Where next for the bonus culture?

'Performance' payouts helped precipitate the financial crisis. So how should the City rethink its bonus culture?

by Joanna Pitman
Last Updated: 09 Oct 2013

It was a Harvard psychologist, BF Skinner, who in the 1960s popularised the theory of positive reinforcement: the idea that giving a reward after desired behaviour would increase the likelihood of that behaviour being repeated. We say 'good boy' to our dog and we give him a biscuit. To our senior executives we say 'good job' and we give them a performance bonus. But in recent years, some companies have succumbed to giving executives a bonus even if they have done a bad job, because the longer-term consequences of their actions were not fully known at the time.

The starkest example of this was at Royal Bank of Scotland where, nine years ago, Sir Fred Goodwin was one of a group of directors each given a bonus cheque of £2.5m as a reward for their successful eight-month campaign to win control, at a cost of £10bn, of rival high street lender NatWest. The bonuses were to prove disastrous. Thus incentivised, these executives went out in search of more deals and ended up acquiring a whopping 24 companies over the next eight years. The final deal, completed with remarkable hubris shortly after the market had begun to go south, was the record-breaking £50bn takeover of ABN Amro.

Today, as we survey the wreckage of RBS, Merrill Lynch, Lehman Brothers and all the other institutions whose breathtaking losses have resulted in them either bailed out by their respective governments, sold off cheap or going under, these bonuses help to illustrate what happens when pay deals reward excessive risk-taking.

The bonus culture, which arrived from the US 20 years ago, has become deeply entrenched in Britain's financial services sector and in the top layers of industry, to the extent that a bonus is now considered by many to be an entitlement. Most unedifying for shareholders and the public is that those investment bankers whose enterprises have been forced to seek government support seem to be continuing to award themselves multi-million pound bonuses, despite the lack of any achievements that would merit such generosity.

In May, there were howls of dismay among shareholders in the nationalised Royal Bank of Scotland over big executive payouts that were tied to vague performance targets. And in the US, top executives at Goldman Sachs and Morgan Stanley, both of which received US government funds in 2008, waived their bonuses last year, but are expecting dramatically increased bonus packages this year. Disquiet is not confined to the financial sector. At Shell's AGM in May, 59% of shareholders objected to its directors' large bonuses, paid in spite of the company's failure to meet targets.

Jeroen van der Veer, the outgoing Shell CEO, even broke ranks with fellow bosses and admitted what until recently has been the ultimate corporate heresy - that the size of the pay packet doesn't equate to the quality with which he performed his job. 'If I had been paid 50% more, I would not have done it better,' he said. 'If I had been paid 50% less, then I would not have done it worse.'

No wonder people get so hot under the collar about the whole subject. 'These sorts of multi-million pound bonuses cropping up again now are totally unjustified and very worrying indeed,' says Vince Cable, the Liberal Democrat treasury spokesman. 'The big problem is that bonuses are deeply rooted in the system and they are often paid out unrelated to performance. It is a system that will be very difficult to get rid of. It's now built into the mentality of the City and in certain top layers of business.'

Most in the City will say that bonus and incentive packages were not the main cause of the credit crunch. The consensus is, however, that they were a major contributing factor to its severity. When they first appeared in the late 1970s, bonuses were regarded as the legitimate way to pay staff in the financial services industry, where there are cyclical earnings and only one real cost, in the form of people.

These old-style bonuses came out of profits at the end of the year, generated by advising companies in a way that did not involve taking big risks that could undermine their performance later. But when the big US investment banks began arriving in the City at the beginning of the 1980s, they pushed bonuses onto a different scale. They began using their own balance sheets to increase profit, by allowing their traders to use the bank's own money to take bets on the financial markets. Bonuses grew as profits grew, and rivalry between the banks to retain their big-hitting traders forced them higher still.

As the credit bubble burst, it became all too clear just how far this dangerous culture had progressed. Banks had encouraged their traders to devise complex financial instruments that apparently fuelled profits and thereby boosted bonuses. This was a high-risk, red-meat-eating culture. The complex and opaque financial innovations they cooked up - CDOs, CDSs and the rest - were not always fully understood by the traders' own bosses, and created big financial stability risks. Now, of course, they're part of the hazardous waste fouling up the financial system.

'In some areas, companies lost touch with the fundamentals,' says Katharine Turner, a principal at executive compensation consultancy Towers Perrin. 'For some employees in the financial sector, bonuses were paid out on the basis of mark-to-market gains that were not sustainable. So some people were walking away with big rewards before the longer-term results of their actions for the business were fully known.'

So should bonuses be phased out altogether? Certainly, there are those who believe they do more harm than good. A Harvard Business School report, published earlier this year, concluded that the beneficial effects of setting goals and the incentivised pay associated with them have been overstated, and that the systemic harm caused by it has been largely ignored. Among the side effects associated with incentivised pay structures, the report cites a rise in unethical behaviour, distorted risk preferences, corrosion of organisational culture and reduced intrinsic motivation.

According to Jan Gillett, chairman of management consultancy Process Management International (PMI): 'There has never been an independent, peer-reviewed report demonstrating the long-term positive correlation between performance-related pay and organisational achievement. We shouldn't forget the emotional and psychological side of these kinds of pay structures, which benefit a small minority of workers at the top of an organisation, and this represents a tiny proportion of the intellectual capital of the organisation as a whole. Those who don't get a bonus, or who get a relatively small one, and who know how arbitrary the bonus awards process is, can become profoundly demotivated.'

Last year at mining company Xstrata, for example, Mick Davis, the chief executive, was paid a package worth almost £14m - that's 424 times the average salary paid to Xstrata employees. This inevitably raises questions over whether, in an organisation that employs thousands, any one person can really be worth that kind of pay differential.

There is also an issue in terms of the way bonuses are structured. Big banks have always paid part of their bonuses in the form of shares in the firm, a system that was thought to reduce excessive risk-taking by ensuring that employees were focused on the price of their own bank's shares.

This thinking has been proved to be faulty - at least in the case of Lehman Brothers and Bear Stearns, both of which had a culture of employee share-ownership and both of which collapsed last year. A former Lehman Brothers staffer, now working in the M&A department of another investment bank, expects to carry on being paid big bonuses. 'As an adviser, I generate huge fees and expect to be paid accordingly. But on the trading floor, where the bank's capital was being used to generate profit, there will probably be a change in traders' bonuses. Their ability to earn returns will be greatly reduced because most banks are now more risk-averse than they were. The risks they take - which are, after all, part of their job - will have to be controlled appropriately, and their bonuses will be reduced.'

This year, there have been moves in the US, largely among legislators responding to knee-jerk populism, to phase out the bonus altogether. Under the terms of the 'troubled asset relief programme', which has bailed out Bank of America, Goldman Sachs and MorganStanley, among others, banks must restrict bonuses to a third of overall pay. And that's only for starters - the appointment of Kenneth Feinberg as US 'pay czar' is a clear indication that the political pressure on executive pay in America is only going to grow.

Comparable changes are afoot in the UK and in Europe. But limiting bonuses will inevitably mean a rise in base pay. Says Turner at Towers Perrin: 'There is evidence that the fixed element in the pay package in financial services will increase. But there's little sign that companies are turning against the basic model of pay packages with both a fixed and a variable element, where the variable can be sensibly linked to performance over the year and beyond.'

The problem with raising base salaries to compensate for reduced bonuses or no bonuses is that it makes it much harder for companies to trade through the ups and downs of the business cycle. 'Great stress would be put on businesses if you start to decrease the bonus and raise base salaries instead,' says Marc Jobling, assistant director of investment affairs at the Association of British Insurers (ABI). 'This would be worse for shareholders, because with higher fixed salaries, other things like pensions and termination pay go up too, and the flexibility achieved by bonus pay during bad times would be gone.'

For banks, whose people cost more than anything else, this is a risky move. It could easily lead to even more and quicker job-losses in any future downturn.

But if, as many believe, bonuses are here to stay, now is the time to reassess the way they are structured. 'The bonus culture will never go back to the way it was,' says Sean O'Hare, a partner at PricewaterhouseCoopers. 'The public outcry has been enormous. And there has also been a huge disconnect between the way the general employee population has been rewarded and how well the heavy hitters have been rewarded. There's a clear need for a reassessment of incentive-related pay. Bonuses can, if well structured and responsibly governed, be a force for good.'

'If we cannot get rid of the bonus,' says PMI's Gillett, 'then we should rethink the whole corporate reward structure. More emphasis should be placed on rewards that can only be cashed in long-term. Pensions should be paid out as a percentage of the company's profit after the executive has retired. Top directors should, after all, have their attention on five years hence, not so much on the here and now.'

One area already changing is that of shareholder activism. Recent AGMs at Shell, RBS and Next demonstrated an increased appetite among shareholders to hold board members to account on performance. And when the clothing retailer rewrote its bonus scheme halfway through the year - allowing directors to pocket an extra £350,000 - the changes infuriated the ABI, which put a 'red top' note on the company.

'To rewrite a bonus scheme retrospectively is inexcusable,' says Simon Walker, CEO of the British Venture Capital Association. 'When the ABI marks a company like that, everyone sits up and pays attention, because it doesn't do it every day.'

Remuneration committees too have come under close scrutiny. When the economy was booming, pay deals tended to be waved through without too many questions. 'By the mid-90s,' says Towers Perrin's Turner, 'captains of industry were being paid less like bureaucrats and more like entrepreneurs. The general view was that they should be rewarded for performance and gain from the value that they helped to create.' After many years of growth and big payouts, rewards began to be considered an entitlement.

The House of Commons Treasury Committee report in May on the City bonus culture argued for the reform of remuneration committees. It pinpointed three problems: first, the insufficient time that non-executives tend to commit to their role, with many combining a senior full-time position with multiple non-executive directorships; second, a lack of expertise; and third, a lack of diversity. 'Too often, seemingly eminent and highly regarded individuals failed to act as an effective check on, and challenge to, executive managers, instead operating as members of a cosy club,' said John McFall, chairman of the committee. 'Such incestuous and frankly ineffective behaviour must come to an end.'

Remuneration committees are generally more active now than they were five or six years ago, but there seems to be plenty of room for improvement. Non-execs often meet just six times a year and look only at the main board, and maybe one level down. There's a need to examine pay policy further down the organisation too, which would require both greater expertise and greater time commitment from board members.

Some look to the FSA to ensure a clearer statement of the adverse consequences of incentivised pay, and to offer clearer guidelines on appropriate controls. There's also an argument for an FSA code requiring greater transparency throughout firms, so that board members would have to reveal not only their own remuneration packages but also those of individual traders who have been paid multi-million-pound bonuses.

Of course, the first bank that put an absolute cap on bonuses would watch its best staff jump ship very quickly. 'If there was an element of FSA guidance or some kind of code applied globally - through the Financial Stability Forum of the G20 maybe - then I imagine that European and American banks would be interested,' says Jobling at the ABI.

Everyone is clear that they don't want politicians to get involved. 'Relatively unsophisticated legislators might take the thing into their own hands with unintended consequences,' says Walker of the British Venture Capital Association. 'I think the private-equity model for remuneration is the one to aim for. It pays enough to hire people and run firms. Performance would be measured when cash is returned to investors; that way, people can make plenty of money when they are successful. But the basic premise is that no bonus is paid until that cash delivery.'

Now is the chance to rethink the pay and the bonus culture, and it is clear that balance, fairness and appropriate checks are essential. But the grasping culture of excess also needs to change too, judging by one City dealmaker's comment: 'Everybody expects us to be greedy. It's our job description. Everyone knows that.'

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