There is an old saying that a bird in hand is worth two in the bush. This proverb is increasingly relevant in reward. More and more often the payment of reward is becoming dislocated from the time in which the rewarded task takes place. Share options, LITP’s, and bonus deferral schemes all move the payment for rewarded tasks to the future; often with an added element of uncertainty due to either the unknown value of equity or further performance conditions. We are frequently seeing situations where reward payments are pushed into the future, but with provisions for reductions in value due to subsequent events and behaviour or even forfeiture altogether. This article discusses some of the issues round these increasingly prevalent forms of reward payment.
Something old, something new
Of course, one form of deferred pay has been around since the time of Henry VIII. Pensions have been considered by many as a form of deferred pay. The benefit is accrued for perhaps twenty or thirty years and paid out, in one form or another, at retirement. One of the first pensions was paid out to the Jester in the Court of King Henry, and some would argue have been a bit of a joke ever since.
The latest reward kite being flown is to defer some bonus payments until retirement. This would enable the granter to ensure that the profits on which the bonus was based were “good” or perhaps sustainable and that the behaviour of the individual was appropriate. The downside is that hindsight has twenty twenty vision. Business decisions that looked fair and appropriate at the time may look, with hindsight, reckless; behaviour that was acceptable in 2013 may not be so acceptable in 2033.
One of the unintended consequences of deferring reward makes it very difficult for shareholders and other stakeholders to see for what outcome a payment is being made. In some organisations an executive may be being paid portions of bonuses relating to several different years and several different schemes with different performance criteria. It may also be that a deferred bonus is payable for actions in a good year, but the payment is made at a time when losses are being made and costs reduced. It can be difficult for shareholders to understand why potentially large bonus payments are being made in years’ in which losses are established. This is particularly an issue in times when cash may be tight. Accruals will have been made in the accounts but the physical payment of cash for bonuses when that resource is scarce will be a problem.
Unintended consequences and diminishing motivation
The time value of money is one of the concepts taught in Economics 101. It states that a pound paid today has more value than a pound paid next week. So, if a bonus is promised in three years it needs to be of a higher value than a bonus paid today. We can calculate what the future value should be by using “net present value” that gives a sum today for an amount paid in the future. We can further calculate what needs to be paid to reflect the uncertainty of reduction in value or a change in the price of the underlying equity instrument in which the bonus is being paid. However, the calculations are only as good as the underlying assumptions and as we all know financial forecasting is perhaps more of a black art than a science.
There is a much more important issue. That is the value that an employee puts on a deferred bonus. I had a coffee with a couple of banking friends of mine recently. They both had bonuses that were deferred in to equity and that would not vest for three years in one case and five years in another. Both of the bonus arrangements had reduction and claw back provisions. Both of these highly intelligent and very numerate traders had discounted the bonuses to zero. They had done this on the totally rational grounds that they had no certainty of receiving the bonus or any reasonable knowledge of the value of the bonus in three or five years’ time. In addition it was normal, in the banking area that they worked, to move jobs every couple of years. This would almost certainly mean that their bonuses would be lost in any event. So the unintended consequence of the bonus arrangement was that it had no motivational or reward effect at all and was only of any use when discussing a remuneration package at a new employer.
It gets worse. One of my friends pointed out that even if she accepted that the deferred equity bonus had value, rationally it would be in her interest to take risker trades. Why? Because the value of the bonus could not be reduced below zero; but if she took a risky trade that paid out well, it would reflect in the equity value and thus the amount of her payment. Not, I suspect, what either the regulators or her employer had in mind when they designed the scheme.
What also struck me during my conversation with the bankers was the issue of trust. The trader had to trust that the bonus would be paid and that the interpretation of the performance conditions, malus and claw back would be fair and reasonable, in the view of the employee. I was recently asked the question by a Head of Reward in a retail bank as to when I thought claw back would operate. I gave my views but pointed out that this was a very tricky legal issue and I would hate to be the first bank or fund manager to face a legal challenge over claw back. A high level of trust is required by both parties when agreeing bonus terms and while the power is with the employer in the first instance; if we see some harsh interpretations of claw back clauses trust will be eroded very rapidly.
The current system of paying bonuses is broken, at least in financial services. But the current fixes suggested by regulators have the same usefulness and longevity as getting your car repaired at ‘Dodgy Backstreet Motors Ltd’. As any student of science fiction will tell you, crossing your own timeline is a very dangerous thing to do. The further out we push bonus payments and the more conditionality attached the more dangerous the situation becomes. The dislocation between event and payment leads to a raft of unintended consequences, damaged motivation, eroded trust and risky behaviour; not to mention additional costs in hedging future promises to avoid balance sheet peril.
Shareholders, for whom the new bonus paradigm was supposed to protect, will find it increasingly difficult to link output to reward and thus to shareholder value. Paradoxically, increases in share price, perhaps only caused by market sentiment or movement will massively increase the potential of bonus awards in equity which the receiver has valued at close to zero. This cannot be in the interests of open and free stock or labour markets. Time for new medicine Doctor, Who?