Neil Woodford’s decision to scrap bonuses at his fund management firm poses the question: does this mean big bonuses in the finance industry are on the way out? I don’t think it does.
There is little correlation between bonus and performance and this is backed by widespread academic evidence.
One reason for this is that badly-designed incentives can incentivize the wrong behaviour, such as short-termism, cooking the books or chasing risk. A further reason is that bonuses can crowd (pdf) out intrinsic motivations (pdf), the desire to do a good job for the sake of it.
However, the financial industry doesn’t pay bonuses because they are good incentives. They weren’t introduced because bosses saw their staff slacking off and decided to incentivize them. Instead, bonuses are a legacy from an old business model.
Consider the old-style merchant banks and stockbrokers – the sort of firm I joined from university. Because these depended upon takeover activity and stock market conditions, they had volatile revenues. Bonuses were the solution to this: the reduced the need to lay off staff during downturns. They were an example of the “share economy” advocated by Martin Weitzman and James Meade; the rich have always liked socialism for themselves.
What they were not were incentives. Staff didn’t much need to be incentivized simply because they were directly overseen by the businesses' owners, the partners – and some of them were pretty scary.
In this context, it’s easy to see why Mr Woodford is scrapping bonuses. His business - for now anyway - has relatively stable revenues so there’s less need to stabilize profits through revenue-sharing. And he only employs 35 people, so he can oversee them directly. I’d add that a big part of his business – his equity income fund – is largely a play upon the longstanding defensive anomaly (pdf), and you don’t need high-powered incentives to do that.
However, whilst his decision is a good one for his business, it might not be applicable to other companies, where revenues are more volatile and direct oversight not possible because of bigger staff numbers.
I’d add three other possible reasons why bonuses might continue:
- Although they might not incentivize good behaviour, there are circumstances in which they might deter (pdf) bad. The prospect of a big bonus deters traders from selling assets cheaply to a rival firm which they later join.
- There’s an element of mispricing in relative salaries in finance: you can end up hiring a duffer for £500,000 or a star for £100,000. Bonuses in the first year allow such mispricings to be corrected; paying a recent hire a bonus is a way of compensating him for having a relatively low initial salary.
- It would be a brave large bank that scrapped bonuses in the hope of crowding in intrinsic motivations. Some people enter banking precisely because they are motivated only by cash – maybe not many, but enough to do damage. They’d get the hump if bonuses were scrapped. The status quo bias is a powerful force, and often rightly so.
I suspect, therefore, that bonuses in some form will remain a big part of finance.