Revisiting Compensation: Lagging Incentive Comp To Match Long Term Performance

The Wall Street Journal's Scott Patterson wrote a piece in Wednesday's edition entitled "Securities Firms Claw Back at Failed Bets."

Mr. Patterson began his article by stating,

"As securities firms rein in risk-taking that ran amok when times were good, the use of clawback provisions is spreading, with Morgan Stanley and UBS AG rolling out rules that allow them to take back money paid to traders and other employees whose bets blow up later.

But the push to clean up an old problem on Wall Street may create some new ones. By giving themselves the power to reclaim bonuses and other compensation, firms might unintentionally make traders too skittish about taking even healthy risks, nudge some of the best talent out the door or encourage employees to conceal their losses, some observers warn.

"It would be hard for traders to hide losses for more than a year or two, but if we incentivize them to do so, they will find a way," said Frank Partnoy, a University of San Diego law professor who has written about corporate malfeasance.

The clawback "has far too long a memory and makes your most successful traders the most risk-averse," added Aaron Brown, a hedge-fund risk manager who used to work at Morgan Stanley."

I must admit, I have no concept of what Mr. Brown could mean. Isn't most of what has befallen traders, and the companies for which they work, in the last year or so too much focus on short term profits of trades, while disregarding the longer term ramifications?

In fact, in this year, of all years, it is ludicrous to be quoted publicly as saying that traders may not take enough risk in the future.

To me, the following comment in the article makes much more sense,

""We're making what we see as a good-faith effort to more closely tie employee compensation to longer-term performance," said Morgan Stanley spokesman Mark Lake.

I have argued for years, beginning with the application of my proprietary corporate performance research for consulting with CEOs, that incentive compensation needs to be vested some 3-5 years after the year in which it was earned. Shareholders benefit from consistently superior returns, not yo-yoing, inconsistent returns. Thus, Morgan Stanley finally seems to be on a credible, effective track for matching employee incentive compensation with shareholder interests.

Regarding other banks, Patterson continued,

UBS, which announced its clawback provision in November, will hold about two-thirds of eligible cash bonuses in an escrow account from which the Swiss bank will dole out payments based on employee performance and UBS's overall profitability."

"UBS acknowledged that its clawback rule could cut into short-term profits if employees become too risk-averse. Overall, though, the policy is expected to result in more consistent and less volatile long-term gains. Reginald Cash, head of U.S. investor relations at UBS, said the provision could create "some limit to chasing the last dollar on any given strategy." "

Again, this is precisely what shareholders should want. Long-tailed investment positions may be profitable trades in the initial year, but come back to haunt the company. Consider how many of the mortgage-backed securities or CDOs may have performed in their early years, versus their valuation changes in 2007 and -08.

Thus, anyone who argues that traders should not bear the risk of their positions in their compensation for the life of the positions is clearly not paying those traders with their own money. And doesn't care about shareholder interests, either.

This is an idea whose time is long, long overdue. In fact, even the name given the approach by financial services companies promotes incorrect thinking.

It's not 'clawing back' compensation from employees after the fact. It's releasing the incentive compensation in concert with each year's successful earning of the money by an employee, on a lagged basis.

Had this type of compensation approach been in place five years ago, there would have been much less damage from toxic structured financial instruments in the most recent cycle.