In defence of bonuses

Bonuses remain essential in attracting and retaining high productivity staff

THE return of bank bonuses has been met with incredulity and outrage from a public that has come to regard them as one of the major causes of a banking crash that triggered the still-ongoing recession.

For many within the public sector, where it is more usual to seek additional remuneration through promotion (achieved through hard work), this concept of reward-for-success remains puzzling. However, within the cloudy world of sales folk, bonuses are very much part of the culture.

This is because lower salaries are given, and the sales person is then given far more latitude on how much commission they can earn. For example, if a salesman sells £50k of photocopiers in a month’s then he (and it usually is a he) gets 5%, or £2.5k added to his salary. If, over the course of a year, the salesman sells £400k, then he might be rewarded with a bonus of 5%, or £20k.

Once basic salary and commission are added together, the remuneration package looks a lot more attractive. The total figure is often referred to as on target earnings (or OTE, in appointment sections).

If the salesman were to sell his entire company’s supply of photocopiers to a big customer with a good credit risk rating like the National Assembly, in a contract worth £10m over 10 years, he would earn £500,000 in addition to his £2k-a-month salary. He’s happy and his company is also happy.

But what happens if the photocopiers break down? If the Assembly sends in the lawyers to recoup the money they spent, and the salesman has already quit and bought his yacht, then the company finds itself caught on the horns of a costly dilemma. If the salesman was unscrupulous, he might have supplied cheaper, low-quality photocopiers, perhaps for £8m. He would earn less commission – £400k rather than £500k – but he would be more likely to win the deal. Initially, the Assembly gets it photocopiers at a 20% reduction. But it will get its money back. The salesman’s company can of course sue the supplier, but the commission has already been paid and it can’t be retrieved.

It’s a reasonably good way of demonstrating what has happened at the banks. If, for example, the value of houses had continued to rise forever, then selling mortgages would have formed a reliable source of revenue, as the money lent by the bank should have always been paid back. But when there was a drop or fall in house prices, and negative equity emerged, the banks faced losses. Once they had paid commission to sales staff, they found themselves in the same position as the photocopier company. In such circumstances, the critical element became the risk attached to the services or goods that were sold.

In the case of the banking crash, this rippled out across the world economy, for two reasons. Firstly, the mortgages the banks sold were sold again, on to other financial companies, effectively removing the risk from their own books and onto those of other businesses.

Secondly, there wasn’t a proper means of identifying the risk attached to those mortgages. When financial products are sold between banks, there is usually a quantified risk. As an example, the risk of my tiny flat in Columbo, in Mexico, being burgled is pretty high. So when Norwich Union insure it, this risk is reflected in high insurance costs. The financial world quantifies its risk by using a time-worn system of three letters. The best risk is AAA while the worst is DDD, and there are many others in between. So the risk of the UK treasury going bust is so small that it is quantified as AAA, along with many other national treasuries. Obviously, the chances of a government not being able to pay its bills seems remote, as it can raise taxes to meet its obligations. However, that wasn’t enough to prevent the Spanish and Irish governments’ credit ratings from being recently downgraded from AAA to ABB.

This quantifying is handled by a small number of companies throughout the world – and they got it wrong, spectacularly. They assessed that the risk of lending money to single unemployed mom in South Georgia was on a level close to a government’s. With hindsight it seems like madness, and the unravelling of how it came about still goes on.

But all of this doesn’t mean that the bonus or commission structure is too risky. Instead, it is the risk needs to be managed.

My personal experience of running a bonus scheme was far less nerve-shredding. My company had around 20 employees when we introduced the bonus scheme. Some of those staff played a key role in winning the sales contracts, while others had a role in producing the software, and others were responsible for working with the customers.

However, everyone received a cash bonus based on a percentage of the cash that the company received. For some of the more senior employees the percentage was higher. But it was the key that everyone was involved and part of their pay related directly to the success of the company. This success was based on the actual banked cash that the company received each month. If we had a bad month then everyone received a much lower amount. And, critically, in months where we had to pay a discount back to customers, because we had failed to deliver, this discount was removed from the commission, effectively giving a negative bonus. In theory, this meant employees paid the company, although in reality this never happened, because we spread these discounts over several months.

The effectiveness of these kinds of schemes clearly rests upon employees becoming committed to working hard to make customers happy, as one less-than-motivated member of staff can have an impact upon everyone’s earnings in a business.

One of the aspects of bonus culture that has drawn much adverse comment is the sheer scale of payouts that often seem incomprehensible. But the most important aspect of high pay lies in the huge difference in impact between average performance and the best performance of key individuals. As a consequence, most businesses believe bonus schemes are indispensable in attracting and retaining the very best staff, and getting the very best from them.

One of the more remarkable lessons that those who are not entrepreneurs take from Dragons Den is how much emphasis the investors place on the character, experience and background of the individuals. Often, this is more important than the idea or invention. This is an indication of how much effort good companies focus on the recruitment process, which is carried out to mitigate problems of individual low productivity outlined above.

A good recruitment process will begin with a filtering of CVs, followed by telephone interviews to identify candidates that don’t have the right skills. Then comes the traditional face-to-face interview. If the business is looking for a specialist, candidates may be asked to prove their skills through a practical test. For example, a software company may ask candidates to write some software. This is often done in intense conditions, in front of several members of the existing team, providing the added benefit of getting five or more different perspectives on any potential new employee.

Some companies go even further than this, giving any existing staff member that is part of the process a veto. Many employers, when faced with a mountain of CVs, may assume that the right candidate must exist someone in that pile. But finding the right candidate isn’t necessarily the same as finding the best candidate, and when you have an approved budget, pressures of backlog and a best candidate, that patience is a tough call.

Inevitably this protracted process can take a long time. But if a business is to go ahead with a bonus scheme, it must have in place the best conditions to make sure it works. It’s worth considering how many financial institutions, in the rush to make money, would have devoted so much time and energy to attracting the best candidates. Candidates who would have played their part in monitoring their bonus structures for evidence of abuse. Candidates who might have applied some common sense in making, buying and selling toxic mortgages.