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By Root 1065 0

get tripped up by the Halo Effect—as the current outrage over compensation in the financial industry exemplifies. The source of the outrage, remember, isn’t that bankers got paid lots of money—because we always knew that—but rather that they got paid lots of money for what now seems like disastrously bad performance. Without doubt there is something particularly galling about so-called pay for failure. But really it is just a symptom of a deeper problem with the whole notion of pay for performance—a problem that revolves around the Halo Effect. Consider, for example, all the financial-sector workers who qualified for large bonuses in 2009—the year after the crisis hit—because they made money for their employers. Did they deserve to be paid bonuses? After all, it wasn’t them who screwed up, so why should they be penalized for the foolish actions of other people? As one recipient of the AIG bonuses put it, “I earned that money, and I had nothing to do with all of the bad things that happened at AIG.”8 From a pragmatic perspective, moreover, it’s also entirely possible that if profit-generating employees aren’t compensated accordingly, they will leave for other firms, just as their bosses kept saying. As the same AIG employee pointed out, “They needed us to stay, because we were still making them lots of money, and we had the kind of business we could take to any competitor or, if they wanted, that we could wind down profitably.” This all sounds reasonable, but it could just be the Halo Effect again. Even as the media and the public revile one group of bankers—those who booked “bad” profits in the past—it still seems reasonable that bankers who make “good” profits deserve to be rewarded with bonuses. Yet for all we know, these two groups of bankers may be playing precisely the same game.

Imagine for a second the following thought experiment. Every year you flip a coin: If it comes up heads, you have a “good” year; and if it comes up tails, you have a “bad” year. Let’s assume that your bad years are really bad, meaning that you lose a ton of money for your employer, but that in your good years you earn an equally outsized profit. We’ll also adopt a fairly strict pay-for-performance model in which you get paid nothing in your bad years—no cheating, like guaranteed bonuses or repriced stock options allowed—but you receive a very generous bonus, say $10 million, in your good years. At first glance this arrangement seems fair—because you only get paid when you perform. But a second glance reveals that over the long run, the gains that you make for your employer are essentially canceled out by your losses; yet your compensation averages out at a very handsome $5 million per year. Presumably our friend at AIG doesn’t think that he’s flipping coins, and that my analogy is therefore fundamentally misconceived. He feels that his success is based on his skill, experience, and hard work, not luck, and that his colleagues committed errors of judgment that he has avoided. But of course, that’s precisely what his colleagues were saying a year or two earlier when they were booking those huge profits that turned out to be illusory. So why should we believe him now any more than we should have believed them? More to the point, is there a way to structure pay-for-performance schemes that only reward real performance?

One increasingly popular approach is to pay bonuses that are effectively withheld by the employer for a number of years. The idea is that if outcomes are really random in the sense of a simple coin toss, then basing compensation on multiyear performance ought to average out some of that randomness. For example, if I take a risky position in some asset whose value booms this year and tanks a year from now, and my bonus is based on my performance over a three-year period, I won’t receive any bonus at all. It’s a reasonable idea, but as the recent real estate bubble demonstrated, faulty assumptions can appear valid for years at a time. So although stretching out the vesting period diminishes the role of luck in determining outcomes,