Industry needs same medicine as the City to cure bonus fever

Much has been made of the problems caused by City traders chasing bonuses but, as George Pitcher points out, industry has the same difficulties. George Pitcher is chief executive of issue management consultancy Luther Pendragon

I was struck recently that three out of five stories on the front of the Business section of The Times were about executive pay packages. The Times currently leads the media’s obsession with pay matters – I would estimate that it carries as many as 20 a week – but it is by no means ploughing a lonely furrow.

This is partly because it is fashionable to peg any form of corporate activity – be it a flotation, a takeover or a good or bad set of results – on what the top people involved are earning. It is also reflective of a callow and more impressionable breed of business journalist – now that the function has been downgraded – for whom this is the most captivating aspect of the story.

I am not going to address the tedious subject of fat cats again. What interests me is not what business people are paid, but how they are paid. It is this issue that was addressed by the Bank of England on Monday, when it issued a fairly unequivocal warning about the size and kind of bonuses that are being given to City traders and there are lessons here for industry as a whole. The days are gone when a Governor’s raised eyebrow was the equivalent of a lashing across the genitalia with a damp bootlace, but it nevertheless still concentrates the minds of banks and their securities and derivatives arms when the Old Lady tells them to watch it.

She says that current bonus structures can destructively influence a trader’s appetite for risk. Even if Nick Leeson’s 830m spending spree in the derivatives market at Barings were not still fresh in the memory, the news last Friday that NatWest Markets had dropped 50m due to pricing errors in its interest-rate options book could not have proved more timely.

It fell to the Financial Times on Monday to point out that a traditional bonus structure, in which a trader’s remuneration rises with the profits he generates, is nothing so much as a call option. His bonus rises in line with revenue, but if there are big losses, all he stands to lose is his job, rather than millions of pounds. In this way, traders share profits but not losses, and one who is against the ropes has nothing to lose and everything to gain by raising the ante (as Leeson did).

The answer, to my mind, is to switch the trader from a simple incentive to enrich himself or herself to a more complicated incentive of collateral enrichment as a consequence of enriching the firm. This may seem like a fine distinction, but what it means in essence is a switch from short-termism – a long-standing ambition of British industry for the City – by deferring bonuses for a period of, say, five years. This would have the added benefit of ensuring that traders just short of their targets do not take huge risks.

That would sort out Planet City but – as my sobriquet implies – it is widely considered to be another world, in which multimillion pound packages are made for reasons far too complicated for the rest of British industry to understand. I don’t buy that. There is one sauce here for goose and gander and it should follow that there are broader lessons to be applied from the Bank of England’s report.

The first is that we should know what we are talking about when we refer to commissions and bonuses in sales functions. Commission is that part of a remuneration package represented by the salesperson’s contribution to sales volume. A bonus is that part of the remuneration package that represents an employee’s contribution to the value of the company.

Manufacturing industry can make just the same mistakes here as the City. For example, by fixing the balance between commission and basic pay wrongly, a sales director is precisely incentivising a salesperson in the manner that the Bank of England condemns for City traders.

To hit sales targets, a sales manager can be tempted to make unauthorised discounts to customers, a risk equally as unjustifiable as a derivatives trader chasing an error to meet a short-term target. I have plenty of examples of sacked salespeople who have felt forced into such discounts. Similarly, chasing commissions can lead to the sale of the wrong products to the wrong markets, a position that can prove costly to unwind – just look at the personal pensions market.

The answer must be twofold: ensure the commission element of a package is not an unduly high proportion of overall remuneration, and pay it on a deferred basis.

Then there are bonuses. Maybe industry should benefit in precisely the same way the Bank prescribes for City traders. If deferred, bonuses would serve the best interests of shareholders, who in turn would be likely to stay in for the longer term. In this context, Martin Sorrell’s Croesus-like package at WPP appears to be a model of long-term probity in the best interests of both management and shareholders.

One final thought. It is said that Labour might favour Gavyn Davies, the Goldman Sachs economist, as a Governor of a new (independent?) Bank of England. Now there’s a man who knows about bonuses.

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