Why It's Crucial To Tie Pay to Performance

Last Updated Nov 17, 2008 2:47 PM EST

For an idea of how compensation is badly out of whack, consider a piece by William D. Cohan, a former Wall Street investor and author of a Lazard Freres history, in an op-ed piece in Sunday's New York Times.
Cohan's argument, which makes enormous sense, is that one reason why the financial crisis is happening is that the compensation system for financial executives is deeply flawed.
How so? Back in his day, Chohan worked at Lazard for six years when it was a privately-held partnership. When the firm made money, everyone, including underlings, got money through a profit-sharing system based on such things as length of service and so on. During good years, everyone benefitted. But during bad years, such as in the 1990s when the firm's municipal finance department badly screwed up, resulting in $100 million in fines, everyone suffered.

Simple concept: Good year, good pay; bad year, bad pay. In other words, chief executives and staffers could benefit or not from directly from the quality of their work.

But in time, these private investment houses started sellling shares to the public, starting with Donaldson, Lufkin & Jenrette in 1969 and then Merrill Lynch, Morgan Stanley, Goldman Sachs and finally, Lazard itself.

With public firms and shareholders, the demand was on to maximize returns. So, the firms did more risky deals. Meanwhile, pay outs to investment firm employees lost their natural link to good performance. In a bad year, the shareholders got stiffed. Insiders got bonuses regardless. Can anyone spell "HUBRIS?"

Cohan says that different compensation schemes should be created through escrow accounts and deferred payments. Not a bad idea. It might be extended to non-financial businesses, too.