The ex-CEO of CalPERS, Fred Buenrostro, has just pleaded guilty to accepting doucers, cash bribes and fees for placing investment business with a specific firm. The economic point that this helps us elucidate is why bankers and fund managers make such vast incomes normally. It's a concept called "efficiency wages". Essentially, when stripped right down, if people are handling or responsible for a large amount of money then pay them very well. So that it's not actually worth their trying to do anything naughty, the risk of losing that high income is greater than what they can gain by being naughty.
Here's the actual announcement of Buenrostro's plea:
Buenrostro is the former Chief Executive Officer (CEO) of the California Public Employee Retirement System (CalPERS). In pleading guilty, Buenrostro admitted to conspiring with Alfred J. Villalobos, founder and operator of ARVCO Capital Research LLC (ARVCO). Buenrostro acknowledged in court today that he understood that Villalobos operated ARVCO as a placement agent that solicited investments by public pension funds into private equity funds. Buenrostro also admitted that he understood that ARVCO was typically paid an agreed-upon fee based on the percentage of the total dollar amount invested by the public pension fund.
To put it simply (and do note that Villalobos has not been found guilty of anything at all as yet and is thus innocent of all charges) there's a layer of agents, or introducers, in the fund management industry. A pension fund, say, is looking around for where to invest, various fund management firms are looking for people to invest and those who introduce one to the other will get a (small) slice of the amount invested. The accusation is that Buenrostro favoured Villalobos in such allocations and then received various parcels of cash, had his wedding paid for etc. as a result. Again, note that Buenrostro has pleaded guilty, Villalobos is innocent.
So far so grubby: but this gives us an insight into why pay is so darn high right across the fund management and financial industry. Simply because these people are handling such vast amounts of money. There's therefore obviously a temptation to make off with some of that vast river of cash that flows through such offices.
As the excellent Falkenblog explains:
The reason we pay people a lot is because we think they are worth it. Many times they are not, but not always. A fund I know shut down one of its funds and people there basically gave away their positions before they left, making payments to the favor bank, for when they went to their new jobs. Why? They were told there would be no bonus, just exit your positions, and get your 1 month severance. A zero bonus is a horrible incentive structure for someone in charge of a portfolio, and it is not feasible to think your back office or audit group can monitor this. The portfolio managers know the best price, outsiders don't, that's why they get paid a lot. In the context of a moving market, and illiquid securities (such as mortgages), you don't really know how much money you are leaving on the table, but look at the incentives at the individual level, and expect people to act in their self interest.
We can look at the amount these people are making and shout "That's inefficient!". But when we think about how much it can cost us if they're not motivated to do the best they can for us then it might be more efficient to pay them those vast sums and not have them dealing inefficiently for us. Thus this idea of efficiency wages.
We don't actually know exactly what Buenrostro's pay packet was but we do have an indication from his successor:
A CalPERS spokesman in Sacramento said he wasn’t sure what Stausboll would earn as CEO, but that the job's annual salary range previously set by the fund’s board was $224,000 to $336,000. She also will be eligible for an annual bonus worth up to 40% of her base pay.
A third of a million is obviously pretty good pay for someone on the public dime, even in fund management. But compared to the wider industry averages it's a pittance:
Hedge fund professionals have seen higher compensation for the third consecutive year, with the average salary for an entry-level analyst at a mid-performing hedge fund totaling $335,000 in 2013, an industry report has found.
Portfolio managers at large hedge funds should also be grinning right now, given that average salaries have reached $2.2 million, the 2014 Glocap Hedge Fund Compensation report, released Thursday found.
Hedge fund management and pension fund management are not exactly the same thing, this is true, although they are close neighbours. And we should also note that CalPERS is one of the largest pension fund investors with some $260 billion under management. But if we take this idea of efficiency wages seriously then we might start to say that paying the CEO of one of the largest pensions funds less than the starting salary of a closely comparable job then we're not in fact being efficient about the wages being paid. For we want the salary and income of those handling those vast sums to be too high for them to consider damaging the investment performance of the fund in order to gain some increase to their own income.
This is of course a subset of the principal/agent problem. If someone's responsible for investing $260 billion then how do we make sure that they invest it to the benefit of the fund holders, the principals, rather than to the benefit of the manager, the agent? As with other finance industry professionals, as with other occupants of C suites around the country, one answer is to pay them in wages and salary more than they could be making from crooked dealings. It's therefore possible that very high wages, those millions of dollars a year, are in fact efficient wages.
Sadly, this is precisely the opposite of what CalPERS was doing around the turn of the century:
For two years running, the members of the board of the California Public Employees' Retirement System, the roughly $150 billion pension plan commonly called Calpers, have been at one another's throats.
The state controller, an elected official who serves on the board, successfully sued Calpers to limit its investment managers' pay -- a policy that recently helped prompt the fund's chief investment officer to quit.
How limited was that pay?
The latest sign of trouble at Calpers came two weeks ago, when Daniel Szentes, the chief investment officer, quit after only 15 months. He told the board that his resignation was prompted in part by a recent court ruling that would force Calpers to trim the salaries and bonuses of some of its investment managers, making it harder to recruit talent. Salaries range from $88,000 to $105,000, according to Calpers, a fraction of what many money managers make in private industry.
We cannot, of course, link those limits on pay directly to the Buenrostro events of a few years later. There are bad apples in any barrel and they don't have to be indicative of any larger trend; they can just be bad apples. But it is interesting that theory tells us that there could be a good case for very high salaries among those who manage money in order to deter little side deals that increase income. And that an organisation that deliberately and specifically paid well under market salaries found side deals going on.
To put the entire idea of efficiency wages into a nutshell: pay people enough that they're too scared to steal from you for fear of losing their well paid jobs. And the more money people handle the more that pay is going to have to be given that there's a great deal more they can steal. All of which is one explanation, perhaps not the complete one but at least part of it, why salaries in finance and fund management are so high: because Buenrostro.
