Is Incentive Compensation a Giant FIB?

Harvard Business School professor Mihir Desai believes American companies and investment firms have erred–horribly–by linking manager compensation so tightly to financial market performance. In the current Harvard Business Review, he identifies this as a giant FIB, a Financial Incentive Bubble:

American capitalism has been transformed over the past three decades by the idea that financial markets are suited to measuring performance and structuring compensation. Stock-based pay for corporate executives and high-powered incentive contracts for investment managers have dramatically altered incentives on both sides of the capital market. Unfortunately, the idea of compensation based on financial markets is both remarkably alluring and deeply flawed: It seems to link pay more closely to performance, but it actually rewards luck and can incentivize dangerous risk-taking. This system has contributed significantly to the twin crises of modern American capitalism: governance failures that cast doubt on the stewardship abilities of U.S. managers and investors, and rising income inequality.

Mihir has nothing against well-functioning financial markets. He emphasizes that they “play a vital role in economic growth by ensuring the most efficient allocations of capital,” and he believes that capable managers and investors should be “richly rewarded” when their talents are truly evident.

The problem is that incentive compensation based on financial performance does a lousy job of distinguishing skill from luck. In finance-speak, managers and investors often get rewarded for taking on beta, when their pay really ought to be linked to alpha. In practice, luck gets rewarded with undeserved windfalls (that are by no means offset by negative windfalls for the unlucky). And that, he argues, results in an important “misallocation of financial, real, and human capital.”

Well worth a read.

5 thoughts on “Is Incentive Compensation a Giant FIB?”

  1. It’s really difficult to find a better economic bomb to destroy capitalism. Link performance to pay and institutionalize the peter principle, along with golden parachutes and crony capitalism and a revolving door between wall street and washington d.c. and voila. The 2nd great depression holds us in it great arms bear hugging us into economic death.

    Oh yeah outsource all industries and as many professional services as possible to 3rd world slave states and communist nations. A mr. Lenin once said, “The Capitalists will sell us the rope with which we will hang them.” – he may not have been an economist, but he certainly understood the blind greed that drove our once great nation to the ropes.

    Marry it to a fiat currency and a financial system composed of highly leveraged derivatives and how can we not succeed in destroying capitalism? Isn’t it funny? It wasn’t the communist who were our greatest threat, it was the capitalists. The irony is wrenching. I’d be laughing if I weren’t living in my car and living off scrap metal collecting.

  2. There’s an interesting take on this sort of thing in Susan Cain’s book “Quiet: The Power of Introverts In A World That Won’t Stop Talking.” Our culture is in LOVE with extroverts. While applying to college, I had to assert that I’m a “LEADER!” and a “RISK TAKER!” even though I’m not really either of those. In the financial world, lucky risk-takers were rewarded and contemplative, cautious, and quiet people were shoved aside. The culture of rewarding the reckless loudmouths smothered the risk-averse “cops” who were more tentative in their transactions. In order to change the incentive mechanism, we’ll have to work harder to change the culture in general – the instant gratification culture that flies by the seat of its pants. See page 162: http://books.google.com/books?id=uyjf3uaQ4TwC&printsec=frontcover&dq=susan+cain+the+power+of+introverts+books&hl=en&sa=X&ei=zuJdT7-KHIS-0AHowfSzDw&ved=0CD0Q6AEwAA#v=onepage&q&f=false

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