Many companies offer annual bonuses, bonuses attached to particular projects or milestones, commissions, and other incentive schemes. Let us consider a few reasons why this is done:
- To create loyalty. In many companies a non-trivial component of total salary is paid in the form of a six-monthly or annual lump-sum for which staff are only eligible if they continue to work for the company past a specified date. This gives staff an incentive not to change jobs prior to that date.
- To manage cash-flow. By paying staff only at the end of the year, companies ensure that they have earned profits before paying out cash. A clear example would be a start-up company with limited initial resources that promises to pay its Managing Director a lump sum at the end of the year.
- To transfer risk. If you have a start-up company or a company undergoing rapid growth there may be uncertainty about how much you could pay staff and yet still be profitable. By having a pay strucuture with a limited base salary and a bonus paid at the end of the year, the Chairman is in a position, when considering bonuses, to decide on total remuneration with less risk to the company.
- To reward staff more precisely according to their individual output. Two staff members that on the surface appear similar may, in any one year, differ considerably in their contribution to the company. It is economically efficient for staff to be paid according to their individual productivity. Bonuses allow this to be done more accurately. This allows companies to pay enough to keep their highest quality staff whilst not over-paying for lower quality staff.
- To direct the efforts of the company to specific objectives. If the shareholders desire that the company should achieve certain strategic goals - e.g. establish a new branch in some country, or establish a certian market share in a new sector.
- To direct the efforts of individual employee or teams towards certain strategic objectives. For example, a sales team might be instructed primarily to focus on selling to older consumers, and be given a bonus calculated on the basis of how many sales are made to older consumers
- To create incentives to put in effort. In many jobs it is much more efficient to provide people with bonuses based on their output than to monitor them with personal managers.
- To create incentives to deliver quality. For example, someone selling pensions might be paid a commission based not on the number of sales or on the value of those sales but, rather, on the amount actually paid in to the pension each year.
- To build esprit de corps by having employees participate in the profitability of the company as a whole.
And so it goes on.
Some of these functions of bonuses are related to the profitability of the company as a whole. Others are related to individual performance. Others are simply a reflection of working at the company past a certain date. It would, for example, be perfectly possible to be legally entitled to a pre-committed bonus if one has worked past the qualifying date, or if one has met one's sales target, or if the section one manages has met its profitability target, even if the company as a whole makes very large losses. Why should the individual employee feel under any obligation to forego her bonus just because the company as a whole has made a loss if her bonus is in no way related to the company's overall profitability? She wouldn't have received any more money if the company had done well - so why should she receive less if it does badly?
Now, of course, incentive schemes can produce perverse incentives as well as useful ones. For example, bonus schemes might produce incentives to deliver high long-term returns to the company when what it really needs is more short-term cash. Similarly, they might produce incentives to deliver short-term cash when what the company really needs is more long-term profits. Either kind of perverse incentive is possible. (Don't buy into the Gordon Brown/Will Hutton myth about how British companies are always too short-termist. Remember that amongst the key financial sector problems in summer 2007 was that highly profitable companies had not focused sufficiently on ensuring they always had enough cash - i.e. they were too long-term in their outlook.)
Now, RBS, for example, has made an epic loss of perhaps £28bn in 2008. So it has done lots of things wrong. Amongst those things might be that it pays its staff too much and/or that some of its staff have perverse bonus schemes. That's entirely plausible - indeed it is almost certain that future contracts need to be different. The question is what to do about what is already in place (if anything). John Humphreys suggested this morning on the Today programme that the government shouldn't care about contractual obligations but should just tell employees that they aren't getting their bonuses. Other politicians (including Conservatives) have suggested that bankers should feel under a moral obligation not to take their bonuses. I don't see why - indeed I think these claims are dangerous nonsense. Non-discretionary bonuses are attached to the delivering of specific goals. If people have delivered those goals then they have done their jobs and are entitled to their pay. The fact that other people in the company were incompetent and lost money is neither here nor there. Further, if we are going to start violating people's contracts, why are we starting with employees? If we are going to do that, I would recommend starting with the bondholders who participated in the wholesale funding gap of banks and thereby were the proximate cause of the credit crunch, telling them that they aren't getting their money back unless they accept equity-debt swaps.
Even for the senior executives, if their contracts say they are entitled to be paid a certain amount of money then that's what they should receive. The government could have allowed these companies to go into administration or it could have taken them over without promising to honour existing contracts. But instead it nationalised them intact. Well, one of the consequences of taking things over intact is that you honour your obligations. And, as I say, if you don't want to honour your obligations I don't see why employee remuneration is the place to start.
Bonus and incentive schemes are very useful devices, particularly well-suited to the nature of work in the financial sector, and the idea that we need to "end the bonus culture" is plain old cheap, pointless political posturing. It is wildly implausible that incentive schemes will not have a significant role to play in an efficient future for financial services. Current political rants are just scapegoating of an easy target. The reason politicians feel they need to do this is that they were unwilling to allow the Market to provide the punishments it offers for poor management, weak work, and bad luck - namely administration, liquidation, dismissal - and the government is also unwilling to engage in the significant restructuring of these businesses that is necessary if they are to be returned to future profitability. Deciding, ex post, that some contracted bonuses were "inappropriate" and ought not to be honoured is just the latest step in the abandonment of the mechanisms of a market in a free society - a system that depends on the honouring of contracts (promises) entered into freely.
