What’s your bonus really worth?

By Hugo Dixon
July 1, 2010

By Hugo Dixon and George Hay

What’s a bonus really worth? Under new European rules, bankers will see part of their bonuses retained, another chunk deferred and some may also be clawed back. The present value of a $1 million bonus could be cut to less than $800,000, according to Reuters Breakingviews calculations.

The starting point is how much the banker gets immediately in cash. The new rules specify that 40-60 percent of the bonus must be deferred for three to five years and at least half of the non-deferred portion must be non-cash. That means there’s a maximum of 30 percent upfront cash. But for bankers on big bonuses — and $1 million would presumably be in that category — at least 60 percent must be deferred. The cap on upfront cash, therefore, is 20 percent, or $200,000.

The next step is to see how much cash the banker will get in future. For our big swinging dick, the deferred bonus is $600,000, of which as much as half, $300,000, can be paid in cash. This sum, though, has to be discounted to reflect the risk of a clawback for bad performance and the delay in receiving it. Assume there’s a 5 percent risk of clawback each year and take a 4 percent discount rate for the time value of money. Over a four-year period, that shrinks the banker’s $300,000 to $213,000.

Now look at the non-cash half of the bonus. The immediate portion, $200,000, will be paid in the form of contingent capital — a debt-like instrument that converts into equity in a crisis — which cannot be cashed in for an unspecified period. The deferred $300,000 is likely to come in the form of common shares.

Bankers are unlikely to find either form of non-cash terribly appealing. Not only is there the risk of loss; its value is much less certain than cash. Assume therefore that two discounts, each of 5 percent a year, are applied. If the contingent capital has to be held for two years, it is worth only $165,000. The shares, which are deferred for four years, have a present value of $205,000.

Tot it all up and the banker’s bonus has miraculously shrunk to only $783,000. Most ordinary people will still think that’s a lot. But bankers will undoubtedly feel hard done by.

EUROPEAN BANK BONUS CALCULATOR:

Pop in your expected headline bonus here, make some assumptions about how much will be non-cash, what proportion will be deferred and various discount rates. Our calculator works out the bonus’ real value to you.

Comments

“The present value of a $1 million bonus could be cut to less than $800,000, according to Reuters Breakingviews calculations.”

Oh poor soul. My heart bleeds for you.

Posted by doctorjay317 | Report as abusive
 

wow…its really needed in real life.

Posted by ckumzubair | Report as abusive
 

Bankers will merely up the base salaries… Restrictions on bonuses won’t stop them and I believe that we are all making a big mistake here. Sure they need to be controlled but forcing cuts in their pay will merely decrease the quality and motivation of their work and in turn, the rest of the economy.

Posted by civictyper | Report as abusive
 

HAH!

Austerity for bankers!

Posted by murfster | Report as abusive
 

Sounds good to me

Posted by edbel | Report as abusive
 

Bonuses are at the heart of the problem of over-risky investing on both sides of the Atlantic. The starting point is that the people making the investment decisions are using other people’s money. If they were trading for their own personal accounts, they would be internalizing all of the risks and their incentive to take either too much or too little risk would be minimized. They are not trading for their own personal accounts, however, and that means that the downside consequences are externalized. In other words, they do not suffer all of the consequences personally if they make bad investment decisions. With bonuses, however, the upside consequences are internalized, and quite probably magnified. In other words, they benefit if they make good investment decisions, and they probably benefit more than would have been the case if they were trading for their own account. This means that the current system of compensating investment decision-makers encourages risk-taking by rewarding the decision-makers for gains from risk while insulating the decision-makers from the consequences of losses from risk. Ideally, one solution would be to have a system where investment decision-makers are required to put up a bond from which trading losses may be subtracted, while at the same time positive compensation would be 100% in the form of bonus. The terms of the arrangement could be set to simulate, as nearly as possible, what the situation would be in investment decision-makers were trading solely for their own accounts.

Posted by Bob9999 | Report as abusive
 

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