10 September 2012

Despite Having Huge Salaries, Top Managers Have Immense Bonuses … It’s Not DESPITE; It’s BECAUSE! (4)

After the economic downturn in 2008 – 2009 it has come to public attention that top managers, particularly in the financial sector, have both huge salaries and immense bonuses. This was followed by a wave of public outrage and indignation. The wave even transformed into a protest movement that went against the top 1% of people who have huge income.

In this post, I will not focus on the public outrage, nor will I try to explain why top managers have bonuses. I guess that it is an old and in my opinion flawed way of reasoning that giving high financial incentives will increase someone’s job performance. If it works or not is still under debate.

What I want to focus on is the magnitude of both salaries and bonuses. Most people that are outraged by the immense bonuses that top managers get think something like: “What do they need bonuses for when they already have huge salaries. I have to work for half a year to earn what this guy makes in a week. What do they need the bonus for when they earn more than anyone could spend”.

Is this outrage justified? I guess so, especially when one was brought up in the philosophy of social equality. I guess that the source of outrage is not especially the absolute sum that top managers get, but rather that they screwed up.

Now, let’s leave the top management obscene bonuses and salaries and engage in what scientists call “Thought experiment”.

Imagine yourself in the following situation: you want to buy a nice new suit and go shopping. After exploring the options in the city center shopping area, you decide to buy a suit that costs 300 Euros. Just before you take it in your hands to go to the cash register, an alien drops out of the sky and sits on your shoulder. The alien tells you that exactly the same suit is on sale at the mall right outside town (30 minutes drive) for 240 Euros. What do you do?
Most people think something like this: “Saving 60 Euros out of 300 just for a half an hour drive, sure! Let’s go there!”

Now, forget everything about the suit and money. Clear your head and let’s do another thought experiment. Imagine that you want to buy a car. You’ve saved some money and decided to get a new car since the old one turned 20 last February. You go to a dealer in the East of the City and look at all those gorgeous pieces of technology. Yes you can imagine yourself driving casually in one of them on a sunny Sunday afternoon and the trunk is big enough to fit in all your (significant other’s) shopping bags.

You go to the sales agent (or consultant as they like to call themselves) and ask how much is the car that you so much can imagine it to be yours. The “consultant” that this is your lucky day because this week there is a Limited Offer and you can buy the car for ONLY 18.990 Euros (yes… psychological price and a lot of bull sh*t sales talk). In that moment a flash appears in the sky and an alien comes and sits on your shoulder. The alien tells you that exactly the same car you want to buy is available at a dealer in the south of the town (30 minutes drive) for 18.930 Euros. What do you do?

Most people think something like this: “What?!? I’m spending over 18.000 euros here and you expect me to drive for half an hour just to get a 60 Euros discount? No way! It’s not worth the effort.”

OK. Now, let’s cool down and breathe. In the first scenario, the alien brought super good news. Our shopper was happy to drive for half an hour to the mall outside town to buy the suit and save 60 Euros. “Man, 60 euros is not spare change!”. In the second scenario the alien was just annoying and really spoiled the magic moment of purchasing a car. How could have the alien suggested that is in any way rational to drive for half an hour just to save 60 Euros???

Again, let’s switch on reasoning. In both scenarios the buyer would have saved 60 Euros at the price of driving for 30 minutes. But in one scenario he was happy to do so, while in the second he was annoyed even by hearing the suggestion. Is this guy stupid or what? After all 60 Euros are 60 Euros and they can buy exactly the same things in either situation.

The key is in the (undiscounted) price of the purchase. In the first case, the guy was buying a 300 euros suit and 60 Euros is a lot when compared to 300. It’s 20%. Who in their right mind would not go to the cheaper shop? In the second case, the guy was buying a car priced at 18.990 Euros. Now 60 euros compared to 18.990 is virtually nothing, or at best some spare change. It’s just 0.3%, who cares about that?

Both rationales tend to make sense, but at the same time, they seem flawed. They make sense if we acknowledge that humans aren’t good at processing absolute values, but are OK processing relative values. It’s hard to understand what 60 Euros means in different contexts. In the “suit” context it means a nice “going out for pizza”, while in the “car” context it means “yeah… whatever”.

Going back to the top managers that have both huge salaries and immense bonuses, now we can better understand the correlation between the magnitude of both steady pay and incentive. If one has a salary of 1 million euros a bonus of 500.000 would mean a lot and in the unlikely case of bonuses actually increasing job performance it will motivate that person to do more. At the same time, if one has a salary of 10 million euros per year, of course a bonus of 500.000 would mean “nothing” and in order to motivate him or her, the bonus would need to be around 5 – 5.5 million.

You might wonder why I said 5-5.5 million. If the first guy gets 1 million and a 0.5 million bonus is good enough, it should be 10 times more if the salary is 10 times bigger. It’s not exactly like that. When talking about large values people don’t perceive differences proportional. Let me give an example. It is obvious that 10 is twice as big as 5. But when talking about 10 million light years the distance is not perceived as twice the distance of 5 million light years. It is perceived as less than double. This means that in order to motivate someone at the level of 5 million Euros, one would need to incentivize that person with slightly more than 5 million (maybe 5.5 million).

A very brief point on why are people outraged by the huge bonuses and salaries, is that they use their own reference points and not the super-rich manager’s reference point. Normal people think something like this “If I can make a living with 20.000 Euros per year, and I work my ass off, why do they need 20 million per year just to do their job?”. However, really rich people lost sense of the magnitude of money. Don’t worry, they also have shoes, but they simply don’t buy them from “Van Haren”, rather they buy from Versace. If you ask them if they believe that they are paid fairly, some of them would even say that they deserve a raise. As a friend of mine said: “you get used very easily and fast to the good life”.

To sum up, this is the basic explanation why people with huge salaries also have immense bonuses. It is not Despite they have huge salaries, it’s Because they have huge salaries that they need immense bonuses to get motivated.

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