The AIG Bonuses -- A Farce, But Perhaps the Needed Sacrifice

The AIG "bonuses" have become the focal point of extremely emotional viewpoints and apparently now will be the focus of specifically designed legislation to punish the recipients. At the core of this issue, however, is an extraordinarily high level of ignorance about the payments and the general nature of compensation on Wall Street. Congressmen "investigating" the payments, however, seem uninterested in actually understanding the payments, but instead are using the situation as a means to purge the public's anger over the state of the economy. That might, surprisingly, be a good thing.

Wall Street Compensation

At most financial institutions of any scale, it is common to pay executive level salaries both on a salary basis and end-of-the-year bonus payments.

This approach amounts to viewing compensation as having a "fixed" component and a "variable" component.

The fixed component is the minimum total annual compensation that a firm and the employee agree is fair. The negotiation of this "fair" level is entirely between these two parties.

The variable component usually represents a discretionary payment by the firm to high-level executives (or to all employees) as an additional method of rewarding employees for the efforts.

The extreme farcical nature of the current media coverage and congressional investigation stems from the fact that no one seems interested in making it clear into which category the AIG "bonus" payments fall.

The problem stems from the fact that AIG -- and almost every major financial firm on Wall Street -- calls a portion of the fixed component of compensation "a bonus."

Further confusing the issue is the fact that the AIG bonus payments were called "retention" bonuses," when in fact, the payments are not intended to "retain" the employee after the payment, nor are they really bonuses.

Retention Bonuses

Most high level employees on Wall Street sign an employment contract which defines their role and responsibility and their total compensation.

However, the total compensation paid is usually broken up into two parts.

The first is the ongoing monthly (or twice monthly) paycheck that is called "salary." This is what most of America receives as their total compensation for services.

The second part of the "total compensation" that is common on Wall Street is the end of year payment, which is contractually defined in the employment contract.

It is this payment that is at the focus of the AIG debacle today.

AIG calls these "retention bonuses."

The "retention" aspect of the payment, however, is the provide an incentive for employees to stay with the firm through the entire year, usually the calendar year, but sometimes the firm's fiscal year.

Wall Street firms do this to ensure that key employees have a strong incentive not to leave in the middle of the year.

Key employees used to be able to "coerce" raises from a firm when they were in charge of extremely important projects or segments of the firm by threatening to leave before a fiscal year ended.

Fearful of the lost momentum of a major segment of income, firms usually gave in to this type of "extortion," since any impact on total earnings would be worse than making the payment. This type of coercive "raise negotiation" was especially powerful if the key executive could also threaten to take his or her "lieutenants" at the same time.

To avoid this type of situation, the "retention bonus" was created.

The "retention" aspect of the payment is to ensure that the employee stays with the firm through the full year covered by their employment contract.

The relationship between how much of the negotiated "total compensation" for a year's work is in the form of ongoing salary and how much is in the form of an end-of-the-year "retention" payment is part of the negotiation.

One benefit, for employees, of this type of retention bonus payment is that they do not have to pay ongoing taxes on their "expected" total year compensation, since they might forfeit the end-of-the-year payment if they leave early. Taxes are withheld, of course, from the retention bonus, but this provides much more flexibility in tax planning for employees.

Performance Bonuses

Performance bonuses are completely different than "retention bonuses."

Performance bonuses are payments made to employees based upon the company "having a good year."

True "performance" bonuses are not contractual obligations. They are entirely discretionary.

This makes a performance bonus different from a profit-sharing plan, which is often (though not always) a contractual obligation of the firm, using a predefined formula.

AIG CEO Edward Liddy made it clear at the hearing on Wednesday that no performance bonuses were paid at AIG, either in 2008 or now.

The payments made were all in the form of "retention bonuses" as described above.

Mr. Liddy, however, made no real attempt to clarify the distinction between retention bonuses and performance bonuses.

This is understandable, of course, since Mr. Liddy was basically answering questions from his "new bosses."

We suspect, however, that few of the elected officials are actually interested in the distinction behind the type of AIG payments.

It's the Time of the Season

The timing of the payment of year-end "retention" bonuses is also fairly uniform among firms, although it does vary somewhat from firm to firm.

Most of the "retention bonus" arrangements are contractually obligated for completed year (in AIG's case, 2008), but are not actually paid until after March 1 of the subsequent year. (It is not clear whether AIG's retention bonuses had this common delay in their structure.)

What this means is that to actually receive the retention bonus due to them, an employee has to complete the entire year at the firm, and then still be employed on March 1.

What happens, then, is that Q1 is the great "musical chairs" season on Wall Street. Employees wanting to leave a firm begin looking for jobs in January and February, with a start date at the new firm after March 1.

This ensures that an employee actually gets his retention bonus, which he/she views as payment for work in the prior year, while still being able to change jobs.

While the full details of the AIG retention bonus plan have never been made public, we suspect that part of the timing of these payments is related to this.

The Bright Side

When the financial markets began to unravel last fall, we discussed our outlooks on the situation in our weekly conference meeting of all Briefing.com analysts.

At one of these meetings in November, we pondered the question of "when will this end?"

This question, at the time, was on everyone's mind, but it was difficult to see when. It was particularly important because the negative sentiment was dominating the market tone, with no fundamental data to cause any type of optimistic outlook.

Scott Smith, Briefing.com's Senior Technical Analyst, stated at one meeting "this won't end until someone goes to jail. We need a fall guy -- someone to take the rap."

The collapse of the internet bubble had Enron, with Ken Lay sentenced to prison.

The collapse of the savings-and-loans had Charles Keating.

The insider trading scandal of the early 1990s had Michael Milken, Ivan Boesky, and John Gutfreund.

Who is going to be tar-and-feathered this time?

It sure looks like Bernie Madoff will be the historically remembered figure, but he never participated in the housing market or took federal TARP funds.

For that aspect of the current crisis, it looks like the AIG employees who received "retention bonus" payments have been chosen.

We think it is fair to feel some empathy for these AIG employees, since their payments were actually part of their individually negotiated total pay for the whole of 2008. If AIG had filed for bankruptcy, these employment contracts would likely have been enforced, particularly if the filing occurred after Dec. 31, 2008.

After all, would you like a retroactive reduction in your salary -- meaning you have to write a check negating some salary you have already received -- extending back to the beginning of 2008? That is what the government action against the AIG retention bonuses amounts to.

But the overall contribution to market sentiment -- and public sentiment -- is likely to be very positive by the aggressive confiscation of these payments.

A purging of anger and resentment is usually required in order to move beyond a difficult period (as any married person well knows...).

If the AIG retention bonus serves that purpose, it may be a positive event for the market and the economy.

Comments may be e-mailed to the author, Robert V. Green, at rvgreen@briefing.com