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Friday 20 February 2009

Perverse Incentives are Daylight Robbery

The Wrong Carrots

An awful lot of what goes wrong in the human world is connected to perverse incentives. These are the carrots that leaders use to encourage people to behave in particular ways only, through the law of unintended consequences, they work in more or less the opposite fashion to that intended.

We often misunderstand the nature of incentives because it’s difficult to figure out what they are or even whether they affect us – but if our business leaders get this wrong we see businesses doing extraordinarily stupid things. Worse, if our business leaders’ own incentives aren’t kept in check they themselves do extraordinarily stupid things. We’ve seen plenty of both in recent times and unwinding the mess that badly designed incentives have done to the world is going to take time, patience and thoughtful appreciation of the issues by the world’s leaders, both political and commercial.

So let’s not hold our collective breath, then.

Obscure Incentives

As many incentives are obscure it’s understandable that we don’t always succeed in stopping all of the worst practices. Sometimes, though, we can detect some of the more obviously stupid ones. Like, for instance, the French authorities in Hanoi offering a bounty for every rat caught. This led to a near instantaneous growth in rat farms and no discernable reduction in the native rat population. Then there was the British tax on windows which naturally enough led to them being bricked up hence, allegedly, the coining of the phrase “Daylight Robbery”. Window tax was, at least, marginally better than what it replaced – the hearth tax which caused people to brick up their chimneys – and promptly set fire to their houses.

Trouble is, even where the effects are obvious, we don’t always do anything to stop perversely incentivised behaviour because we don’t appreciate the real damage that being done. It’s like smoking – smokers knew for years before the medical evidence was overwhelming that it wasn’t good for them. Wheezing loudly after walking upstairs to the bathroom and starting each day with a ten minute coughing fit does not constitute good health under any scenario I can think of. Trouble was we didn’t know exactly how “not good” for us it was until we’d forced a generation of puppies to cough up a lung in the name of science – thus managing to be morally ambivalent and bloody stupid at the same time, all for the perverse incentive of a nicotine fix.

Perverse Share Options

Many of the worst practices in business involve share option schemes that effectively transfer equity from shareholders to company executives. Shareholders taking a long-term view of this can only really regard it as perverse – why would I want, in effect, to give some of my shares to a bunch of executives who are already being handsomely compensated for running my company? If executives aren’t being paid well enough already then give them more money, not part of your company – if they want shares then they should buy them along with the rest of us (see, for example, Buyback Brouhaha).

Incentivising managers to get their company's share price up on a relatively short-term basis can only promote bad habits. Worse still, the hurdles set to allow executives to reward themselves at the expense of the shareholders are often absurdly low, incredibly crude and wilfully obscure. And get re-priced every so often when share prices fall. Here in the UK we’ve seen a spate of companies doing just that while simultaneously announcing rights issues that instantly guarantee the managers a juicy profit and a greater slug of equity. Nice work if you can get it, but ethical?

Peverse Shareholders

If these awards are so obviously perverse why do shareholders permit them? Well guess what? Many of these shareholders are themselves being perversely incentivised to do so. Larger companies have shareholder lists dominated by various pension and investment funds and the managers of these organisations are rewarded – short-term – by how well they do against various targets, most of which are directly related to the share prices of their funds’ underlying holdings.

Unsurprisingly asking these institutional shareholders to safeguard private shareholder value is like asking a kleptomaniac to look after the shop while you go on holiday and then acting all surprised at the lack of takings, stock or said kleptomaniac on your return. Most such shareholders – and there are honourable exceptions – are all in favour of management incentives that reward short-term performance of company share prices without regard to the longer-term impacts.

The Dangers of Share Options

Being a perceptive sort I’m sure you’re thinking to yourself “what’s wrong with share prices going up in the short-term?” In and of itself the answer is “nothing” – if the performance is directly related to the success of the underlying business. The trouble is the ever present incentive to finds ways of pushing up revenues – it’s awfully tempting to managers to take on risks and debt or engage in creative accounting in order to get the share price up, particularly when the options are out of the money. As we've seen in CEO Pay - Because They're Worth It? there's a suspicious correlation between artificial share price manipulation and the senior executive's stock option packages.  Correlation isn't causality, but it is suggestive.

Arguably the practise of not expensing options – a particular bugbear of Warren Buffett’s – led companies to over-report revenue for years:
“If stock options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world do they go?”
Even at lower levels we all too often find companies getting muddled in their incentivisation plans. Generally, you’d think, the main aim of a customer service call centre would be to provide customer service – make customers happy, ensure they remain customers, give them whatever service they’re paying for. Classic sort of customer service type stuff. Naturally companies want to cross sell down these channels which is fair enough up until they stop incentivising staff to provide customer service and start incentivising them to generate cross-selling revenue. Which results in declining customer services levels. Well, duh.

Pyramid Sales

As an immediate example there’s little doubt that the pyramid of mis-selling that’s led to the astonishing bank write-offs of mortgage debt can be directly traced to the huge incentives offered to sales people to bring in business. Add to this a management that is determined to remove any checks and balances in order to ensure their own bonuses and you have a recipe for disaster. See this NYTimes article.

Conversely when companies get incentive schemes right they have powerful multiplier effects. The classic example, oft quoted by Charlie Munger, is FedEx who spent years trying to work out how to incentivise its workers to ensure they met their delivery times. Eventually someone figured out that merely paying people to be present on a shift simply guaranteed their attendance, not their performance. Paying them the same money and allowing them to go home as soon as they’d met their targets resulted in an instantaneous surge in output. Simple, yet brilliant.

There’s nothing at all wrong in executives being paid extraordinary amounts of money for extraordinary performance but rewarding them disproportionately for simply being there is nothing more than gross negligence on the part of shareholders. If shareholders accept that it’s the long-term that matters and reward managers appropriately all sides would be much better off. This is a race in which the thoughtful and consistent tortoise starts with as an inbuilt advantage over the hyperactive and inconsistent hare.

Related Posts: The Death of Homo economicus, CEO Pay - Because They're Worth It?, Hedge Funds Ate My Shorts, Unemotional Investing is Best, On Incentives, Agency and Acqueducts, Gaming the System

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