Executive Salaries – The Talent vs. Compensation Battle

You may have recently heard on the news, that Prime Minister Kevin Rudd is going to work with the Australian Prudential Regulatory Authority (APRA) to bring fat-cat pay packets under control. To quote him:

“This is not just a question of fairness and perceived fairness in the system, it goes actually to the kernel of the incentive structures around risk-taking. The Australian government will be examining – with APRA – what domestic policy actions would be appropriate in pursuit of this objective – that is to deal with the problem of executive remuneration to financial institutions.”

Of course this is a very significant issue in the Financial Industry, and one that needs to be carefully controlled and measured. The reason I use the words “carefully controlled and measured” is simple – it’s because there is a positive correlated relationship between talent and remuneration in the financial industry – and if the Government too heavily targets the remuneration component – Australia will loose its talent pool to overseas countries. Of course, the flip side of the coin is simply that many more companies will try and remain private. That is, they will not trade themselves on the share market to get public money which would then mean that they never have to disclosure their payment figures anyway.

I am very much sympathize  with the general public, when they see huge – and often ridiculous- “golden parachute” payout figures from people in the Financial Industry. One, very public example, was the criticism leveled at the former Macquarie Bank chief – Allan Moss- who managed to walk away with more than $26 million in salary this year – down from $35.5 million last year.

Of course, the media usually never explains that this is not “cash” – as most people think – but a mix of cash, shares and options. The options, of course, are probably now worth nothing given the current state of the market. However, its beside the point – the amount that is paid out is clearly phenomenal.

So what is a fair balance?

I think many people are very quick to jump down the throat of executives would earn large sums of money. I definitively and very strongly believe that executives have a moral obligation to donate significant sums money back to the community – but this is a personal belief and one that is not shared by all. Of course, the real argument being brought out by Prime Minister Rudd is the risk vs. return argument and whether executives are placing their personal interests ahead of the companies they work for, in order to generate larger returns and therefore – large bonuses. Mr. Rudd arguments are solely focusing on the Risk vs. Return hypothesis – with the logic being that by reducing, or capping, the overall return available to executives – the “risk” taken will reduce.

Of course, I argue that this is only a small part of the problem. The organizational ethos of large financial institutions needs to change before the Risk vs. Return argument is going to have any significant impact. Internal Firm pressures is always going to result in staff trying to increase their performances in order to achieve higher salaries, and greater bonuses. Sure, putting a cap on the amount of risk may help, but it’s certainly not going to change the internal dynamics of financial organizations. Shareholders and stakeholders in financial organizations demand good performances and subsequent returns – otherwise they wouldn’t bother to invest. These external pressures are passed onto senior management – who, in turn, pass them onto their sub-ordinates and so on. I am not sure there is any way to “change” this – since this is an internally driven factor, not any externally driven one. Risk, by is nature, is what drives returns. To cap risk, in some sense, is to cap performance and therefore cap returns available to investors – which effectively halts the core “free market” ideology.

I think a better strategy would be more adequately encourage balanced performance ratios and more accurately peg performance remuneration to a base salary, rather than a performance bonus. The core problem relates to the bonuses – called “short term incentives” in the industry – being the majority of a persons salary. For example, a typical investment banker may earn $60,000 AUD in cash and then have a maximum available bonus of $300,000 indexed to a portfolios performance. So if this person achieves a 25% increase on their portfolio, compared to the market, they would get the entire bonus. You can start to immediately how this creates problems because these investment bankers take greater risks, in order to get better performance bonus. I believe that by reducing the performance bonus and increasing the base salary – firms would be able to more adequately balance the risks they take.

The Talent Pool

In addition, by reducing the degree and amount of risk taken – is Mr. Rudd going to reduce the talent pool available to Australian Organisations ? If you were a fresh, smart and very capable university student – who has just finished a Bachelors degree, and perhaps even a Masters – would you want to go to an organization which offers only “average” pay rates ? Of course you wouldn’t, you would look for the highest salary and bonus compensation you could achieve – even if it means leaving the country. And that, if Mr. Rudds plan is passed, is exactly what is going to happen.

The best people will leave Australia – and this hurts everyone. No doubt, you have a superannuation fund. How do you think this fund makes money ? it has a very smart and skilled talent pool working for  them – who pick, choose and trade investments in order to maximize the amount of money that your superannuation is earning for you. If you don’t adequately reward these people for doing this – your superannuation investment suffers, and these people will go somewhere else. You demand good returns, and the only way you are going to get these is through smart people – and if these people are not in Australia, everyone suffers.

Conclusion

Don’t get me wrong – I do agree that some executives are paid much more than they are worth. But I definitively do not agree that all are. If you work hard, study hard, devote a lot of your personal time to increasing the wealth of others – you should be rewarded. It’s the people who don’t do these things and take large risks in order to achieve large returns AND are still paid ridiculous sums of money that are the problem.

I believe something needs to be done – as I’ve stated above – but I just think Mr. Rudd needs to be more careful in his wording – because it really does effect every Australian.