Tag Archives: incentives

Putting Fun Into Finance

Can personal finance be fun?

Photo: Melodi2. Source: Morguefile

For most of us, money matters are unpleasant. They involve budget issues and trade-offs and hard choices that frustrate everyone. So we need to encourage ourselves, to set up some kind of incentive program.

For example, estate planners say you should update your will every three years or so. So: think about what would be a special treat—like eating at a favorite restaurant, or going to a special show—and reward yourself when you update your plan. Similarly, you should look at how you are doing against your budget quarterly. Find a special activity that you can look forward to, and treat yourself when you do a review. (Just be sure it doesn’t break the budget.)

This may seem hokey, but it works. We like to do things that are fun for us, and we avoid the stuff that’s unpleasant. If couples fight over money, they tend to avoid dealing with those issues, which usually makes any problem worse. If they can find some way to make money matters less daunting or more enjoyable, they’ll probably address these problems more faithfully.

Photo: Pexels. Source: Pixabay

Not everyone finds balance sheets and cash-flow statements boring or intimidating, (although most folks do). But everyone responds to incentives. By encouraging ourselves to act responsibly, personal finances can change from being a chore to being something to cheer.

Douglas R. Tengdin, CFA

Scientific Recruitment

Do we need more science majors?

Photo: Analytical Mechanics Association. Source: NASA

That’s what a lot of people think. And as a science major myself, the husband of a science major, and the father of four science majors, I certainly believe in the utility and importance of studying science in college. It helps young minds develop rigorous, analytical thinking, along with quantitative skills.

But some proposals to provide special encouragement for kids to study science seem misguided, like college-loan forgiveness or different tuition rates for different majors. These will just lead institutions to game the system. Incentives are already out there for all to see: last year’s top-paying majors were systems, aerospace, and chemical engineering. The bottom-paying fields were social work, culinary arts, and family studies.

Sometimes an industry has a potential talent shortage and needs to take action to encourage, recruit, and retain talent. This happened with nuclear power 20 years ago. Nuclear power wasn’t “cool.” It was where Homer Simpson worked, and the workforce was aging. But employers worked with universities, community colleges, unions, and the military to find good workers. Now nuclear engineering majors are also among the highest paid groups.

These kinds of micro-initiatives are much more successful than massive programs. Big plans require rigid rules that people can play with and distort to reclassify cooking into alimentary-engineering. And most of the new money gets eaten up by bureaucratic bloat.

The marketplace knows what skills it needs and pays people accordingly. It’s called supply and demand. That’s the most scientific recruitment tool I know.

Douglas R. Tengdin, CFA

Chief Investment Officer

Follow the Money (Part 6)

What can go wrong?

Pecora Commission Hearings, 1934. Source: Sunday Times

There are lots of ways for compensation schemes to get off-track. If they aren’t properly tied to the company’s goals, the wrong types of behaviors are encouraged.

My industry, financial services, is filled with stories of misaligned incentives and workers behaving badly. The most egregious are financial traders who get a cut of their trading desk’s profits. They use their firm’s financial position to go long or short various financial instruments—stocks, bonds, commodities, currencies—and are paid based on how these positions pan out. If the desk does well, the trader scores big. If not, he or she may be out the door.

This asymmetry is what causes rogue traders to pop up again and again. These folks know how to circumvent the system’s limitations to take huge positions. If these go south, their firms can lose billions. Traders will hide losing trades in various ways, or manipulate their mark-to-market systems to inflate their bonuses—especially around the end of the year, when the bonus is calculated.

This same sort of thing happens in more mundane settings. In the late ‘90s I knew of a bank trust department that used to pay bonuses based on whether client portfolios did better than an equity index—irrespective of risk. That scheme just incented their portfolio managers to concentrate their client’s portfolios with high-flying tech shares. One portfolio was loaded with over 60% technology companies. Whoops. Needless to say, those clients didn’t do very well when the internet bubble burst.

Traditional commission-based brokers and agents face incentive conflicts all the time. The temptation can be to elicit trades from a client whether these are needed or not. This is called “churning” an account. And salespeople are also paid varying fees from different instruments. Mutual funds and annuities are particularly prone to abuse. These pay up-front commissions and trailing fees that aren’t always clearly disclosed. In some accounts the investor can pay more than 3% per year, and these fees are largely hidden from view.

Photo: Kevalaer Niederrhein. Source: Pixabay

These types of abuses are what’s behind much of the recent regulatory reform. The Dodd-Frank legislation tries to address trading issues at banks; the fiduciary rule for IRAs is an attempt to rein in the worst problems with commission-based investment products. But like most rules-based compliance, these reforms will only work until someone figures out how to get around the regulations and game the system again.

The problem with the financial services industry is that it sees itself as an industry and not as a profession. It focuses on its finances, and not on customer service. Practitioners are more concerned with profits than they are with their own expertise. There will never be a perfect solution to the principal-agent problem: some people will always take advantage of other people and their own situation. But if professionals’ interests are tied to their clients’ financial well-being—their risk-adjusted long-term objectives—the compensation structure could at least encourage practitioners to do the right thing.

Upton Sinclair once noted that it’s difficult to get someone to understand something, when their pay depends on their not understanding it. If we get the pay right, maybe the understanding will follow.

Douglas R. Tengdin, CFA

Chief Investment Officer

Follow the Money (Part 5)

What’s the balance?

Source: Gratisography

How do you balance employee interests and owner interests? Customer concerns and management issues? The goals of all stakeholders—owners, employees, clients, and communities—should be considered.

They key word for all these parties is equity. Equity as in people inside and outside the firm feel they are being treated fairly. And equity in the sense that employees have a proprietary feeling about the business—a sense of ownership, that what they do and how they do it makes a difference to everyone’s bottom line.

The ideal compensation plan is contextual: it’s tailored to the type of business and the stage of growth that the company is in. And it’s meaningful—the incentives are large enough to have a material impact on someone’s behavior. Goals have to be specific, achievable, and tied to the firm’s performance. And some of the incentives should be deferred. If employees leave, they should have a real sense that they are leaving something behind.

One of the unseemlier sights in the financial industry is the annual “bonus shuffle” that happens every spring. After annual bonus checks are cut—usually sometime around March—many top performers go job-hunting, searching for another big score. Because too much of their pay is tied to short-term performance, they don’t have much reason to stick around. And the nature of accounting is that while the financial payoffs can be seen up-front, many of the underlying risks aren’t visible for years. Employees should feel the same concerns as owners—concern for the bottom line, concern for the business’s long-term viability, and concern for other team members.

Photo: Dave Meier. Source: Picography

Finally, a good plan needs to be simple. People shouldn’t need a spreadsheet to figure out what they’re being paid. If a plan is too complex, workers just forget about it and fall back on what they know—and managers lose the ability to structure the business and change the culture.

A good incentive system is like a good relationship: it has short-term, medium-term, and long-term objectives. Each of these contributes to a firm’s success—something everyone wants. But if folks fail to plan effectively—balancing all these objectives—they’re effectively planning to fail.

Douglas R. Tengdin, CFA

Chief Investment Officer

Follow the Money (Part 4)

Can’t we all just work together?

Photo: Roy Lister. Source: Wikipedia

Every employer’s dream is to have their workers act like owners. They want their employees to be diligent and energetic, and to treat customers well. They want workers to look out for the top line and the bottom line—growing revenues and maximizing earnings. And they want their people to behave in an ethical, sustainable way.

But how do you get there? The principal-agent problem can’t just be wished away. For part of the workforce, companies address this issue by using a commission structure. Commissions are a common way to reward sales people—those responsible for generating revenues. One of the most common forms of commission structures is “on-target” earnings, where the employee earns a percentage of revenues based on achievement of specific sales targets. Usually, that percentage rises as sales go up.

But conflicts abound. If the certain rules aren’t in place, sales people will be incented to steal business from each other, rather than raise new revenues themselves. After all, if a customer is already doing business with the firm, changing who represents it doesn’t seem as hard as generating new sales. And the principal-agent problem may end up transferred to the employee’s relationship with the client.

In real estate, for example, brokers earn a percentage of the sales price. But sometimes the listing broker will offer an added bonus to buyer’s brokers in order to get more showings—and perhaps to create a quicker sale. But the actual purchasers may not know this. Are they being shown a property because it fits their criteria, or because there’s an extra incentive for their agent? Their time is valuable. As Ben Franklin wrote, time is money.

Source: Free Photos

It’s been said that you can’t pay a salesperson too much. Indeed, top performing sellers are often the most highly compensated individuals in a company, earning more than the executives. If the commission structure is right, that statement can be true. Owners should want to encourage and retain top talent. But if the incentives aren’t well thought out, the sales platform can feel like the rumble scene in a Mad Max movie—everyone out for themselves.

Incentive systems are like the weather at the beach. When they’re good, they’re very, very good. But when they’re bad, everyone runs for cover. It makes sense for investors to try to understand the sales culture of the companies in their portfolios. The last thing they want is an investment that eats its own.

Douglas R. Tengdin, CFA

Chief Investment Officer

Follow the Money (Part 3)

Do salaries create conflict, too?

Source: Gratisography

Salaries have also been around a while. Our word “salary” comes from a Latin word for salt. Roman soldiers were given “salt money” as pay; we still may say that workers are “worth their salt,” meaning that they earn their pay. Salaries are set monthly, or annually.

Salaries became more common during the industrial revolution. They were used to pay administrators and managers whose work was difficult to measure, but who weren’t partners or partial owners of the firm. When Japan industrialized in the early 20th century, a new Japanese word—salaryman—was coined to describe these office workers. As our service economy has grown, the share of salaried employees has grown as well. Today, in the US, about 40% of all workers earn a salary.

Salaried employees suffer from a principal-agent problem. Shareholders want the most work possible out of the firm’s employees. Salaried employees may just want to “get by,” without taking a personal interest in the performance of the company. To get around this, salaries are now often considered part of a total compensation system, which may also include bonuses, incentives, benefits, and other perks. These are designed to help employers link rewards to an employee’s measured performance.

Source: Wikipedia

But the devil is in the details. Poorly structured incentive schemes create more problems than they solve. They can put employees at odds with each other, with their supervisors, and with their customers. A bad incentive compensation system is often worse than no system at all—leading to poor corporate performance and high employee turnover.

The difference between employee and employer can be seen in how they approach payday. For one, it’s a source of hope and expectation; for the other, it’s a matter of anxiety and dread. If we want workers to “earn their salt,” they need to know that what they do matters—for their customers, for their employers, and especially for themselves.

Douglas R. Tengdin, CFA

Chief Investment Officer

Tour des Femmes?

Can women save the Tour de France?

The race covers 2000 miles and takes 23 days, winding along country roads, through city streets, and up tortuous mountain passes. The rider with the lowest aggregate time is the overall winner, although there are team prizes as well. But the world’s premier cycling event is reeling. Between 1995 and 2010 only one winner wasn’t linked to doping, which is affecting its popularity.

Thirty years ago Tour organizers included a parallel women’s Tour, using the same finish lines, but the event was cancelled after five years. Women’s sports have come a long way since the ‘80s, however. Many female athletic events attract a larger male than female audience. And doping scandals are rare among women.

Other endurance sports, like marathon or triathlon, have women’s divisions at the elite level. The hope here is that stars will emerge that can bring in additional viewers—as has happened in tennis and golf. With all the scandals, the sport needs help.

It wouldn’t be the first time women have ridden to the rescue.

Douglas R. Tengdin, CFA

Chief Investment Officer

Tax Man

Today is tax day. What have we learned?

Every year, it never fails. April 15th rolls around, people file their taxes, and vats of ink are spilled on what our tax system means and how it could be improved. But the day they should focus on is April 18th this year: tax freedom day. That’s the day that that the average working American stops working for the government and starts working for him or herself. Of course, this varies by state. If you live in Tennessee, tax freedom day is April 2nd; if you live in Connecticut, it’s May 13th.

This is important because no one every changes the oil on a rented car. When people work for themselves, they tend to work harder and longer, innovating when possible, either finding a way forward or making one. We live in an entrepreneurial culture and lower taxes encourage this.

Since the early ‘60s, our Tax Freedom day has hovered around mid-April. Other countries aren’t so lucky: in Germany it’s July 19th; in Belgium it’s August 3rd. Is it any wonder that many Dutch-speaking residents of Belgium want to join Holland, where their tax-freedom day is a month earlier?

Motivation matters; incentives matter. But you need to have enough government to provide adequate basic functions, or you might end up like countries whose tax-freedom day is in March: India, Albania, and Cyprus.

Douglas R. Tengdin, CFA

Chief Investment Officer

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