## This is compensation, it is also a game.

I wonder how compensation would be a different process if it was more strategic. The way it currently works is a number is handed down to someone senior. “Your division’s bonus pool is X, it is [up/down] Y%.” For this year, for example, securitized products might have had a bonus pool that was down 50-70%. So the person who gets this news then allocates two layers–the bonus pools for the groups that report to them are then allocated as well as the bonuses of the people who directly report to him/her are decided (as their bonus was most likely decided by the person who delivered the new size of the bonus pool).

There is an interesting subtlety. One doesn’t have any say in one’s own bonus–it comes from above. Common sense tells us that this is the correct and accurate way to do it, no? Well, let’s think about this for a second. What if a group of revenue generating employees was  grouped together, and given a bonus pool size. They were then told they had to agree and that someone above them would veto completely ridiculous allocations (“I’ll get all of it next year and none this year.” “I won’t agree to anything except 90% of the bonus pool.”).  What should happen? As with anything in finance, let’s make some assumptions:

• Dollars to allocate: \$1,000,000
• Revenue generated: \$10,000,000
• Number of people: 4
• Revenue generated by person: Person 1 (P1) generated \$2,000,000 in revenue, Person 2 (P2) generated \$1,000,000 in revenue, Person 3 (P3) generated \$5,000,000 in revenue, Person 4 (P4) generated \$2,000,000 in revenue.

Taking a simple approach, one might say that the correct way is to give each person the same percentage of the bonus as their percentage of the revenue they generated (e.g., P3 gets \$500,000 bonus dollars because P3 generated 50% [5,000,000/10,000,000] of the revenue).  If someone were to force an inequitable allocation then the person who was given less than their fair share could simply leave and get another job (it’s not uncommon for a bad pay year to drive a senior person to another firm). Also, the subtlety here is that the people deciding the bonus allocation here understand, fully, what each other’s true contributions are. If P1 and P4 work together then how they account for their respective contributions will most likely show a more nuanced understanding of their actual contributions versus their perceived contributions. Perhaps P1 and P4 had an arrangement where extra work will be shared, or perhaps P1 did 90% of the work on something and then handed it to P4, where the credit was then given to P4 for the entire amount of revenue generated. Is this more fair? Perhaps. I find it quite common that very senior people will set bonuses for people they interact with very little.

Obviously a solution like this is rife with issues, and I would never claim something like this should be implemented. It is, however, definitely instructive to think about the situation and wonder how it differs from the status quo. What extra infromation comes into play that doesn’t in the current system? What would the difference be in someone’s pay if this system was adopted? Why? Just a thought.

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### 2 Comments on “This is compensation, it is also a game.”

1. […] This is compensation, it is also a game […]

2. quantum probability Says:

Easy answer, dude. Raiffa-Kalai-Smorodinsky equilibrium. Or perhaps in finance, people are more “rational” and it would be the arg max of the Nash product of employees’ utility functions of bonuses.