Incentive pay remains key to growth

SUBJECT: Performance incentives in capitalism - what they are and why they matter.

SIGNIFICANCE: The controversy over financial sector bonus awards in the United States and elsewhere has generated debate about the value of incentive-based pay systems. Most justifications for these remuneration schemes turn on assumptions that performance is largely a function of engineered incentives schemes (both positive and negative) - but these now appear faulty or incomplete.

Monetary incentives are essential to capitalism and economic growth.

It is clear that flawed incentive-based pay systems played a significant role in exacerbating financial sector systemic risk, the bubble in US housing and associated derivative products, and the current economic crisis.

However, incentives are a key factor in promoting innovation and entrepreneurial behaviour - which help drive long-term growth.

ANALYSIS:

Incentives are fundamental to modern Western societies, affecting all aspects of political, social and economic life. Free market economies embed the concept of monetary gains as the key motives driving household, corporate and individual behaviour. Equally significantly, the rule of law, government and corporate institutions provide incentives (either in the form of rewards, or penalties) to citizens to encourage, or deter, certain forms of behaviour.

Incentive-based pay systems were meant to embed this ethos in corporate structures: rewarding leadership that benefited the company as a whole, and deterring purely self-serving behaviour. Instead, they recently seem to have done the opposite.

Super-productive CEOs? Incentive-based remuneration for executives of public companies was designed to align the interests of managers and shareholders, by rewarding executives who presided over long-term value creation. Former Treasury Secretary John Snow justified the huge growth of executive compensation over the past two decades as a simple validation of such incentive-pay systems: in the aggregate, he claimed, "it reflects the marginal productivity of CEOs".

However, given the sluggish responses of board-level compensation committees to the massive shareholder-value destruction over the past year, such justifications of the increasingly huge pay disparity between executives and line workers appear increasingly questionable.

Performance government While financial industry executives' bonuses have attracted the most media attention, schemes designed to incentivise public sector employees have been widespread in government agencies since the 1980s. In the United States, United Kingdom and many other developed economies (including Canada and Australia) senior-level bureaucrats work with specific annual performance targets; exceeding them produces bonuses.

Such schemes can also apply to the rank and file within government bureaucracies. UK National Health Service reforms enacted since former Prime Minister Margaret Thatcher's era have been based on encouraging efficiencies by hitting performance targets in exchange for rewards.

Bonus culture The current economic crisis has revealed that the objectives of bonus schemes have become seriously misaligned from their outcomes: indeed, incentives may have fuelled the leverage-based implosion of the financial sector. For example, before finalising its merger with Bank of America in December, approximately 700 Merrill Lynch managers and employees were awarded bonuses of over $1 million (Dh3.67 million) each, despite the fact that last year Merrill posted one of the largest losses in US corporate history ($27 billion).

Types of incentives While such anecdotes have stimulated public outrage, it is worth remembering that incentive-pay was specifically designed to serve public or shareholder interests better than ordinary forms of remuneration. Incentives are judged the most efficient means to produce desired collective and individual goods (both products and behaviours) in society. There are several common types:

Financial incentives In capitalist societies, economists and other social scientists believe individuals respond most to direct monetary rewards. The profit motive produces efficient market institutions governed by supply and demand, which in turn rest on calculations about the human desire for monetary gain. The simplest of these incentives is salaried pay based on experience, expertise and training (or education); more complex schemes involve pay directly linked to various measures of performance. Without adequate monetary incentives and penalties, neo-liberal economists argue, no society can attain efficient allocation of resources.

Targeted incentives To achieve particular objectives, employers and governments design incentives to ensure that people act towards these ends. For example, US auto sector worker buyout schemes offer employees vouchers for new cars, in exchange for accepting voluntary redundancy.

Moral incentives Societies can provide intangible, but still significant, rewards in the form of social capital to individuals and corporations that engage in certain ostensibly altruistic activities. Such incentives are non-monetised, but confer benefits that can reduce significantly the cost of doing business.

Coercive incentives Centralised state planning systems, such as those in many Communist and authoritarian countries, also created incentives - but failure to meet these targets resulted in such severe punishment. Such coercive incentives exist, in much milder forms, in developed capitalist economies.

The story of recent problems with incentive pay systems is interwoven with the effects of rule changes in US and international financial markets since the late 1990s. They helped facilitate the growth of a massive, leverage-fuelled financial market:

Financial markets bubble These changes, coupled with a period of exceptionally low interest rates following the 2001-02 recession, encouraged the growth of a massive property market bubble - abetted by an even larger expansion in the market for mortgage-backed securities and associated derivative products.

Bumper profits The bubble, in turn, produced several years of record profits at financial services companies, which were reflected in increasingly large executive bonuses collected through incentives packages. Subsequent incentives packages provided even greater incentives to increase profits -largely through using cheap, plentiful credit to gear up and further expand lending via disintermediated, structured products.

Illusory gains Many of the leverage-driven gains of the bubble years turned out to be illusory. For example, Merrill Lynch lost a total of approximately $35.8 billion in 2007 and 2008 - a figure equal to the total earnings of the firm over the past eleven years.

Incentives and moral hazard The great danger in creating any system of incentives is that it may unwittingly encourage behaviour subject to moral hazard - that is, circumstances under which individuals or firms engage in increasingly risky actions because they perceive that the costs or adverse consequences of such behaviour may be borne by others. In the case of the interplay between incentive pay at financial firms and the housing market bubble, this appears to have occurred: massive profits reflected in executive pay encouraged further leverage, without enquiring too closely about the risks involved.

Yet it is also clear that properly structured incentives can mitigate, rather than promote, risky behaviour in several key respects:

1. Subtle nudge incentives: Two prominent University of Chicago economists long have argued that giving individuals a gentle nudge towards more sensible behaviour can produce outsized dividends. Under this "libertarian paternalism" relatively small changes in environment or policy - for instance, a small compulsory saving scheme for workers or placing healthy food in more visible places in supermarkets - can result in very positive behavioural changes.

Their scheme essentially involves a mild form of social engineering, whereby small changes in choice options - what they term "choice architecture" - can have significant outcomes for society and individuals.

Under nudge initiative plans, incentives are regularly modified to guide citizens towards more sensible lifestyle, economic and social choices. Intellectually, this thesis builds on the important findings of behavioural economists about how individual market decisions are sometimes irrational or self-defeating; therefore, fostering good decision-making sometimes requires structuring choices.

Nudge incentives also represent an attempt to forge a middle way between neo-liberal market incentives (which are premised on individual and corporate rationality) and the coercive incentives practice by state-planned economies. The framework aims to find a balance between cumbersome social democratic planning and market fundamentalism.

2. Growth incentives Economic growth and development depend to some extent upon incentives institutionalised in public policy. For example, a significant factor in the rapid economic growth enjoyed by Ireland in the 15 years before 2008 was a generous corporate taxation regime, which gave incentives to large international corporations to locate there.

3. Innovation incentives Successful entrepreneurial economies make an effort to encourage both established firms and start-ups to innovate. Policy can create incentives to sustain and foster entrepreneurial behaviour. For example, regulation can be minimised for new start up firms. Guaranteed lines of credit are also important. Property, patent and copyright rights need to be enforced effectively to affirm the incentive to engage in innovative work.

The importance of innovation to economic growth was a lasting insight of the Austrian economist, Joseph Schumpeter, who argued that institutional arrangements could create the incentives appropriate to innovative activity at the firm level.

Investing in ideas is distinct from fixed capital investments since an idea can be used by anyone once it has been formulated. Idea generation rests, in part, upon incentives to ensure that firms recover the costs of investment in research and technology.

The scale of financial sector bonuses in the period from 2003-2007, and the single-mindedness with which executives continue to pursue these - despite record losses and continuing financial and economic meltdown - suggests that the system of incentive pay was flawed in several fundamental respects:

It focused almost entirely on providing incentives for boosting quarterly or annual corporate profits, without accounting for increasing product-based and systemic risk.

The role of leverage in these returns, and their associated risks, were similarly discounted.

There were rarely efforts to measure individual and corporate performance in context: profits produced by rises in broader markets, or an environment of cheap credit and low volatility, were often attributed entirely to the individual genius of executives.

The time horizons of corporate managers and investors were obviously misaligned.

Financial innovations, such as structured products, that actually served merely to increase the speculative housing bubble, were mistaken for real, long-term value generating innovations.

Therefore, the most current corporate performance-based pay systems appear flawed, principally because they encourage the aggressive pursuit of profits without accounting for risk - which is not in the long-term interest of most shareholders.

These failures have already produced a regulatory backlash, which risks going too far by eliminating the positive aspects of incentive pay systems. For example, US President Barack Obama's $789 billion economic stimulus Bill, enacted earlier this month, heavily restricts the size of top executive bonuses at financial institutions receiving federal aid.

Yet well-designed incentive systems can clearly foster better individual and corporate performance, and innovation. Indeed, the administration is aware of this, which is why the stimulus Bill also contained major new incentives for companies pursuing "green" technologies.

It would stand to reason that incentives could also be leveraged to assist the US economy's most distressed sector - perhaps by better aligning financial executives' interests with those of their shareholders and society at large. For example, nudge incentives could be used to foster the extension of sound forms of consumer credit, and facilitate the restoration of strong bank capital adequacy ratios.

CONCLUSION:

Economic and monetary incentives are the lifeblood of capitalist market systems. However, effective incentive pay systems are built around distinguishing between long-term profits streams and gains produced in the context of a rising market, adequately costing leverage and other forms of high-risk behaviour, and rewarding "good risks" such as investing in innovation.