The Bonus Dilemma Essay Example

effects. Anger towards financial institutions has been fueled by the sizeable $700 billion bank rescue legislation enacted in early October.The recipients of aid from the EESA are facing anger, particularly from committee chairs in Congress. In response to public outrage, the committee chairs have demanded that institutions receiving bailout funds provide a thorough explanation of their methods and distribution of bonus pools for this year. Moreover, these institutions must ensure that taxpayer money is not utilized to expand these bonus pools.

There have been calls for banks to refrain from paying bonuses this year, according to elected officials. On Nov. 12, the four major U.S. banking regulatory bodies issued a joint statement instructing banks to review their compensation policies in line with organization objectives and risk management practices. Critics are demanding a stop to year-end cash payouts for all employees, not just corporate officers, resulting in a tense situation where many firms are delaying bonus decisions.

Goldman Sachs and UBS announced on Nov. 17 that their top executives will not receive bonuses for 2008. Additionally, UBS has introduced a new incentive structure applicable to its group executive board, executives one level below them, and other employees involved in key roles relating to risk capital and financial risks. This new structure includes a bonus/malus system where each year's bonus is deferred and can be reclaimed if future losses occur.

The Swiss bank assured its employees that their variable compensation will largely remain unaffected by the changes. However, the political emphasis on compensation presents both immediate and long-term risks for financial institutions.

An apparent immediate danger is when a company restrains year-end incentives more severely than its competitors, which may result

in losing talented individuals to rival firms early in 2009. Any discrepancies that arise between similar firms in terms of incentives have the potential to cause employees to defect. Even struggling banks and hedge funds will take advantage of opportunities to attract dissatisfied top talent from other companies. Therefore, during this period, recruitment teams should prioritize gathering real-time information about the actions of their closest counterparts regarding year-end incentives. Internal recruiters can provide valuable insights to divisional and department heads, as well as other decision-makers responsible for compensation. Apart from the risk of immediate defections, an organization that allows public officials to dictate its compensation procedures may gradually transform into something resembling a government agency. In public agencies, salaries are often determined by published charts rather than the discretion of managers, and bonuses are nonexistent.

If a bank chooses to go down this path, it may result in the departure of risk-takers and innovators who will seek employment elsewhere. This could lead to an increase in the number of individuals who are comfortable with high levels of transparency and public oversight regarding their own compensation packages, particularly those interested in careers in public service. After five years, it may become impractical to return a partially nationalized bank back to the private sector due to the government taking on a new role as an activist shareholder and the potential for industry-wide losses worsening this quarter. The final calculation of compensation expenses at year-end may decrease. Additionally, a significant portion of year-end awards will be distributed through shares and other deferred forms of compensation. However, there is still a noticeable minority of employees who are unprepared for any

reduction in their compensation.

According to a survey conducted by eFinancialCareers in mid-October, around 1,400 Wall Street professionals are expecting changes in their bonuses for this year. Out of those surveyed, 36 percent anticipate a larger bonus compared to last year, while 30 percent predict a smaller bonus and 34 percent foresee no bonus at all.

The finance industry is currently experiencing shifts that are influenced by different factors impacting compensation decisions. These factors include the increasing focus on commercial banking, reduced activity in alternative investments, and decreased recruitment threats from hedge funds. As a result, resources are being redirected from institutional to retail and commercial banking. Hedge funds are also offering smaller pay guarantees than in previous years.

Determining compensation levels for portfolio managers, analysts, and support staff heavily relies on prospective fee revenue. However, constraints such as negative portfolio returns, high-water marks, an unfavorable market outlook for next year, and limited leverage opportunities are hindering fee revenue growth. Additionally, declines in asset markets and redemptions due to risk-averse investors reducing their investments further affect management fees for hedge fund firms.

These challenges have led experts in the sector to predict that a significant number of hedge fund firms currently operating will exit the industry within a few years.In addition, smaller investment banks and boutique firms are becoming increasingly competitive. The media is also covering changes in staffing at both long-standing companies like Jefferies Group and Piper Jaffray, as well as newer players like Moelis & Co., Evercore Partners, and Thomas Weisel Partners.

Many financial firms claim to have avoided significant damage from the mortgage meltdown. Now, their executives openly state their intention to recruit top performers from well-established

institutions whose compensation packages were previously unattainable for a second-tier employer.

HR, Shake Hands With PR

Anecdotal evidence from various sources suggests that 2008 bonuses will decrease by at least 30 percent compared to the previous year. However, many professionals in the financial markets will still receive some form of bonus. Companies that refuse to implement a company-wide and industry-wide bonus freeze will face a public relations challenge. If the industry wants to defend its compensation practices effectively, it needs to articulate its stance using concise and impactful statements, as advised by Cognito, a reputable financial services PR and marketing firm.

Banks should educate the public about the distinction between C-suite executives and hard-working professionals in other industries. It is important to differentiate between banking and other industries where employees receive fixed salaries rather than salary-plus-bonus packages. Banks should emphasize that the term "bonus" is misleading, as year-end incentives make up the majority of banking professionals' compensation. Most individuals on Wall Street do not primarily work for their salary, or what is referred to as their "base." It is important to note that not all finance professionals earn seven or eight-figure incomes and were not involved in the creation or sale of products such as asset-backed CDOs that were considered "toxic."

Nationwide, approximately 850,000 individuals are employed in securities dealing, trading, or investment management. Many of them are in administrative and support roles and earn incomes that, although higher than what other industries typically offer for similar work, demonstrate the human side of banking that critics of the industry are striving to mask. By providing concrete, detailed real-life accounts and testimonials from these individuals, the industry can counteract

the stereotypical portrayal of Wall Streeters as wealthy tycoons driving Porsches, wearing Rolexes, and hopping between islands. Another effective approach is to highlight how the temporary nature of the bailout program has direct implications for firms' compensation practices. Since taxpayer funds have been invested in the industry, the government requires an exit strategy that ensures banks continue to function well enough to be eventually returned to full private ownership. If total compensation is significantly reduced and every banker's pay is subject to congressional review, will talented, motivated, and highly educated individuals still be attracted to banking careers? Currently, the idea of transforming Wall Street into a replica of Washington seems to bring a sense of satisfaction to some voting taxpayers. By enlightening these taxpayers about the fact that Wall Street would consequently remain under permanent government control, the industry can help them realize where their genuine interests lie.

Long-Term Reforms

UBS is expected to take the lead in implementing compensation policies that other institutions are likely to adopt. Starting in 2009, UBS will hold at least two-thirds of an executive's annual bonus in an escrow account. If the bank experiences future losses, this balance will be reduced accordingly. This new approach will apply to top executives and employees who have the ability to put the bank's capital at risk. The specific definition of this group has yet to be determined, but it is estimated that around 2,000 out of UBS' nearly 80,000 employees will be affected based on information from the Times of London. The incentive plan introduced by UBS was influenced by proposals from the Institute for International Finance (IIF), a global organization that brings together

banking leaders, central bankers, and regulators. Josef Ackermann, CEO of Deutsche Bank and chairman of IIF, has been actively advocating for reforms in compensation practices.

An IIF "Best Practices" report published in July connected the current financial turmoil to "excessive risk-taking resulting in part from incentive compensation tied to revenue or short-term profitability. Bonuses sometimes were awarded "without sufficient regard for the risk and revenue profiles of products that often span several years," according to the report.

Recommendations:

1. Base bonuses not on a trader's raw profit, but on profit adjusted for risk and capital costs.
2. Pay the majority of bonuses in the form of "deferred or equity-related components."
3. Time payouts to align with the period in which a firm's capital is at risk.
4. Create comparable incentives for risk-takers across different business groups within a firm.
5. The ideas in this White Paper draw upon three commentaries published on eFinancial.

Footnotes:

1. http://www.federalreserve.gov/newsevents/press/bcreg/20081112a.htm
2. http://financialpr.blogspot.com/2008/11/wall-st-bonuses-ii.