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Julian D. A. Wiseman
Abstract: It is very inefficient to pay bankers in a form that is lost upon resignation; it is very efficient to part-pay academics in the form of Vintage Port.
Publication history: only at www.jdawiseman.com/papers/finmkts/20101202_pay.html. Usual disclaimer and copyright terms apply.
Contents: Introduction; Bankers’ Pay; Academics’ Pay (Vintage Port and the Author); The Moral; Afterword.
“Fairness is on everyone’s lips” writes Will Hutton in a recent Op-Ed in the FT (A fairer pay gap between top and bottom, 1st December 2010). The question about public-sector pay follows widespread comment about the pay of bankers, and in particular, that it is so much larger than pay outside finance. This essay joins the chorus of criticism, but on the grounds of inefficiency rather than magnitude. It proceeds by discussing the much-lauded but inefficient paying of bankers’ bonuses in equity; and contrasts this with a much-mocked but highly efficient part of the pay of some academics.
What is meant by inefficiency? If some benefit costs an employer £1, and is valued by employees at £1.50, that is very efficient pay. But if a benefit costs an employer £1, and is valued by employees at £0.50, that’s inefficient, as paying £0.75 in cash would improve the welfare of both employer and employee. It is a simple standard: if paying money would be better for both, pay money.
Bankers’ pay has traditionally taken the form of a basic salary, and a bonus that was in theory variable but was also shaped by expectations. A proportion of this bonus would be held for two or three years, different banks having different rules at different times. Whilst held, this part of the bonus can be forfeit for several reasons, including resignation or being fired from the bank (though is usually safe against redundancy). The intention is to lock the employee to the employer by making it expensive to take employment with a competitor. Typically, but not always, the withheld part of the bonus was invested in the employer’s equity. At the end of this period the withheld part of the bonus would vest and be paid to the employee.
Now consider the position of a young competent banker, gaining experience, whose career is still climbing. In three years this employee will be much more valuable, whether to the current or to a new employer. The gain in pay from switching employer may well exceed the size of the unvested pot; and so there is a very real possibility of resigning before receiving this money. Bankers do not assign much value to money they aren’t going to get.
Informal conversations over the years suggest that employees apply a high discount rate to such unvested sums. Money payable in three years might be valued at fifty to sixty pence in the pound. Indeed, one proof-reader of this essay admitted to a near-infinite discount rate, valuing money payable by the employer in three years at approximately zero. (The reader is invited to ask similar questions of bank employees.) So the employee perceives a pre-tax gain of little more than half of the cost to the employer. That is woefully inefficient pay.
What can be done? Bank employers should cease to make vesting conditional on continued employment. Of course, if non-trivial mischief is discovered, the monies can be forfeit, but this is very rare. But if the employee quits, whether to go elsewhere in finance, to join the public sector, or to do something completely different, the vesting schedule should not change. In return for this gain to the employee, the size of the pay could be lessened, which would also have political gains for the employer.
In the UK some of the finer academic institutions have formal feasts, at which vintage port is served. This is a staple of mockery of academics, but is actually a very efficient form of pay.
Good non-trophy Vintage Port can be bought for £40-45 per bottle; and for institutions that already own the Port the marginal cost is the sale price, which is lower. A typical academic feast might have a third of a bottle per person: let’s say £15 of Port per person. But that isn’t the ‘pay’ an academic receives.
The academic can only receive this ‘pay’ by attending the feast. Also there will be Professor A, Dr B, and Dame C. Professor A and Dr B will spend the evening putting each other down, the insults sometimes being less subtle, and sometimes cloaked in references to things of which only some will be aware. Of course, the most highly-regarded blows are those neither seen nor understood by the competitor—but such victories of such sweetness are rare. Then there is Dame C, whose presence changes the game, Professor A’s flirtatious but unrequited optimism fettering his rudeness, but sharpening Dr B’s. The spectators, including the never-yielding Dame C, thoroughly enjoy the game, as do the main protagonists. They have each been ‘paid’ extra, and a micro-economist must assign it some ‘value’, say £20 (though it might as easily be £10 or £50). So something that has cost the employer £15 is worth much more to the employees—having a form of pay that loosens tongues and must be received collectively causes each to bring and share, but not to charge for, some wit.
This is a model of efficient pay, albeit mocked by almost all who comment upon it in public.
The moral: in micro-economics, fashionable ≠ efficient.
|— Julian D. A. Wiseman
2nd December 2010
From The Financial Times, 27th February 2011, Deferred bonuses seen as having less value:
Bonuses that will not be paid for several years are significantly less valuable to corporate executives than cash in hand, raising questions as to whether deferring pay actually curbs risk-taking, fresh research suggests. …
Asked whether they would prefer a 75 per cent chance of receiving £250,000 immediately, or a 75 per cent chance of receiving £400,000 in three years’ time, more than half the 100 executives surveyed chose the smaller sum.
In fact, deferred pay awards were discounted by an average of more than 20 per cent a year – meaning a £500,000 bonus payable only after five years would be worth next to nothing in the minds of most bankers. …
“The extent to which executives devalue deferred pay calls into question the effectiveness of bonus deferral,” said Tom Gosling, a remuneration partner at PwC.
Summary: deferring pay is expensive and inefficient.