With summer vacations behind them, money managers have a brief period when their undivided attention will be on portfolio management. By the time Thanksgiving rolls around their thoughts will turn to bonuses. Money management firms run on incentive compensation, whether its beating a particular benchmark, reeling in a certain number of new clients, or achieving a specific profit target. If you are mutual fund investor, the general terms of these plans are described in the Statement of Additional Information, which is an obscure appendix to the funds prospectus. Its readily available but seldom read.
These bonus schemes are highly rewarding because the most senior people have the biggest base salaries and are also entitled to the biggest multiples of their base salaries. For example, a lowly junior analyst in New York or Boston might be paid a $150,000 salary and be eligible for bonus that is 50 percent to 100 percent of her base salary. Here in North Carolina, there are plenty of analysts who can only dream of salaries and bonuses in this range, although the overall compensation system is the same. At the upper end of the money management organization, a portfolio manager might enjoy a seven figure base salary along with the opportunity to earn three, four, or sometimes even ten times his base salary.
Lets set aside the question of whether seven figure base salaries make sense and focus on incentive compensation. Believe it or not, these bonus schemes have little to do with driving performance, even though money managers like to tell their investors that these incentives create alignment between managers and their clients. Theoretically, bonus plans are supposed to create powerful incentives for money managers to achieve certain goals or targets. In other words, if a portfolio manager is eligible to receive a big bonus, he will try harder to achieve top quartile performance (top 25 percent among all managers investing in a similar manner) on behalf of his clients.
There are several flaws in this theory. First, I have never seen any evidence that portfolio managers with bigger incentive plans work harder or do better than those with smaller incentives. Everyone is striving (and most are failing) to beat a benchmark like the S&P 500. A bonus scheme doesnt make it any more probable that a portfolio manager will figure out a winning strategy for his clients. If these bonuses promoted exemplary performance, youd expect to find it on a relatively consistent basis.
Second, if the incentives are paid, the performance generating the bonus is based on dumb luck, not skill, as I discussed in my column two weeks ago. Most incentive plans pay out managers for generating good performance over short time periods such as one or three years.
Third, money management bonus systems are almost always asymmetric. In other words, portfolio managers earn bonuses for good performance, but arent punished for poor performance. Moreover if you are one of those investors who read prospectuses, you know that managers seldom lose their jobs, and mutual fund boards never insist on changing portfolio managers.
Finally, many of these bonus arrangements encourage portfolio managers to take excessive risk, especially if theyre performing poorly. A manager trailing his benchmark as year-end approaches has little to lose in turning up the risk in a portfolio. If his gamble pays off, he might still earn a bonus, and if it doesnt, hes no worse off.
Pay plans spreading
The incentives for marketing money management products are equally flawed. A sales professional often makes a lot of money under an incentive plan simply because an investment product has an enticing short-term track record. In other words, the product sells itself. A sales professional might earn the sales commission if he could entice a prospect into a product with less than stellar performance history. Ive never seen it done.
Id have less concern about these incentive compensation schemes if they were confined to Wall Street. However, these types of plans are spreading. For example, many states offer schoolteachers a 5 percent or 10 percent bonus if their students achieve certain test scores. If a teacher hits the targets, we consider her a hero and willingly pay out the bonuses. Never mind that the teacher in another classroom or district was a much more effective teacher and taught in a more challenging environment.
I find it rather ironic that Wall Street and money managers who insist that they need to make 5 or 10 times their base salaries in order to produce their financial alchemy think that small bonuses to school teachers are going to change educational outcomes. I suppose the teachers should be grateful because these schemes are about the only way theyll make more money. We on Wall Street and in money management have our nerve criticizing a profession where a large portion of the practitioners spend their own money to meet the needs of their classrooms, while we charge every expense possible to our company or investors despite our seven figure pay packages. We should examine our own pay practices before recommending them to others.
Andrew Silton is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/