“Cheapest, say the prudent, is the dearest labor”

Ashby Monk

How can sovereign funds design an effective compensation plan that attracts, incents and retains the necessary human capital needed to run a modern financial institution? As I’ve said before, SWFs have to fill public sector jobs with individuals that can compete in and with the private sector. That’s no easy feat, which is why many C-level SWF execs have been searching around for innovative solutions to their compensation problems.

Interestingly, friend-of-the-show Keith Ambachtsheer (full disclosure: ‘funder-of-the-show’) has just published an interesting paper entitled “How Should Pension Funds Pay Their Own People?” And I’m really glad he did, as it’s a very useful starting point for anyone dealing with these human resources issues.

Keith starts his paper by noting that the modern compensation mantra is ‘pay-for-performance’. However, as Keith notes, the real difficulty with this approach is how you define the “performance” piece. He offers some interesting questions to guide one’s thinking:

“What is the relevant benchmark? Is it some absolute target rate of return or hurdle rate? If so, where does that return target come from? Alternatively, is the benchmark the return on an investment (or portfolio) that represents a reasonable alternative to the investment(s) actually made? If so, what is a good reasonableness test?

How to convert gross returns to net returns? The cost of investing can make or break any investment program. Thus understanding and measuring these costs is critical. They can range anywhere from a few basis points on a large, liquid, passively-managed securities portfolio to very high but hard to measure costs on outsourced hedge fund and private equity management mandates.

How to adjust net returns for risk? The search for the right prospective price of risk has been as elusive as the search for the Holy Grail. For example, the realized price of risk (as measured by the realized equity risk premium) has swung between +12% and -6% per annum for holding periods spanning 10-20 years. Some years ago, we floated the idea of using the cost of a put option that would eliminate the risk of a negative realized risk premium as a proxy for the price of risk; there were no takers for this idea.

How to pay for skill, rather than noise, and recognize and control the open-ended nature of option-like payoffs? Even well-intended compensation schemes can have unintended consequences. For example, the measured out-performance of a portfolio relative to a benchmark may be due to random (and hence reversible) events or measurement error rather than investment skill. As another example, asymmetrical performance-based compensation schemes with a downside floor and unlimited participation in upside participation induces excessive risk-taking and are inherently adversarial and unfair.”

In short, it’s really, really hard to define individual performance in a way that truly meets the needs of the institution. Given that the interests of the individual and the institution are inherently different — the former is short-term (0-4 years) while the latter is long-term (generational) — SWFs have an extremely difficult problem. And, to date, the ‘best solutions’ (e.g., smoothing performance compensation over 4 years) only partly align interests.

Perhaps this is why… (economists, ear muffs please) …I’ve heard some SWF professionals say that the “pay-for-performance” paradigm should be reconsidered in the context of an intergenerational investor. Why? Well, performance-based comp can create time-inconsistency and agency problems within their sovereign funds. One individual even said that s/he thought a better way to pay management would be to offer high base salaries with no (i.e., zero) performance pay linked to financial returns. The only performance-based comp should, instead, be a function of broader organizational objectives, such as training, governance, communications, management, etc.

Anyway, I tend to agree that divorcing compensation from financial returns would be quite an elegant way of incentivizing employees within these very long-term oriented funds. But, for now, it’s just pie-in-the-sky thinking. In reality… (economists, it’s safe to listen now) …most sovereign funds will have to come up with mechanisms to pay for performance, while also trying not to create the sorts of agency issues that can put individual behavior at odds with institutional objectives. And, in this regard, Keith’s paper is a really useful starting point. Download it here.

2 Responses to ““Cheapest, say the prudent, is the dearest labor””


  1. 1 William Scott May 19, 2011 at 11:53 pm

    I am reminded of a comment made to me by an experienced director when we were discussing remuneration for executives in an investee company… “If there was a formula that gave the right incentives for management under all conceivable outcomes, we wouldn’t need directors”. It was a reminder that in any complex multi-dimensional problem (like managing a large investment business) assessment of performance (and by extension remuneration) will need to be handled with qualitative holistic reasoning as well as objective, mathematical processes.

  2. 2 Ashby Monk May 20, 2011 at 9:13 am

    I think you’re right, Will. There has to be some qualitative assessment to go along with the quantitative. And good governance practices (and research) undoubtedly confirm the strategically important role of directors! Cheers! Ash


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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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