19th January 2004

"The Achilles heel of the fund business"

By AMIN RAJAN

No cost model is worth the paper it is written on unless it attacks the unusual pay system that has long prevailed in most fund management houses on both sides of the Atlantic. Under it, basic pay rates are affected more by stock market indices than by the demand and supply forces in the labour market. Likewise, bonuses are determined more by funds under management than by investment performance. It is, then, a system bizarrely detached from economics.

As the chief executive of a large US house observed recently: "In a raging bull market, even a monkey could make money." Yet, few firms feel brave enough to change the system or to publicise their successes. Like the British House of Lords, the more the system changes, the more it looks the same.

Estimates produced within companies show that a more realistic remuneration system can produce cost savings that easily dwarf the gains from the biggest outsourcing deals. This is unsurprising, since cash pay typically accounts for more than 50 per cent of total operating costs.

To be fair, in the bear market, seven out of ten firms have reduced their total compensation, according to estimates produced by Create and KPMG, the professional services company. Detailed data provided by 30 significant firms show that the brunt of the decline has been borne by bonus. They also show that although the cyclical fall in the value of funds under management has been the prime driver in 75 per cent of firms, three other secular changes have been at work among 20 per cent of firms, with the rest doing nothing.

First, funds under management have been replaced by either individual or team or business performance as the principal criterion for determining the size of a bonus. In firms such as T Rowe Price and Capital International, the criterion is performance over more than one year.

Second, "golden handcuffs" - the legacy arrangements that guarantee bonuses year after year irrespective of investment performance, are being phased out or bought out with one-off cash payments.

Third, base pay has been frozen in the belief that it was set in very different market conditions. The aim is to ensure that henceforth performance-linked bonuses become a higher proportion of total rewards.

Although their incidence is relatively small, these secular changes command widespread interest, not least because of the "shareholder activism" role stipulated under the Higgs governance rules in the UK and the Sarbanes-Oxley Act in the US.

Among others, these require fund managers to stamp out "fat cat" remuneration practices in the boardrooms of companies in which they invest.

They cannot do this unless they set their own house in order first.

Of course, the recovery in markets in the last six months has eased cost pressures to the extent that the current interest in performance-based pay may be just a bungee jump: as investor greed fuels the markets, the old ways will become the norm again, so powerful is the magnetism of the past.

But the dominant view is that "business as usual" will be a recipe for disaster in what looks like a low nominal return environment. This is evidenced in the US and Europe by mounting interest in two areas: flexible rewards and equity stake.

It is increasingly recognised that factors that motivate people differ over their life cycle: help towards school fees may be valued more than medical insurance when an individual has a young family.

Furthermore, performance goals have to be seen as achievable. The Nobel Prize, for example, is only motivating for a small group of research scientists who feel that they can, in fact, win it. For others, it is not a factor, even though they would like to receive it. They need different carrots.

On the subject of ownership, the chief executive of a large French fund manager observed recently: "People want to have equity in the business that is closest to them. They want to be incentivised in relation to that aspect of the business over which they have direct control."

One approach now being tried out is worth mentioning. It involves creating mini-businesses centred on individual product lines and having them jointly owned by their managers and the parent company.

The trend towards specialist mandates is an important facilitator of such independently branded and owned businesses, buying support services from their parent company on a third party basis.

Early results show that such an ownership model is especially conducive to product innovation, cost control and entrepreneurial spirit.

It confirms the view that, in equities at least, size is the enemy of alpha and ways must be found to create a small-company craft mentality in the more rigid environment of a large company.

Amin Rajan is chief executive of Create, a research consultancy specialising in new business models in financial services: amin.rajan@create-research.co.uk.