No, this is not a blog about airline or credit card rewards programs. It is about the incentive systems in our society and how we reward job performance. Incentive systems have enormous implications beyond the organizations that craft them. Most people’s eyes glaze over when thinking about incentives and compensation, but it is worth a further look.
Early Exposure to Incentives
One of my first cases involved a sales compensation dispute before the California Department of Labor. My employer sold large telephone switches. At the time, some of these switches were as large as a small office building. Sales representatives received half their commission when they signed a deal and the balance when the switch was installed and paid for. In my case the sales representative left between these two benchmarks. He received only the first payment, and thereafter brought a complaint for failure to pay wages. My company prevailed, arguing that the sales representative had not fulfilled the second half of his sales responsibility. He had customer service requirements to ensure the switch was installed to the customer’s satisfaction and payment received, and that did not happen on his watch. The reality is that in many cases the sale is never consummated, or the customer does not pay. Thus, the sales representative was only partially rewarded for signing the customer: a partial payment for a partial job.
Misaligning Incentives and Rewards
We are now living through an age of misaligning incentives and rewards. One could argue that this misalignment is the root cause of the current financial crisis. A look at some of the misalignments:
- Countrywide and Washington Mutual were poster children for misaligned compensation systems. Regardless of ability to afford payments, mortgage brokers recklessly wrote subprime, 125% loan to value, no documented income, adjustable rate and other questionable mortgage products. Compensation was earned on closing. There was no “claw back” of the compensation provision when the mortgage holder ultimately defaulted.
- Wall Street financial engineers created inexplicably complex credit default swaps and other financial derivative products. These products were sold to cities, pension funds and college endowments. Many of these weapons of mass financial destruction caused shocking losses. At AIG these derivatives blew up, sending insurance companies into government receivership. Writing these bad toxic financial products had no adverse consequences for AIG executives. In short, the head of AIG Financial Products collected $300m in compensation for creating fiendish products. See We Were ‘Prudent’: AIG Man at Center of Crisis. Again compensation was paid up front without a “claw back” when these products misfired.
- Money center banks and Wall Street firms were given $700b in TARP funds. No restrictions were placed on compensation, and no requirements were imposed to lend to businesses. A zero interest rate policy incented banks to borrow at near zero cost, buy longer dated treasure securities at virtually no risk and earn large profits. All this resulted in near record financial firm bonuses in 2009 and 2010 and almost no lending to small businesses. Even worse, many of these Wall Street bonuses were based on illusory profits. Suspension of “mark to market accounting” overstated profits and the resultant bonuses.
In each of these instances rewards were based on the initial sale rather than outcomes. No one owned the outcome and society suffered.
Other Misaligned Incentives
Outside the financial area we have misaligned incentives:
Politics – The expense of purchasing mass media to run a national campaign or a local campaign in an expensive broadcast market requires endless fundraising. Given the Supreme Court removal of restrictions on corporate campaign contributions it is no surprise that we have a Congress and executive branch held hostage by corporate contributors. The end result is earmarks for special interests, endless increases in defense spending and watered down financial and health care reform shaped by corporate sponsors. Congress is incented to reward special interests at the expense of the broader good.
Executive Compensation – Executive compensation for CEOs is open to endless possibilities for “gaming” the system. If increased earnings per share is the target objective, a skillful CEO can effect share buy backs, delay recognition of expenses or cut the research and development budget. If options are granted, the same techniques can be used to boost share price. Need to meet cash flow targets? Easy! Just cut expenses through layoffs and reduced product development and research. Virtually any financial target can be manipulated in some way to the CEO‘s advantage.
We Have Learned Nothing
The financial crisis should have been a wakeup call that we cannot continue the same path of misaligned incentives. Financial executives have paraded before Congress with the sorry excuse that they really did understand the derivative products that they were selling or the consequences of a worst case economic scenario. This behavior should be unacceptable and is a failure of both senior corporate management and boards of directors. Nevertheless, the banks and Wall Street firms continue to expand their derivative business. See Far More Derivative Exposure Today than Two Years Ago
Recently, the CEO of D.R. Horton, a major home builder was quoted in the Wall Street Journal:
“As I tell our salespeople as I travel around the country, if they are warm and they have a pulse, write them,” he said on an investor call for the company’s fourth-quarter earnings Friday. “Write them, and then we’ll figure out whether or not we can get them qualified.” Heard on the Street – Overheard: Still Dreaming
We are back to business as usual. We continue to incent bad behavior at the peril of our economy. There continues to be no ownership of outcomes. We should not be surprised if the new year includes a rerun of 2008.
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