Wednesday, November 7, 2007

Performance Pay, Irregardless of Performance

The New Yorker's latest Financial Page article, Performance Pay Perplexes, looks into the obscenely large amounts of pay market movers and shakers are raking in. A quick glance at the headlines will let you know that performance pay isn't quite working right now.

    The havoc on Wall Street following the collapse of the subprime-mortgage market boils down to a simple truth: for years lots of very smart people took lots of very foolish risks, betting borrowed billions on dubious mortgage derivatives, and eventually the odds caught up with them. But behind that simple truth is a more surprising one: the financial whizzes made bad decisions in part because that’s what they were paid to do.

The article is interesting because it breaks down just how things get paid out. Hedge fund managers, for example, get 2% of asssets under management as their fee, plus they get to keep 20% of the profit (above a certain benchmark). Problem is, their bonuses are obviously not exactly return to sender, and so the next year when the fund tanks they're sitting pretty on forty million. He also breaks down CEO compensation pay.

    Not surprisingly, a recent study of almost a thousand companies by the management professors W. Gerard Sanders and Donald Hambrick found that C.E.O.s whose compensation was made up mostly of stock options tended to “swing for the fences,” making investments and acquisitions that were riskier than those made by other executives. As a result, the performance of the companies run by the risk-takers was far more volatile, and not for the good of the companies: the risky strategies were more likely to end in a big failure than a big gain.

Essentially, the payoff for hitting that big score is so astronomical, and the chance of financial risk hitting their own pockets is pretty nominal. Hello, market cluster f*¢k. In this day and age, I'm sure we would all love those odds.

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