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Are Bonuses Evil?

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Oh sure, there was plenty of outrage to go around when word got out that AIG had paid out $165 million in bonuses back in March after taking a $180 billion handout from the government, but it turns out that was just the beginning. New disclosures reveal the embattled insurer actually shelled out an additional $454.7 million in performance bonuses to employees last year.

Now, before everyone goes and brews a fresh pot of indignation, let's take a quick look at the logic behind "attaboy" compensation. Are bonuses inherently evil? Not necessarily, and not even usually.

In most industries, salaries tend to be fixed within a certain range. Imagine if workers' salaries fluctuated every year; it would be a logistical nightmare for employers and employees alike. Cash or stock bonuses are more flexible ways to give top employees their gold stars.

Manufacturing companies first hit on the idea of rewarding executives for performance in the 19th century, as America's Industrial Age was cranking itself up. Bethlehem Steel was one of the first titans to embrace bonuses; during that company's boom years, the compensation of its executives was legendary and occasionally record-breaking. Initially, bonuses were just for the head honchos, the guys (always men in those early years) who had drivers and their own bathrooms apart from the hoi polloi. Wal-Mart'sMarch announcement that it had distributed $933.6 million in bonuses to 1 million rank-and-file workers would have been unthinkable.

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The bonuses those early executives earned were based on the company's fortunes that year. Initially, there was no Six Sigma, no personal-growth benchmarks, and none of the other metrics modern companies use to measure performance. Rewards for meeting departmental or personal goals came along in the early 20th century. By the 1930s, the multi-tiered bonus structure we're familiar with today had taken hold.

Prior to the Great Depression, stock was the preferred method of rewarding corporate bonuses, until the market plummeted, which led to cash's ascendance. Today, companies employ a mix of both to keep worker bees motivated. Cash is more widely used as a reward for meeting short-term performance targets; stock options and grants are longer-term vehicles.

The glaring anomaly

The financial services industry is a glaring anomaly, though, when it comes to the size of bonuses. While many industries give out annual bonuses, workers in other parts of the economy receive bonuses that are a fraction of their salary, not multiple times the amount of their base pay. Why are financial services bonuses so outsized? Part of it has to do with competition. Ever-inflating performance and retention bonuses are a kind of human-resources arms race. Could it be argued that in high-stakes industries like financial services, it's necessary to throw piles of cash and stock options at the best and the brightest? Sure. Have those rewards gotten excessive over the years? Maybe, but no company is going to stick its neck out and try the equivalent of unilateral disarmament by scaling back.

The other driving force behind bonus inflation is cultural. Base salaries for most Wall Street types don't reflect the amount of dough they can earn for their company in a good year. Despite the current populist outrage, the underlying idea still makes sense: If I earn $10 million on behalf of my company, shouldn't I get a few bites of that pie? Of course, those with a slightly more nuanced sense of outrage may point out that some of the AIG employees receiving outsized bonuses turned out not to have earned all that money after all. This is the reason, along with Wall Street's perennial boogeyman of regulatory intervention, bonuses are likely going to look a little different going forward.

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Expect to see claw-back provisions, more officially known as executive compensation forfeiture, become more commonplace. The Sarbanes-Oxley Act of 2002 made claw-backs standard fare with regard to fraud; in other words, if you're cooking the books, you can't keep your bonus. Over the last few years, they have gained popularity as a performance-related stick to the bonus carrot, and that's only likely to increase in the future. In a more radical step, some companies may rethink the practice of contractually obligating themselves to pay bonuses.

What about retention bonuses, the source of much of the animosity directed toward AIG? On its surface, the idea of paying people simply to stay at their desks without any regard to what or how well they're doing seems counterintuitive. In some cases, a retention bonus might be a company's strategy for keeping a major player out of the hands of its competition. It's a tactic to keep key people around in a tight labor market. Today, Wall Street employers have already shed thousands of jobs. As the recession grinds on, it's likely that the number and size of retention bonuses will fade away on their own.

Explainer thanks Bruce Ellig, author of The Complete Guide to Executive Compensation, and Barry Gerhart of the University of Wisconsin-Madison.