How AIG's Bonuses Threaten All Stock Prices

John T. Landry is an editor of the Harvard Business Review.

The furor over AIG's bonuses is ratcheting up taxpayer unrest over the big government bailout of banks. But it has the potential to disrupt all companies that depend on outside shareholders. That's because it's the culmination of a series of revelations that will shake investor trust in the stock market.

As the newly released documents show, AIG's "guaranteed retention awards" were little more than salary. The plan's preamble aims to align employees with shareholders, but the actual details have so many qualifications that even large payouts that were required to be deferred had only a tenuous link to changes in AIG's stock performance. Like many bonus plans at companies even outside Wall Street, the arrangement allowed companies to tell investors that they tied executive pay closely to performance — while burdening executives with little of the risk that real investors face. It's telling that AIG even allowed people to call the retention arrangement a bonus.

A similar story came out last month, as scores of companies allowed managers to cash in their now deeply underwater stock options for new ones with low trigger prices. Even Google, which prides itself on not doing "evil," followed suit. Repricing makes a mockery of the idea of stock options linking executives with investors. Companies could have prevented this problem by issuing stock options indexed to the market, as HBR argued years ago, but they refused.

As I've explained elsewhere, companies play these games because they think it would be unseemly for investors to know how much they are paying managers for just doing their job. Companies think executive talent is far more important than financing, so they want to pay executives a lot of the profits that might otherwise go to investors. But they try to have their cake and eat it by portraying the pay as performance-based. Now the extraordinary attention over AIG is showing the phoniness of of most incentive plans. (And just wait until the media dredges up the scandal of backdating options, which had little effect when the stock market was still hitting highs.)

Meanwhile, investors are starting to hear about all the details of stock markets that insiders have known and not told them. Jon Stewart may have picked the wrong target in exposing Jim Cramer, but the attention to his show did send a strong message that the financial media dropped the ball in guiding investors through the complexities of investing. Investors may start concluding that the media is in cahoots with executives and financiers, or at least that the stock market is a game only for insiders.

On top of all that, the stock market has plunged to mid-90s levels. For years, middle class people have been told to invest their money in equities because of the long-term annual returns around 7%. If you calculate real returns now, they look more like 3%, not so different from low-risk, unglamorous bonds.

After the Great Depression, it took an entire generation before most investors went back into equities. Prices were flat from the mid '30s to the mid '50s, and didn't reach 1928 levels until 1960. Anyone over 40 (like me) has to be thinking seriously about shifting their retirement money into government or corporate bonds.

After all, we investors might argue, companies are setting up their cash flow to steer more and more of the excess to executives. They devote only as much cash flow to investors as they need to keep us around. So let's formalize the process and go into the (relative) safety of bonds.

That might make sense for you and me, but it would be a disaster for the economy. Not so much for big companies, which rely mainly on retained earnings for fresh capital, but for IPOs of the new companies that fuel much of our innovation. Let's hope we emerge from the recession with transparent executive pay practices that reassure stockholders that most of the profits will actually go into their pockets.

By Susan Jackson  |  March 20, 2009; 6:40 AM ET  | Category:  Economy Watch
Previous: How to Go Back to the Economic Future | Next: Why Small Companies Will Win in This Economy

Comments

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These schizophrenic shell games go on in corporate America all the time these days. It is the reason we arrived at the mess we are in.

Posted by: Maddogg | March 20, 2009 9:10 AM

I have been investing for 20 years now - long and diversified - and don't have much to show for it. I have been upset for years at the incredible compensations for Execs of US companies and the sweetheart deals they get and investors do not. Lately I have ben think of cashin out my American stocks and just keep bonds and some foreign indexes. I think if the market goes up to the point where it is not too painful for me to lock in my losses I will do just that. I've had a bellyfull.

Posted by: sux123 | March 20, 2009 10:19 AM

Git a rope.

Posted by: ews25 | March 20, 2009 11:06 AM

of course the bankers say this..they want things to remain the same as usual..they believe the u.s. economy is their treasure trove and that they are entitled to rape and pillage us..
..........
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LET'EM QUIT..
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PERHAPS THEY CAN FIND A JOB WITH BEAR STERNS..OR LEHMAN BROTHERS..OR WACHOVIA BANK..OR COUNTRYWIDE FINANCIAL..OR MERRILL LYNCH..OR CIRCUIT CITY..
..........
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lots of opportunites for bright guys and gals like them out there..right???
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..........
was that a large order of fries, and would you like a hot apple pie with that sir???

Posted by: w04equals666 | March 20, 2009 11:24 AM

Mr. Landry,
This is not rocket science - I have felt that the exec compensation is a complete rip-off of the shareholder for years.

There are two ways we, the general public who actually WORK to earn money are getting ripped off.

1-Insider trading, transaction fees, financial manager conflict of interest, fradualent ratings (etc). So we, the people investing CASH into 401K funds and mutual funds don't have a chance - we never get truthful information.

2 - CEO's and execs contributing to the situation above and colluding with the rating agencies and brokers/banks AND bleeding their employees dry by downsizing and shrinking their wage expenses by shipping jobs overseas or bring in H1b visa workers who will work for lower wages out of desperation.

They take the cash raised and give it to themselves and their buddies in this exorbitant compensation and stock option schemes.

We, the people, are the schmucks who fund the whole thing and are now funding it even more through our taxes.

All these execs should be fired, ala the Asian solutions in their financial crisis years ago.

Until honesty and truthfulness somehow magically appear in our financial industry with actual regulation that enforces it, I will not be putting any of my hard earned dollars into the stock market.

Obama better figure this out fast - this is the basic problem right now - most ways I look at it, the problem is greed and fraud at the highest levels of these corporations and on "the street".

Posted by: NeedhamPrice | March 20, 2009 11:32 AM

It seems to me that our lawmakers are about 10 steps behind what big businesses do to get around regulation. Polititians are totally out classed. Reporters don't dig before reporting. Most news and financial shows are like watching Entertainment Tonight. I expect it of Jon Stewart but expect better of serious news organizations.

We news readers and watchers don't get to pick what "news people" report on. Riling folks up over millions in bonuses misses the real story but outrage sells.

It's a difficult problem but it seems to me that we need smarter elected officials but why would an intelligent person run in the media atmosphere we live in? Businesses can either trick out leaders because they aren't the sharpest tacks in the box or simply buy them. It's all legal anyway because lobbyists are allowed to write the laws.

Charlie
Aiken SC

Posted by: cbej21 | March 20, 2009 12:10 PM

Investors are finally beginning to see the light on these contracts that do nothing but take from their pockets and deposit right into exec bank accounts instead of back into the company to increase dividends.

I can only pray that this is the start of shareholders demanding REAL accountability of the leaders they are invested in. I doubt it will hold attention for more than a few months after we get out of the recession.

Posted by: theobserver4 | March 20, 2009 1:17 PM

Wonderful article!

Posted by: GC4Life | March 20, 2009 2:36 PM

Actually, I've been waiting for something to happen that would shed light on the out of balance executive pay. I suspect that if some bright graduate student decided to do his thesis on opportunity cost as it relates to executive pay versus business concerns, we'd find that a lot of businesses wouldn't have to lay people off to stay afloat.

Greed, lack of ethics, weak regulation, and media manipulation are the cornerstones of our current dilemma. Some humility at the top would probably go a long way to resolving some of the public angst.

Posted by: rhmn | March 23, 2009 12:00 PM

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