Monday, May 14, 2012

Asymmetric Risk Situations

These days, a good bit of my consulting practice is dedicated to defined benefit pensions and executive benefits and compensation. Over the last several days, in reading the news, it occurred to me the significant asymmetries in the two practice areas.

For those who have been living under a rock, certainly, at least in my opinion, the biggest business news has been the trading debacle at JPMorgan. Ina Drew, a long-time employee of JPMorgan who oversaw the trading unit is being held responsible. According to JPMorgan's proxy issued this spring, Ms. Drew earned approximately $14 million last year (frequent readers may know that the total annual compensation disclosed in a proxy may not be an excellent representation of the actual amount earned) making her, according to the proxy, the 4th highest compensated employee of the bank.

By all publicly available information that I could find, Ms. Drew has a reputation as being one of the best at her field. This from a Reuters article, "Until the loss was disclosed on Thursday, Drew was considered by some market participants as one of the best managers of balance sheet risks."

For full disclosure, I was once an employee of JPMorgan. I became one when my employer at the time was acquired by a JPMorgan unit. My employment there ended when the division of which I was a part was sold by the company. As a result of JPMorgan's incentive compensation plan which requires certain employees to defer parts of their incentive compensation ( the plan has previously been disclosed publicly), I have control of a relatively small number of shares of JPMorgan stock. This post is neither intended as approval nor condemnation of the company or its employees. JPMorgan happens to be in the news, currently, but on a different date, I could have chosen a different company.

So, where am I headed with this? Pension plans and individual (executive or commissioned) compensation represent entirely different risks. Each is asymmetric, but in opposite directions. So, this post is about behavioral risk management. It could easily be extended elsewhere, but I have no expertise in social psychology, for example (you may argue that I have none in the fields that I am writing about either, but I am going to defend that I have some, at the least).

Under current US pension law (see for example, Internal Revenue Code Sections 430 and 436), if we leave out transition rules and there are many, non-governmental qualified defined benefit plans typically get treated differently at funding levels of 60%, 80%, and 100%. Speaking in significant generalities, if your plan is less than 60% funded, there is not much that you can do with it. Participants generally cannot accrue new benefits, the plan sponsor can't improve the plan; essentially, all you can do is fund it, and the funding rules for plans less than 60% funded are pretty onerous (not judging the appropriateness of this part of the law here). Once a plan gets over 60% funded, but less than 80%, things get somewhat better. Restrictions are less. Between 80% and 100%, things are generally pretty uniform and a plan sponsor can operate on a normal ongoing basis, so to speak (this is not intended to be a course in pension funding law; it's illustrative). If your plan is better than 100% funded, it may be unusual these days, but funding gets easy. Note that there is no nice threshold in excess of 100%.

What does this tell us? If your plan is less than 60% funded, there are no more downside thresholds. The sponsor, oversimplifying significantly, has little downside risk. Between 60% and 100%, there is both upside reward and downside risk, and while they are not identical, there is certainly a degree of symmetry. Once your plan is better than 100% funded, there is almost no upside reward, but there is downside risk.

These risks and rewards should inform the asset allocation decisions. They should inform the fiduciary decisions and, in my experience, they often do.

Let's turn our discussion to compensation, specifically that of two types of individuals: 1) top executives whose incentive reward potential often dwarfs their base pay, and 2) commissioned salespeople whose commissions have the potential to exceed their base pay or are their entire compensation.

Here are some facts about the compensation of many of the people in both of those groups:

  • There is little, if anything, that applies in practice that limits the upside of their incentive compensation. Even to the extent that it is limited, those limits are very rarely reached. (Some plans are not designed this way, but many are.)
  • Unless a plan has clawbacks (a means for recovery of compensation for various reasons, often related to fraud or other criminal activity), employees don't receive a negative bonus. At least, I have never seen it.
In the context that we used for pensions, there is plenty of upside reward potential, but there is little downside risk. Suppose I am a commissioned salesman. Further suppose that my compensation is entirely based on a percentage, 3% for example, of my sales. The smallest that my compensation can be is $0. I cannot sell less than nothing. The most that my compensation can be is 3% of infinity. That's a big number. I have an incentive to take risks. 

In their best-selling book, Freakonomics, authors Levitt and Dubner discuss this in the context of real estate agents (excerpts can be found here). Oversimplifying, a real estate agent can sell two types of homes: someone else's or their own. When selling someone their own home, an agent has an incentive to sell for the highest price. For each additional dollar of sales price, the agent receives nearly 100 cents (their broker and the agent on the other side each receive something). When selling a client's home, out of every additional dollar of sales price, the agent gets about 3 cents. According to Levitt and Dubner (and I agree), the agent selling your home has an incentive to get sell your home quickly. If they can get an additional $300 for getting you an extra $10,000 in sales price, the system motivates them not to do it because $300 doesn't mean anywhere near as much to them as $10,000 does to you. Speed is more important. But, if they are selling their own home, that $10,000 represents more than $300,000 in sales of other people's homes. If they can afford to, that system motivates them to hold out for more.

Executive compensation is not quite the same. But, often, it's closer to the real estate agent model. Incentive payouts for many CEOs and their direct reports is discretionary. It may have theoretical limits, but according to dozens of proxies that I have examined (you can get proxies at the SEC website),an executive who has a fantastic year may have their compensation exceed even the upper limits specified in a plan. Upper limits are often more than twice a target. The incentive is there to take risk. 

Why do people play the lottery? It's a losing proposition ... for all except the winners. The upside is huge, however. But, it's a game of chance. You know that going in. And, if you play, you are willing to risk some amount for a huge potential upside. 

Should you treat your pension plan as a game of chance? I don't think so. The system has been set up against it. The system has rules and those rules should, in my opinion, inform your behavior. Whether the current system is the correct one is irrelevant. It is the current system.

Should your executive compensation program be a game of chance? Should it contain asymmetric incentives? When I am a shareholder with an opportunity to vote my shares, my bias is against it. I prefer the companies of which I am an owner to not take inappropriate risks. It's human nature. Even for an incredibly ethical person, incentives matter. If you give me an asymmetric bet, and that bet is in my favor, if I use the logical part of my brain only, I should take it. We would like executives to use logic.

When we give them an asymmetric risk opportunity, are we not asking them to take perhaps inappropriate risks? Are they risks that you wouldn't take in your pension plan?

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