The Idea of Incentives

I have recently been chatting about recent events with some of the people that I live with, namely, the whole fiasco with AIG handing it's executives a massive bonus with the bailout money that came in. They were pretty vitriolic about this move and pointed out that these guys probably have no concept (or more likely, don't care about) the public image that such an action has.

Personally, I can understand why they would make such a move, and it all comes down to incentives. AIG does need to make sure that capable businessmen are in charge, and paying them out is a positive incentive to make sure that those who were there that are good businessmen would stay there. If all the talent ended up leaving the company, like rats fleeing a sinking ship, it would be just as disastrous as not handing them the bailout money in the first place. Of course, understanding this is completely different from supporting it.

The issue that I want to explore is the one of incentives, especially for those who are in power and/or are already wealthy. In this case, we have a business that needs to keep operating, and, more importantly, needs reform. How can we ensure that the management that fucked up in the first place won't continue the same poor practices that cause the difficulties the second time around?

The other difficulty comes in with more with a culture thing. The only real negative incentive that seems to be employed on a professional level is firing or threatening to fire someone from their position, but this doesn't work when you're looking to leave because the company is going to sink. Are there examples where an iron fist has helped solve the problem by forcing those who caused the difficulty in the first place to clean up their mess? How can you enforce this in a culture whose money will easily be moved out of the country, soon to be followed by the owner, free from prosecution for the vast problems caused by them?

So, I would like the heart of this thread to talk about Incentives, and how to effectively apply them.

The thing about the AIG bonuses is that they are contractual. They can't really be viewed as incentives, as they were part of the deal to begin with. In order to have stopped them from going through the government would have had to break the contracts, which I don't believe they can technically do (and if they can I know it wouldn't be a simple process). The American people are upset, and it is logical from their perspective to be so, but at the end of the day even if the contracts were broken that would serve as a contra-incentive which could potentially create a scenario similar to the rats escaping the sinking ship.

On the point of incentives generally though, application is pretty easy. Incentives are inherently positive, inherently desirable, and motivate those they are granted to no matter what we are talking about. Where the difficulty lies is in the degrees and the frequency. Too frequent (or too easy to attain) and they cease to be incentives, too small and the incentive is not worth the action required, too large and the danger of outcry from exempt parties exists. It is quite difficult for me to speak on the proper application of incentives generally, as most times incentives are dictated by situational factors, but as for a primary general guideline to effective incentives I would say say this: Any incentive should require an relative proportionately impactive action. This is where AIG (as well as many other organizations of corporate America) failed, and should really be reformed, especially considering the current psychological state of the public.

As far iron fist authority effectively fixing things, there is not a strong history of this in America or anywhere else I can think of off of the top of my head. For an iron fist policy to truly be effective it must be administered by an authority which has no reasonably acquired competitive authority, and it must not call for a situation which would lead to any situation worse than what could reasonably be attained if it is avoided (I had trouble wording this sentence, I hope my meaning is clear). It requires a delicate balance, and it is hard for any non-authoritarian, non-totalitarian system to pull off. For example, criminals will not voluntarily face justice if they could reasonably avoid it. An executive will not restructure an entire division if they could reasonably acquire a new job, or if it would be more reasonable to bail before the shit hits the fan. Basically, you have to make it worth it, otherwise they will avoid it. That is the difficulty in iron fist policy and it not one I care to theorize a solution to at this moment in time.

To summarize, incentives are good and can be properly applied, they just often times aren't; whereas, contra-incentives are difficult to effectively apply, and I can not think of a thorough non-authoritarian, non-totalitarian example of them succeeding outside of situations where the burden is lighter than any alternative inconvenience.

Presumably the best application of a bonus in business is to reward good performances. If you are the CEO of a company and you meet the bonus requirements, then it qualifies as a good incentive. The problem with this instance is, as Mr E says, the bonuses are actually built-in to the contract. i.e. they're not bonuses in any way, just an addition to the salary. Obviously, the problem is that in the corporate world all boards offer huge bonuses as contractual and not based on performance, so if you don't offer it on the grounds that it isn't a realistic incentive, you simply won't attract the best candidates.

As coqauvin pointed out, some executives simply might not care or be motivated by their reputation. Why? Because the combination of salary and bonus ensures that even if you're completely incompetent when you reach the top, you're still financially very well-set. There is no financial incentive to drive the performance of your company if you're already very wealthy.

Are the best candidates motivated by other means? How big a factor is reputation? I won't pretend to know what these high-profile failures are thinking when they get their golden parachutes, but I'd hesitate to label all of them as entirely lazy and only interested in a bonus payment that'll sort them and their family out for life.

Obviously government can't step in and tell companies how to run their businesses, that would be ridiculous. If they want to ruin their company by pampering the very people responsible for running it then that's their prerogative, but I would think that after this, a) the heads of failed banks and companies won't find getting another job so easy, and b) I *hope* good business practice will compel boards to offer financial incentives that actually are incentives, not just gimmes that only amount to a larger salary.

I think a primary problem here is exactly what benzss was commenting on, a bonus/incentive that is built in and guaranteed is no incentive at all, is is just an extension of salary. I believe fully in incentives. It helps give a person motivation and drive to do their best. The problem is when people still get their incentives for performing at sub-par levels. I know the bonuses were contract, and I am not disputing that, but if you are a criminal and nearly take down your company, let alone the US economy (or partly responsible), then you should get no bonus at all. It is like they are being rewarded for screwing people over.

There are several people who think there should be no extra rewards or bonuses for "doing your job". But unfortunately people do more to get more when a few extra bucks are on the line. I think it has something to do with motivation and human psychology. Most people view their base salary as a "given", as automatically earned if they just meet the job requirements...why put in ALL of this "extra" effort and time to go above and beyond? I'll take my career as an example, I work for a company that does computer / network support for small to medium businesses. My job is mostly technical and part customer service and selling. If I "sell" or get customers to agree to extra services that aren't on their contract I get 10% of the amount. So a customer declines to have a monthly support contract on their client workstation PC's. One of them gets infested with nasty spyware and viruses, technically the customer is on their own because they declined our service contract on that item. If I convince the customer to let me come in, wipe it clean and get them going again at our billable hourly rate, then I get 10% for getting the extra business to our company. Now people might say recommending and capturing this service is just part of my job and I should do it anyway... and they are partially correct, but I am a human being and it benefits me to help the company, 1, more money for the company means more job security, and 2, it puts cash in my pocket for doing it.

Now here is where the psychology comes into play. I earned about 8,000 dollars in bonuses last year (not just selling service, but maintaining high scores on customer service surveys and a few other things). Now if they took my base salary and just added 8000 dollars to it, and expected me or anyone else to do what it took to earn the 8000 "extra" dollars, chances are performance would be LOWER than what it would have taken to EARN the 8000 dollars. Or, you lower the salary a little bit, give incentives to get more, and the company gets better results and higher numbers because the employees think they are really doing something and earning some good cash doing it. In the end paying people a little less and having them earn it via incentives garners better results than just giving a base salary of that same amount and telling them they need to get XX amount of extra service.

So in the end, with the SAME amount of money payed to an employee (one all salary, one salary + bonus) the results are higher because they employee had to EARN it. That is the benefit of incentive. Now there are balances and personalities that come into play on this. Someone that is 100% commission may be too aggressive. Like Mr. E said, if the incentive is too low for the amount of work required, then it won't get done because it is not worth it.

For example, if you were a manager, and were going to pay someone, say 35,000 for some kind of sales job, with certain numbers being required to keep the job, that's fine and dandy. Now if you hire them in at 30,000 dollars and offer a 5000 dollar bonus for going above and beyond the numbers needed, you will probably get better performance than the base salary with no performance motivator (besides just keeping your job).

As has already been mentioned, the American people have no right to be upset with AIG for those bonuses that were built into contracts long before the government bailed them out; they ought to be upset with the administration for jumping into it haphazardly.

The complaint, specific to the AIG case, is that the incentives packages controlling behavior of individuals did not promote their acting in the best interests of the company. Unfortunately, the disparity between the incentives for one party and his supposed duty is usually considerable. There are probably a thousand examples of this.

One commonly referenced one (thanks to Freakonomics, mostly) is that real estate agents sell their own houses for something like $10,000 more than their clients' houses. A real estate agent also keeps his house on the market some 10 days longer than his client. Does this seem unethical to you? Maybe, but consider the incentive structure. Say an agent shows your house once every 2 days (probably a low number for a good, active agent with a quality property.) If your house stays on the market 10 days longer, he has to show it to 5 more clients, taking time away from his ability to show them someone else's house. Now consider what $10,000 means to you and what it means to your agent. He sees 8% commission on the deal (sometimes this is actually split with another agent, but whatever, let's assume he gets it all.) If he waits out 10 days, 5 clients, and earns you an extra $10,000, what does he get? 8% of 10,000 is only $800. Eight hundred fucking dollars? For 10 days worth of work? That's only $80 a day. If your house is worth $250,000 and he takes 2 months to sell it, he makes $20,000 on commission, or $333 per day. In many markets, during most economic conditions, a house worth $250,000 wouldn't even take that long to sell. Simply put, it's not worth his time to keep it on the market longer, so he talks you into dropping your price a little bit to make the sale today. He loses $800 and saves himself 10 days of work. It costs you $9,200.

Incentives drive every rational decision. The only way to make up for a disparity in information is to draw incentives inline with desired behavior (and, in turn, that behavior had better be sure to accomplish the goals of the group.)

In reading some further testimony, I have come to the realization that some of these salaries that people were working for were, in fact, nothing at all withou the bonuses involved. Some were working for an effective salary of $1USD, but with the understanding that at the end of the contract, a significant bonus was going to be added. The idea, for them, was that they worked hard for 10 or 12 months, and they feel entitled to the 6 figure bonuses coming in.

My view on this is a little different, in that, well, they may have worked hard for those 10 or 12 months, but the effect of their actions and the work that they did was, in some cases, directly linked to the potential downfall of the company and required government handouts in order to keep it afloat. In return for such shoddy work, they still feel as though they deserve the salary they were promised.

This isn't counting the execs like this fellow, who is forfeiting his bonus, after receiving a salary of $1, in spite of the fact that he was not involved with the sector of AIG that led to the problems, nor did he profit from this. In his own words: “I did, however, like many others here, lose a significant portion of my life savings in the form of deferred compensation invested in the capital of AIG-FP because of those losses. In this way I have personally suffered from this controversial activity – directly as well as indirectly with the rest of the taxpayers.”

I think that there needs to be more effective negative reinforcement in the business sector. Perhaps not iron-fistedness, but actually holding people criminally accountable for their actions. In a case like this, where the economy takes a huge hit, it is possibly to trace a trail to people who could be called instigators, or at least were snowflakes causing avalanches. Why aren't they held responsible for their actions? Why is it that the companies who bought the faulty goods, either knowlingly or unknowlingly (they have my pity with the latter and my scorn for the former) are being held fully responsible for them rather than those who sold them, knowing the goods were faulty? If it was a casual transaction on the street, this wouldn't even apply, but the repercussions of this action completely transcend the concept of "buyer beware".

So, how is it that the snake oil salesmen get away with this (I'm looking at the banks and their ridiculous mortgages, although I could be mistaken), and the people who started this rousing round of hot potato and those who kept it going aren't really getting pegged with anything? What incentives, or what style of incentives, could be employed to prevent something like this from happening again?

coqauvin why would you possibly want to press criminal charges against the people working for a failing company when you've got investment banks with visible conflicts of interests and news media driving the system into which people trust their long term investments to produce solely short-term profits without so much as a care or consideration for the long-term effects for their clients.

The major issue is that no one really understands the system and they buy into the bullshit we get fed by the media and the President. I am willing to be that 90% of the taxpayers upset about these bonuses couldn't explain the market in even the most basic sense. People still believe the market is a safe way to invest for the long term and they aren't realizing that the rest of the market is manipulated for the next week, not the next decade.