Moral Hazard Pay

Once working for a big firm they decided to shift our compensation plans away from simple salary toward something a larger emphasis on an individual bonus.  During the many meetings where the HR people outlined the new plan one of my more amusing colleagues slowly maneuvered the presenter into realizing that the scheme created strong incentives for us to game the system.

My colleague began by revealing that he was puzzled: would not this create incentives for him to ignore his professional expertise in preference for short term advantages.  From there he began, with a bit of help from others in the audience, to introduce other hypotheticals where one might be tempted to set aside this or that goal that was outside the reach of the incentive’s scoring system.  At which point the CEO chimed in that that would be unethical.  Surprisingly that invoked a wide spread chuckle from the audience.

But, of course, one function of an incentive system is to shift behaviors away from things the employee might do otherwise.  Possibly because he’s easily distracted, possibly because he is more loyal to his profession than the firm’s next quarter, possibly because he is too risk adverse.  The list goes on.

I recalled that story after reading something in the most excellent blog at footnoted.orgFootnoted recently highlighted a perverse example of how incentive design can play out.  One of Bank of America’s recent filings reveals that they paid out 1.2 Billion dollars to Merrill Lynch associates.    Payments triggered by a “change in control” clause in their contracts.

The change of control clauses in executive contracts are part and parcel of the “bribe the pirate” pattern seen in publicly traded companies.  Given the desire of shareholders to have executives to take large amounts of risk, since that shareholders can diversify away most of that, you do two things: let them share the upside, remove the down side.  In this case the change of control clause is like a life insurance policy for the pirate.

Having mused for while that 1.2 Billion dollar pay out was the insurance policy these guys were given to take risks that might destroy the company it has finally occured to me that this is that movie plot; i.e. evil person murders for the insurance money.  So this isn’t about how incentive plans always create moral hazard, which they do, but rather this is actually a kind of adverse selection.  But unlike the insurance company afraid that the only people who will buy life insurance are those soon to die in this case the incentive designer was intentionally trying to attract actors to take life threating risks.    I now recall.  Many many years ago a VC who very much wanted to entice me into working on an idea of his said to me – “We can structure this so you needn’t take any risk.”

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