The end of the bankers’ bonus cap – thoughts from new 3XO Principal, Stephen Forbes

Matt Sinnott’s recent article on the removal of the bonus cap in the UK (here if you missed it: The end of the bankers’ bonus cap: raising the ceiling, or lowering the floor?) got Stephen thinking about how companies might tackle the difficult topic of whether to rebalance back from fixed pay to variable pay for those staff that were previously subject to the cap.

My first thought was that many will do two things, which can be thought of as Stay compliant, Stay competitive:

1. Stay compliant: Ask the lawyers what is permissible within the legal and ongoing regulatory frameworks; 

2. Stay competitive: Find out what the competitors are doing to ensure continued alignment with the market. 

I don’t deny that these steps are important, but I would suggest that there are a few other things worth considering when making these big decisions:

i. The impact of any change on behaviours.  The rationale behind the bonus cap was around reducing behavioural risks created by incentives.  Each company should consider, with input from the Risk function, how a rebalance might impact that.  

If there is a rebalance from fixed pay to variable, there will be more variable pay available to take away in cases of bad behaviour or risk events for example (‘malus’ as it is called) – that might cause some to think twice about their behaviours before they act.  

However, when the bonus cap was in effect, staff typically received higher levels of fixed pay and lower bonus opportunities – meaning they had less potential bonus available in the first place (the intention being they wouldn’t take excessive risks or behave badly to get that larger bonus if it wasn’t available.)

The question is then:  which of these approaches is more likely to minimise risk to the company of a major incident and support a culture of positive behaviours?  Something of a behavioural economics question, but one that shouldn’t be ignored.

ii. How big are the benefits of rebalancing back into variable pay?

There are two sides to this I think – it should be considered at the individual level, as well as in aggregate.

At an individual level, it could be argued that under the bonus cap, some were overpaid while they underperformed, given high levels of fixed pay (as you can’t reduce fixed pay when performance is poor).  To test this, a very simple lens would be to consider previous years, and the number of zero bonuses paid out (particularly in bad years).  If there were not many zeros awarded where performance was poor at a business and/or individual level, even with higher levels of fixed pay, then lowering fixed pay would be unlikely to change things much, at an individual level. At an aggregate level, the argument is that there will be more control of profitability – that compensation costs will be more varied once more, in line with changes in revenues.  I think companies should take a critical look at what that might really mean for them – looking at prior years and modelling future scenarios, as well as considering the impact on KPIs such as cost:income ratios could provide valuable insight into whether any benefit is likely to be significant or not.

iii. Would a rebalance be perceived negatively and create issues with staff?

A pound of fixed and a pound of variable were often considered equivalent (1:1) when going from variable into fixed pay, but (as you might expect!) a perceived discount is likely to be applied going back from fixed pay into variable (fixed pay is almost certain, variable is certainly not).  This perception is likely to be heavily influenced by what the competition does.

iv. How will shareholders view any commensurate increase to the bonus pool, particularly if performance has been challenging?

Will any transfer create further difficulties for listed companies, where the disclosed bonus pool already comes under significant external scrutiny?  

For example, could it create potential difficulties at the AGM, where shareholders are unable to recognise the alignment between pay and performance given the added complexities of a rebalancing?

There are no doubt many other questions worth considering before making this pivotal decision.

Or of course there is always just: Stay compliant, Stay competitive!

If you would like to explore any of these questions further, please reach out either to me or one of the 3XO team.

Stephen Forbes, Principal 3XO