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.
Please email us to report offensive comments.
Posted by: Maddogg | March 20, 2009 9:10 AM
Posted by: sux123 | March 20, 2009 10:19 AM
Posted by: ews25 | March 20, 2009 11:06 AM
Posted by: w04equals666 | March 20, 2009 11:24 AM
Posted by: NeedhamPrice | March 20, 2009 11:32 AM
Posted by: cbej21 | March 20, 2009 12:10 PM
Posted by: theobserver4 | March 20, 2009 1:17 PM
Posted by: GC4Life | March 20, 2009 2:36 PM
Posted by: rhmn | March 23, 2009 12:00 PM
The comments to this entry are closed.