Performance Related Pay: Was the Money the Root of all Evil? Interviewer: Steve Macaulay Interviewee: Ruth Bender 14h November, 2008 SM They say that money is the root of all evil. In this downturn, it certainly seems to be so in relation to executive bonuses in the banking sector. Both the size of the bonuses, which seem colossal to many people, and also that it is promoting the wrong behaviour. Today I am interviewing Ruth Bender about this issue, who has researched extensively in this area. Now Ruth, what is the problem and could you give me some context on this? RB OK Steve, well the first problem is that you got the quote wrong – everybody does! It’s actually the love of money that is root of all evil, not money itself. And the problem is we have situations where people are rewarded mostly by bonuses and performance‐related pay rather than salaries, which was brought in as a really good thing. But because everything is out of kilter ‐there is so much riding on the bonus‐ that it’s incentivising behaviour, but it’s incentivising the wrong behaviour. Now, historically it started for very good reasons. People like performance related pay – it seems a good thing. In fact the Combined Code, which UK listed companies have to follow, says that a significant amount should be related to performance and if companies try to pay their executives flat salaries without that, they would be horribly penalised by the investing institutions who would say why are you doing this? With the financial services sector, it took on a whole new layer after the Big Bang in the mid 80s, when the investment banking environment opened up – the Stock Market environment opened up – we had a lot of American practices brought over. And one of those practices was very large bonuses for people in the financial services industry. And so we moved immediately to a higher level of bonuses and moved from there to a continually higher level of bonuses, such that your basic salary is small – well its large compared to a University lecturer’s, but small compared to that environment and the bonus might be six or seven times as much as the salary: sometimes considerably more than that, which means that there is a lot riding on it. So, you try to do as best you can to make that bonus. The main problem with performance related pay is any performance measure, if you just go for that performance measure, can lead to dysfunctional behaviour. So for example, if Cranfield were to give me a bonus £500,000 for doing brilliantly in profit terms this year, trust me I would do brilliantly in profit terms for this year, but it might screw up the whole future of my department. But I would have made the bonus. And so that is just a fundamental problem with performance‐related pay and you have to work around it. SM It’s all very well being wise after the event, but you can’t help saying how on earth did we get to this situation where you are paying people a million pounds plus for this terribly, terribly wrong behaviour that has ended up in banks being bankrupted. RB Yes, I don’t think we can totally blame the bonuses, but they certainly didn’t help. And it’s not necessarily wise after the event. There is a lot of research that says when you pay people in certain ways, for example in share options, it incentivises them to take riskier behaviour because the pay‐off of an option increases with risk. So there has been research throughout the 90s that says if you encourage people to take risks in your payment structure, they will take risks. The fundamental problem in banking was twofold: first of all people weren’t taking account of the risk. They were saying great, we will pay you for the profits, but they should have said we will pay you for the risk adjusted projects. They weren’t taking account of the risk at all in that. And the second problem – which is nothing to do with the incentive schemes – is just that nobody appreciated how much risk was being taken and that just cumulated it. SM So where do we go from here? RB It’s very difficult. There are an awful lot of people up in arms about this and there are two separate problems. There is the corporate governance problem where everybody is quite reasonably saying, Lord, that was a lot of money and, Lord, that was very bad performance and so something needs to be done about that and we want to cut down on pay because that is a good thing to do because these people are getting paid a lot of money and because the popular media is up in arms about it. But on the other side, there is the HR problem that says actually some of these people are very, very good at their jobs and we need to keep them around to sort out the mess that we are in. And from an HR perspective, you do need to find a way to continue to pay them and incentivise them to do that, or they will either jump ship because there are quite a few parts of the world who would be very keen to have some of these good people and they would jump ship to that; or they will just get out and do something easier. So you have an immediate conflict of motivations between them. And then if you look at it from the regulatory point of view, all the regulators are saying something must be done, but very few of them are going into details. So for example, over in the States the Treasury has $700 bn of bailout and they haven’t yet specified in detail how they are going to control executive pay; they have said they are, but they haven’t specified it in detail. And I should point out that it is not just executives. A lot of the more highly paid people weren’t board directors of these financial institutions, they were traders and that sort of thing whose pay hasn’t been regulated up until now. In the UK you have the issue that Gordon Brown has in one speech said something needs to be done about this and we will make sure that people don’t get paid too much. But in the same speech he said – quite reasonably – but it is not the Government’s job to sort this out. It’s gone to – in the UK – the Financial Services Authority and Hector Sants, who runs the FSA, has written to 28 of the big financial services companies – to the CEOs – saying basically, look you need to get your house in order on remuneration; if you put in remuneration structures that seem to be taking too much risk for your banks, we will penalise you by demanding that the banks hold much more capital. On the other hand, we at the FSA are not in the business of setting your remuneration schemes or capping your remuneration, so it’s up to you to sort it out and we will comment on it. SM So what is your judgment about where performance‐related pay is going in this area? RB Ok – well let’s take it step by step. We are not going to get rid of performance related pay. We started off with the love of money quote, basically much of civilisation is based on the fact that you give people incentives to do things, so we are never going to get rid of performance‐related pay. I think what is going to happen is performance measures and targets are going to be looked at more carefully and, for a while at least, people are going to look at what dysfunctional behaviour they drive. So not just say it is good to make profits, but it’s good to make profits provided this, this and this happen. I think you will also see people moving things to the longer term. So for example, with a bonus bank, so you might earn a bonus this year, but it will be held over two/three/four years so that we can see if your brilliant profit position unwinds, and you only get the bonus at the end of that. There is talk about using claw backs. The idea being that if you get a bonus and then it turns out that several years later what you did wasn’t a good thing, it led to a loss, the company could take the bonus back from you. Although I think in practice that would be incredibly difficult to arrange, there is a lot of talk about it – but I am not sure that anybody has worked out how to do it yet. The basic problem we have with performance‐related pay, it always comes down to performance measures and it always will because what we do is we will reward you for your actions rather than for the outcomes of your actions. Because in financial services those outcomes might take place ten years later. It is going to get more rigorous, but it is not going to go away. SM Ruth, thank you very much.