Incentive Structures - Moral Hazard and Behavior

The problem with most institutional incentive structures, ie. those promulgated by major corporations, is they overemphasize increasing revenues and maximizing profit to the detriment of customer experience/service. The reason is, they already have the customers, they are now just milking them with sales and marketing gimmicks and internal employee incentives to achieve their goal of profit maximization.

At some point they will go too far. But because these organizations are so large, the cost (in fines) or damage to reputation are not sufficient for customers to move away (they already have them locked in and switching costs are high).

The other thing about the incentive plans is they are invariably unbelievably complicated. That is because, as with most things bureaucratic, they are heaping performance measures on performance measures (when new ones come along, they usually don't scrap the old ones), which will also ultimately be self-defeating due to their complexity. A structural issue which can effect employee morale is when incentives and bonuses are based on unrealistic goals, then either behavior becomes severely distorted (really leverage and exploit the client) or employees lose motivation. Both circumstances are bad and should be watched out for.

Fines are other penalties are just considered a cost of doing business.

If there are so many things wrong with these plans/structures, why don't companies reform them or change?

One reason is that they are the most effective way to exact more money out of clients. Another reason is that senior management is served by these and this effect with bigger bonuses.

One of the real problems is employees become demotivated and begin seeing the absurdity of the company and its business.

A Rough Estimate

At a pinch, I would guess that the financial services industry has spent more than $2 trillion dollars on information systems, computing power, and investment expertise over the last thirty years. The end result has been a net decline in alpha. Every penny spent has actually resulted in a net decrease in ability to produce above market results. Notch that up to the "paradox of skill."

What would be interesting also, is to gauge how much the industry has spent on sales and marketing. 

One day I am going to take a much closer look at these areas and get a better idea of the money spent (compared to the amount of value added for investors).

 

The State of Financial Consultant Direct Calls

Just received a call from a TD Ameritrade Consultant who had taken over my account (I didn't know I was part of someones book) from a guy who has moved on from TD...It was not particularly compelling.

She had recently come over from Schwab having been at Schwab for six years prior. Doesn't inspire confidence when you see the revolving door of financial consultants.

Several things she said left me incredulous:

• In the first instance she mentioned they were doing a sales promotion - ding! ding! ding! I don't like being sold to - that would reward me with $100 for every $25,000 I moved over (0.40% - you've got to be kidding me). 
• In the second instance she tried selling me on some management program (forget the name I have seen it advertised before) explaining how it uses independent research house Morningstar to construct portfolios from the best 37,000 mutual funds (emphasizing twice that 37,000 number to highlight how difficult it is to navigate the financial marketplace). I asked whether that included Schwab and Fidelity funds which she had dished previously as implying their programs were biased by including them, and she was not sure. And when I asked if any Fidelity and Schwab funds might rate well, she unbelievably said she didn't think so (remember, this is someone who has been selling Schwab funds for six years).
• She indicated the fees for the managed program ranged from 0.3%-1.25% with an average of 1%. Ouch. 1% for a little bit of automatic tax harvesting. That can't end well. 
• She spoke about Tony Robbins new book that raved about TD Ameritrade as though he were an authority upon the subject.

If that is the state of Fidelity, Schwab, TD Ameritrade direct sales then they really need to sharpen their pencils. They are in pole position with their existing clients and it really shouldn't take much to upsell additional services.