Friday, August 28, 2009

Lucian Bebchuk: Bonus Guarantees Can Fuel Risky Moves -

Lucian Bebchuk: Bonus Guarantees Can Fuel Risky Moves -
"Guaranteed bonuses create perverse incentives to take excessive risks, and they consequently could well be worse for incentives than straight salary.

Introducing a guarantee into a bonus plan eliminates some downside risk but leaves the bonus compensation sensitive to performance on the upside."

In effect these guaranteed bonus plans set a floor and then reward performance beyond some level. To get to the higher level, the manager has an incentive to take larger risks (think of on option that is out of the money and a fixed payment.

From Bebchuk's piece on the Harvard Law Forum on Corporate Governance and Financial Regulation:

"Consider a bank that sets annual compensation for an executive...a fixed salary of $1 million and a bonus plan rewarding the executive with $1 million for each $10 million of profit - a plan that, depending on the unit’s performance, would provide the executive with an amount between $0 and $10 million. And assume also that, concerned about losing the executive to competitors, the bank decides to guarantee the executive’s getting a bonus of at least $5 million and thus a total compensation of at least $6 million.

The introduction of a $5 million floor for the bonus would insulate the trader from the downside risk of low profit levels: the trader would get the same bonus amount of $5 million whether the unit’s profits are zero or $50 million. But the bonus plan would still give the trader an incentive to seek a high profit level."

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