Bonus baby.

Photographer: Victor J. Blue-Getty

Wall Street Bonuses Actually Make Sense

Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”
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I come not to bury bonuses, but to praise them.

Yesterday the New York State Office of the Comptroller released its annual report. The report is chock full of great tables and charts (see this, this, and this). The key takeaways include these data points:

• The bonus pool for securities industry employees who work in New York City grew by 3 percent to $28.5 billion in 2014.

• The average bonus rose by 2 percent to $172,860 in 2014, the highest level since the financial crisis. 

• The securities industry added 2,300 jobs in New York City in 2014, after years of downsizing.

• The cost of legal settlements related to the 2008 financial crisis continues to be a drag on Wall Street profits.

Two factors have made Wall Street bonuses a contentious issue: The size of the payouts, and that they were awarded in so many companies that had been bailed out.

I have been highly critical of both Wall Street and the bailout of banks during the crisis. However, it's important to distinguish how Wall Street's rank and file employees are compensated from what senior management “got away with.” Most professionals understand this difference intuitively, but much of the public and many elected representatives do not. They view enormous bonuses as a sign of excess or corruption.

QuickTake Banker Bonuses

As a denizen of the Street for a few decades, I've received bonuses big and small. The bonus structure on Wall Street serves three primary purposes:

- As a recruitment and retention tool in a competitive marketplace;

- As a form of risk management against losses;

- As compensation.

The first is obvious: If you want to hire talented (revenue-producing) bankers, traders, analysts and the like, you have to compete against other firms trying to hire the same talent. Hence, a simple calculation determines what sum is worth paying these people while still enabling you to make money on their labor. That's how a competitive marketplace works. It’s why the Cleveland Cavaliers pay LeBron James more than $20 million a year. If they didn’t, someone else would.

I know people in sales whose bonuses equal 300, 500, even 1000 percent of their base salary. Their base pay is low, so they are highly incentivized to bring in more business.

Imagine if LeBron were paid only $250,000 a year in salary, but received additional monthly compensation for every rebound, point, assist and block. Next, he gets a quarterly bonus based on how many games the Cavs win. On top of that, he garners more bonus money based on how profitable the Cavs are from ticket sales, merchandise, television and other revenue streams. A sweetener is added for playoff victories and the NBA Finals.

That’s not too different from Wall Street's bonus structure, except no one there gets paid for dunks.

Some firms have used the bonus structure as a way to discourage skilled employees from leaving. They defer compensation, including holding commissions for two or even three years. Stock options vest over time, so that employees who bolt lose the unvested portion. Holiday bonuses seem to get pushed further back each year, with many firms paying them long after Christmas -- even as late as February. (“Here's your Christmas bonus -- Happy Groundhog Day,” is as annoying as it sounds.)

The risk management aspect of compensation is also fairly obvious. Trading losses are an omnipresent possibility, litigation is not unheard of and lots of other actions might produce large losses. Withholding a substantial chunk of what would otherwise be monthly compensation (in the form of commissions or trading profits) gives an employee the incentive to keep on the straight and narrow and gives banks a cash cushion in the event things go south.

In reality, what most professions treat as a discretionary annual bonus is, on Wall Street, merely deferred compensation. That's how employees who are compensated based on commissions, trading gains or executed deals actually receive their pay.

Now compare this compensation system with the ill-gotten gains by senior executives who helped drive their firms into crisis: Dick Fuld at Lehman Brothers, Stan O’Neal at Merrill Lynch, Joseph Cassano at AIG Financial Products and too many to mention at Citi. These folks all walked away with tens of millions of dollars after not doing their jobs properly.

Critics of Wall Street bonuses should understand the difference between the system that rewards rank and file employees, and the one that rewards senior management. They are worlds apart.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Barry L Ritholtz at britholtz3@bloomberg.net

To contact the editor on this story:
Francis Wilkinson at fwilkinson1@bloomberg.net