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Heads I win, tails I don’t lose

Lucian Bebchuk writes:

Financial firms seeking to retain talent are reported to be making substantial use of guaranteed bonuses, and the French Economy Minister recently called for limiting such bonuses. While many now focus on how guaranteed bonuses affect the level of pay, my [Bebchuk’s] piece focuses on their effect on incentives. I show that guaranteed bonuses create perverse incentives to take excessive risks, and consequently could well be worse for incentives than straight salary. . . .

The above discussion has implications that go beyond the question of guaranteed bonuses. It’s now well recognized that bonus plans based on short-term results which may turn out to be illusory can produce excessive risk-taking, and that plans should therefore be structured to account for the time horizon of risks. But even though tying bonus plans to long-term results is desirable, it isn’t sufficient to avoid excessive incentives to take risks. Bonus plans tied to long-term results can still produce such incentives if they reward executives for the upside produced by their choices but insulate them from a significant part of the downside. Bonus plans that provide executives with such insulation from downsides – either by establishing a guaranteed floor or otherwise – can seriously backfire. . . .

I can see why the bankers want such incentives–as a tenured professor, I can see the appeal of a system with a floor but no ceiling–but Bebchuk makes a convincing argument that the incentives aren’t good. So maybe it’s just as well that professors don’t get fat bonuses as part of their compensation packages.

6 Comments

  1. Slacker666 says:

    > So maybe it's just as well that professors don't get fat bonuses as part of their compensation packages.

    But we do. They're called retention offers.

  2. Andrew Gelman says:

    When we start getting retention offers that come every year and that come to many multiples of our annual salary, I'll let you know. I don't expect that to happen anytime soon.

  3. Slacker666 says:

    Who said they have to come in every year or be several multiples? Sure, the actual distribution is different than for bankers, but it's still part of the upside-only incentive one gets for taking risks when tenured. Heads you score big in publications & the job market, tails you keep your current job and your 2.5% merit raise.

  4. Andrew Gelman says:

    I agree that tenure puts a floor on the downside, but the upside is much much less than the upside of these Wall Street bonuses. This is fine–I'm not saying that professors (or bankers) deserve these bonuses, and Bebchuk argues why they can be bad for the incentives they create.

  5. Ben Hyde says:

    These discussions about incentives are almost always entirely wrong. They treat the firm as the unit of analysis. But, the goal of designing such incentives is to bring the behavior closer to what is desired by the highly diversified investor; and he doesn't care: not about the firm, not about the employees, and certainly not about all the adjacent actors in the supply chains. What he wants is a large pool of high risk gambles. Ones who's distribution of outcomes is very wide and who's median is close to zero. Remember, due to the nature of the limited liability corporation he get's to cut off all the outcomes below zero. It's a perverse system and we don't say labor flexibility or creative destruction for nothing.

    Yeah, the tenure system plays a role analogous to that of limited liability. Food for thought is what role the graduate students are playing in that analogy.