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Jeffrey D. Korzenik

Wall Street's skewed pay structure

By Jeffrey D. Korzenik
March 20, 2009
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THE CONTROVERSY over AIG's bonuses has brought new scrutiny to compensation on Wall Street. Having lived in (the lower range) of Wall Street's bonus culture, I've witnessed how the pay structure distorts decision making. Before our policymakers try to fix the system, they must understand how past legislation fostered this problem.

On Wall Street, a "bonus" differs from most Americans' conception of the term. The industry views bonuses as a core part of an employee's pay, not as a reward for exceptional achievement. Accomplishments and economic conditions determine only the size of the bonus, not its existence, and employees receive salaries well below the fair value of what they contribute to the company. My own situation was typical: My salary didn't change in 10 years - no longevity, cost of living, or other adjustments - but through the bonus system my compensation grew appropriately. It is not uncommon for even mid-level executives to have a salary that is a mere one-fifth of their total pay.

This system has outlived its usefulness. The bonus orientation was originally intended to recognize individual achievement and to provide firms with better flexibility in managing costs. Because salary increases generally were minimal or nonexistent, bonuses became a greater proportion of Wall Street pay over time. My colleagues often joked that, "we get paid once a year" - bonus day.

Academic work has shown that not just the size but the structure of compensation matters. The orientation to variable pay puts an undue focus on achieving the goals by which bonuses are determined, usually measures tied to profits. Unfortunately, no simple statistic can capture critical intangibles like prudent judgment or fiduciary responsibility. Wall Street professionals clearly set both aside in pursuit of maximizing variable pay. The bonus system skews participants to greater risk-taking and overlooking their responsibilities both to shareholders and to clients.

How did this system go so wrong? Well-intentioned regulation has played a huge role. The primary culprit is 1993 legislation, codified in IRS Code 162(m), designed to curb perceived executive pay excesses. The tax rule limits the deductibility of salaries for top executives at public companies to $1 million, while non-salary compensation like bonuses can be deducted almost without limitation. Although the IRS rule governs only a company's most senior leadership, it helps set the culture throughout - after all, when CEOs must meet certain measures to earn 90 percent of their compensation, they generally impose similar arrangements on others. The rule may not create a "swing for the fences" culture at all firms. But it ensures that senior executives, those responsible for being stewards of shareholders' capital, are paid to overlook long-term risks.

Congress may be tempted to impose stricter controls on pay - especially because the financial industry has received so much taxpayer money. But the consequences would be unpredictable. Overly burdensome pay rules may well drive talent and business overseas. Attracting qualified professionals to Wall Street might be harder. Such change would not necessarily be bad - perhaps we'd be better off if highly trained engineers actually built superior goods rather than spent their talents modeling the tranches of securitized subprime mortgage pools. Still, legislatively dictated pay will not be able to adapt to a changing world and may well set us up for some future, unimagined crisis, just as IRC 162(m) contributed to the current meltdown.

While the idea of self-regulation has taken a hit lately, the industry needs to develop its own best practices for compensation - and companies represented by industry trade groups have strong incentives to fix the system. My own belief is that a greater emphasis on base salaries would be an improvement. Firms would see lower compensation expense as most employees would willingly substitute some of their total pay for the greater certainty of a higher salary. Such a shift would encourage employees to take a more balanced look at risk, to the benefit of both shareholders and society. We all want a competitive, profitable financial services industry free of taxpayer support. This goal will never be met unless we get the paycheck right.

Jeffrey D. Korzenik is chief investment officer at VC&C Capital Advisers in Boston and author of the financial blog "Inefficient Frontiers."

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