Bonuses: here to stay

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.

First, though, a word of praise. Mr Woodford’s colleague Craig Newman is right to say:

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.

Comments

[gastro george]

So the original motivation was profit-sharing, so why not call it that and flatten out payments, so that the benefit is group-wide rather than individual?

[chris]

@ Gastro - I suspect there was an element of gift exchange - reward for doing a good job. I can't say how egalitarian or not bonuses were back in the day.

[Phil]

Still boggling at the idea of £100K being at the low end of, well, anything - once you get over £150K you're literally in the top 1%. (I'm in the top 20%, as it goes, & don't consider myself at all hard done-by, but it took me a while to get here.)

But I've said this before, elsewhere:
http://crookedtimber.org/2015/02/27/how-to-keep-your-dignity-at-bonus-time/#comment-615398

[BCFG]

Yes £100k for what? What contribution to society? Actually while we are on the subject, why does anyone in the whole wide world need more than £100k a year to live on? Why don't we pose that question now and again!

All the reasons for bonuses could easily apply to any industry, the reason the bonuses are so high in the finance industry is surely because so much money comes through the finance sector and they cream off as much as they can! They have so much they don't know what to do with it, other than enrich themselves!

[chris]

@ Phil, BCFG - you're right of course. I was describing the world as it is, not as it should be. The av. salary at Woodford's firm is over £300k.

[James Webber]

Back around 2000 the bank I was working at in the City imposed a 10-15 percent cut in salaries in response to weak trading conditions. (I think this is illegal under UK labour law, but let that pass). When Christmas came around, with the salary cuts still in place, bonuses were paid as usual! It's hard-wired into the system and would be almost impossible to eradicate.

[Um]

Um, "Paying a recent hire a bonus is a way of compensating him for having a relatively low initial salary" should really read "him or her", no? Or at least if not, you should address why not. Sorry, watching piece about unequal m/f pay in Newsnight as I type

[jono]

"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"

Scrapping bonuses isn't going to change total comp. We know this from seeing how bank salaries have adjusted to recent bonus regulation.

The point about bonuses is that it allows employers to reward/punish productivity in a far more granular way than a salary scheme ever can. It's a massively useful tool for management and, if they could, I suspect most employers would wish to be able to pay what is essentially "discretionary salary". Equally, a certain type of employee is attracted to it because they believe they will be an outlier performer and don't want to subsidise others.

[An Alien Visitor]

Yes from an employers point of view the bonus scheme is a bit like the slave masters whip or the old slave practice of starving unruly slaves to death. Great for the slave master in the short term but crap for everybody in the long term!

It is a great example of where managerialism could lead if left to its own devices.

Where I work it is noticeable that the biggest barriers to home working is the attitude of a certain level of management. These people are dinosaurs who need dragging into modernity. And they often accuse the unions of this! Go figure!

[Bob]

The government needs to ban the banks from activities not serving the public purpose. Bonuses is a distraction.