comments were not really about the current obligation to pay bonuses; and nor do I deny that bonuses generate specific behaviors which can be argued to be beneficial. The issue I have is whether in fact the entire fabric of modern banking actually creates any sustainable social benefit (and there are a growing number of experts who are questioning this) and secondly, even if the work is worthwhile, then is the bonus system the most appropriate way to reward it? These are not entrepreneurs gambling with their own money. They mostly appear to be perfectly ordinary workers who are gambling with other people’s money – and then turning to society as a whole to bail them out when they get their betting wrong.

      But more broadly, as a community that should be engaged in judgments around ethics and principles, do we beleive that today’s financial bonus systems are in fact consistent with business and social interests? My question ot our community is ‘do we think there is a better way forward?’ – and if so, what is it?

  2. Richard Given permalink

    Tim, I think you will find this TED talk interesting: http://www.ted.com/talks/dan_pink_on_motivation.html
    Behaviour is always driven by what you measure. There is no such thing as a neutral observation (the quantum scientists have it right there…).

    • Thanks Richard – a couple of people have mentioned TED so clearly I should read it right now!

  3. Greg King permalink

    There is a recent article (30 November 2009) by Henry Mintzberg in the WSJ on this topic. See the link below. I fully subscribe to Mintzberg’s sentiments on this topic – “Scrap the whole thing. Don’t pay any bonuses. Nothing”

    http://online.wsj.com/article/SB10001424052748703294004574511223494536570.html

  4. Hi Tim

    I couldn’t agree more. You may want to check out the following article from WSJ from a recent interview with Paul Volcker (http://bit.ly/4z7AJX). Unfortunately it appears that Volcker is getting sidelined in the current administration.

    Further to address Mike Wall’s comments, I don’t think that they are entirely accurate. Specifically:

    – His reference to “best financial institutions” is somewhat debatable considering it is subject to many of the same problems that have tripped up the US Financial industry.
    – Just as Bill Gross recently pointed out that the US needs to move away from manufacturing paper, so does the UK. (http://bit.ly/1yk8v8)

  5. Joginder Yadav permalink

    The debate on whether banker bonuses are good of bad will continue – the fact is those at the top of the food chain anywhere (from lions in the Sahara to bankers on Wall Street) will always be in a position to create situations where they enjoy the “lion’s share” so to speak of the total communities resource pool. I am not defending it, but that its a reality one can’t do much about. So unless we can import the solialist principle of “from each according to his capacity, to each according to his need” and assume that bankers have ordinary needs), into the capitalist system, such steps are doomed to fail.

    Of immediate interest at least to me is how we can convince sales and delivery to be incented (or disincented) in a manner that delivers the right value to their companies over the life of a complex and long term services contract. Its often the case that companies that fail to do so have stars in the sales team but over time there are failed projects because they are not paid or penalised for managing or failing to manage risk under the customer contract.

    Does anyone have any best practices, examples and argumentation on this issue.

    Joginder

  6. Gregg Barrett permalink

    Joginder

    When you say that there is not much you can do about it, I completely disagree. The math is pretty simple. If you don’t bail them out, they go out of business. AIG, Goldman, Citi and the rest would have no fat cat pay checks without the help of tax payer money.

    Huge bonuses raise the cost of doing business. But the finance industry has not had to address this issue because their model is based on leverage. So you simply lever up and take more risk in an effort to capture a bigger pay day, because if it comes tumbling down, well then that is for someone else to worry about because we are TBTF.

    If allowed to fail, risk and the true cost of doing business would be realised and the industry would revert to a state of parity with other industries within the economy. At the moment the rules of the game allow them to live within their own bubble. And as long as the bubble is prevented from bursting such problems will repeat themselves.

  7. John Walmsley permalink

    Tim

    Interesting blog. Bankers aside, the question you ask about where incentives should rest in the procurement process is an interesting one. Spreading the sales bonus out over the first 24/36 months of a project/contract delivery and linking it to achieved outcomes for the supplier (and possibly customer too) means the test becomes “was it a good bargain” and not just “was is a good sale”.

    Final thought – A former boss’s view was that to offer a bonus so people might strive further, deliver more, made no sense, given that they should already be delivering their best for the firm.

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