Tuesday, March 3, 2009

The truth about compensation.

The US congress is talking about limiting compensation for Wall Street managers. By all reports the financial community thinks this is a bad idea and will be counter productive since the managers get large bonuses for creating profit.

A great idea if they actually had created big profits!

Unfortunately those big profits that drove big bonuses were illusory. We know they were illusory because the companies that paid those bonuses for generating those big profits are the very companies with their hands out to the government. If they really had made big profits, they wouldn’t be begging for government bailouts.

The real problem is that the companies linked compensation to SHORT TERM results and this led to only looking at how big the sale was without regard to the long term quality of that sale.

If you want to share in the rewards for good times, simple honesty demands that you be equally willing to share in the costs of the bad times. Maybe the better way to structure bonuses would be like the commission on insurance policies. You get an upfront commission for the sale but the rest is paid as a residual for as long as the policy payments are continued.

Managers would get their bonus with some percentage up front and the bulk in relationship to each successive year’s profitability, so that if you make short sighted decisions you’re residual income is directly impacted. While the details might take some time to work out, it would force the decision makers consider both the short term gain and the long term cost.

Severance pay for top executives should be the same as anyone else in the company. If the janitor gets 2 weeks severance pay for every year they worked for the company, why shouldn’t the president? The senior executive of a bank might get $1,000,000 a year while the janitor might make $20,000 so if each worked for the company for 5 years the janitor gets $20,000 divided by 52 equals $385 times 5 or $1,923 severance pay. The senior executive gets $1,000,000 divided by 52 equals $19,230 times 5 or $496,153.

Before you bring up the argument that the senior executive is more valuable to the company and harder to replace than the janitor, remember that severance pay has nothing to do with relative value. Severance pay is supposed to be compensation for good and faithful service and both employees gave good and faithful service or they would have been fired for cause and be ineligible for severance pay.

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