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.