This is my first post in response to a posted question. Does this mean my blog has grown from its infancy into toddler-hood?
In a comment to my posting about Capital Requirements, JD asked for my thoughts about employee salary structure and the public backlash to AIG paying bonuses with government bailout money.
This is a politically charged topic and the details of the AIG mess are still surfacing, so I'm wading into murky waters on this one. I'm going to start by describing how I think salaries should work, in general, and we'll see if I can answer JD's question without offending anyone.
In much of the private sector, an employee's main monetary compensation is based on three sources: salary (the weekly paycheck), profit sharing (the company does well and you get a piece), and an individual performance bonus (you do well as an individual and you get some extra). These should all be spelled out in an employment contract and have as many measurable benchmarks as possible to determine the amounts paid. Let's talk about each source.
Salary should be static and the company should pay it without issue as long as you don't violate your contract. Doing a crappy job doesn't merit docking this pay. In most cases, the only out a company has on this one is to fire you. This pay is usually transferred in the form of weekly, biweekly, semimonthly, or monthly pay checks.
Profit sharing is based on how the whole company is doing. As the name implies, the company is sharing some of the profits with you. This payment is not directly related to your performance. You could do a great job or a horrible job, but all that matters is how the whole company did. Imagine you are a salesperson at GE in the jet engine division. Your sales are way down, because the recession is hurting the airlines and that means the airlines don't want to buy new airplanes. Meanwhile, the microwave division has been doing really well as people eat in more to save money. If GE were just composed of those two divisions and microwave's successes outweighed jet engine's failures, GE would make a profit and ALL the employees would get a profit sharing check.
Individual performance bonuses are dependent upon your personal performance in your job. When designed and funded well, these are independent of company profits and other things you cannot directly control as an employee. How efficient you are, your sales numbers, how well you work with your colleagues, and finishing projects ahead of due dates are examples of qualities that may merit a bonus of this type. This bonus shouldn't have an automatic minimum, but there should be an amount awarded for just "doing your job." It doesn't need to be much, but having this base floor allows an employer to withhold money to punish you for screwing up without having to resort to drastic measures like firing you. Remember, they have to pay your salary and profit sharing, despite your performance, unless they want to fire you. If you do your assigned job (or better), you should get this bonus even if the company is doing horribly and getting taken over by the government.
That is how those terms are defined objectively, but companies often setup reimbursement practices that meld different aspects of those together and call them bonuses. Some companies always give their employees a "Holiday Bonus" except when the company is failing or a particular employee screws up. This is profit sharing with a withholding option for bad employees.
AIG claims to have contractually obligated Retention Bonuses that it had to pay to its employees, even the ones that caused all the trouble the company is dealing with. These aren't bonuses, they are salary. If the company is obligated to pay despite employee or company performance, then it must be salary. If that is the way the AIG contracts were written, we need to honor those contracts, but don't call them bonuses. It's a misnomer.
That said, AIG had more options than they often talk about. Again, these are Retention Bonuses. AIG was contractually obligated to pay them if they wanted to sign these employees on for another year of employment. These sorts of salary devices are used to keep your employees from quiting and going to work for a competitor. The question is, why would AIG think that they needed to do this? In this employment environment, there aren't any jobs for those employees to go take if they did quit AIG. AIG could have said, "We are happy to have you work here for another year, but we are going to renegotiate your contract to remove the Retention Bonus. Quit if you like." Plus, there are plenty of people willing to take the AIG jobs if the current employees did quit. I know a about 40 Boston College MSF students who are graduating this summer and looking for work in Finance. Call us.
Wednesday, March 25, 2009
Monday, March 16, 2009
Capital Requirements
I was driving home from class tonight and heard part of an episode of Fresh Air on NPR. Terry Gross was interviewing a journalist from The New York Times about AIG. They were going through the notable topics of the nice ride that AIG has given us around the block, how much they paid the drivers, how much change is falling out of our pockets into the back seat, and so on.
Anyway, the guest used the term "Capital Requirements" a number of times. Lots of other media folks use it too, but I'm not confident many people know what that means.
A little setup:
The US government lends money directly to private banks. Other countries do it too and it happens every day, not just in times like now. I'll explain how that all works another day. Banks generally take this money and lend it to other banks. Banks also borrow from other folks (your savings account) and lend it to others (your brother's car loan). This is a big way that banks make money: borrow money from someone at one rate and lend it out someone else at a higher rate.
Another setup point:
These banks are somewhat protected by the same government that lends cheap money to them. At the very least, their depositors (you and your checking/savings/CD account) are protected through the FDIC if the bank goes bankrupt. They might also be deemed "too big to fail," which has other protections that are harder to specify.
Now, imagine you decide to go start one of these banks. You set up shop, borrow money from the government, lend it out to your brother and his friends, and take a tidy profit home every night. Think about this for a minute and you will probably start doing it more and more. All you need is some cash to run the office and do marketing, and you can ride the borrow-lend-profit train all the way home. Not only that, but if things go badly for your bank (your brother's friends are deadbeats) you can just close up shop and let the government take on the losses. You lose the bit of cash you were using to pay your expenses, but you can go start another bank tomorrow with the rest of your money.
The government can see this plan as clearly as we can, so they protect against that. They require that banks put a few cents in the game for every dollar that is lent. The number of cents changes, depending on the bank, the type of lending it is doing, the economy, politics, etc. This helps to make the incentives right. If a bank has to put $10 million of its own money on the line to borrow $90 million from the government, the bank won't just lend out the $100 million willynilly. It will try to make good and profitable loans, because it knows that it will lose its $10 million if things go bad. In fact, that $10 million is supposed to be the first money that is lost when things go wrong.
Those cents are the "equity" and the dollar borrowed is a "liability." These are both parts of the capital structure of the bank, which is why these are called Capital Requirements.
If you've bought a house with a mortgage, this probably sounds familiar to you. Your down payment was a capital requirement. That hard earned cash in your house is one of many things that motivates you to keep the building and property in good shape, because if you sell the house for less than you bought it you will be the one to take the first loss.
Anyway, the guest used the term "Capital Requirements" a number of times. Lots of other media folks use it too, but I'm not confident many people know what that means.
A little setup:
The US government lends money directly to private banks. Other countries do it too and it happens every day, not just in times like now. I'll explain how that all works another day. Banks generally take this money and lend it to other banks. Banks also borrow from other folks (your savings account) and lend it to others (your brother's car loan). This is a big way that banks make money: borrow money from someone at one rate and lend it out someone else at a higher rate.
Another setup point:
These banks are somewhat protected by the same government that lends cheap money to them. At the very least, their depositors (you and your checking/savings/CD account) are protected through the FDIC if the bank goes bankrupt. They might also be deemed "too big to fail," which has other protections that are harder to specify.
Now, imagine you decide to go start one of these banks. You set up shop, borrow money from the government, lend it out to your brother and his friends, and take a tidy profit home every night. Think about this for a minute and you will probably start doing it more and more. All you need is some cash to run the office and do marketing, and you can ride the borrow-lend-profit train all the way home. Not only that, but if things go badly for your bank (your brother's friends are deadbeats) you can just close up shop and let the government take on the losses. You lose the bit of cash you were using to pay your expenses, but you can go start another bank tomorrow with the rest of your money.
The government can see this plan as clearly as we can, so they protect against that. They require that banks put a few cents in the game for every dollar that is lent. The number of cents changes, depending on the bank, the type of lending it is doing, the economy, politics, etc. This helps to make the incentives right. If a bank has to put $10 million of its own money on the line to borrow $90 million from the government, the bank won't just lend out the $100 million willynilly. It will try to make good and profitable loans, because it knows that it will lose its $10 million if things go bad. In fact, that $10 million is supposed to be the first money that is lost when things go wrong.
Those cents are the "equity" and the dollar borrowed is a "liability." These are both parts of the capital structure of the bank, which is why these are called Capital Requirements.
If you've bought a house with a mortgage, this probably sounds familiar to you. Your down payment was a capital requirement. That hard earned cash in your house is one of many things that motivates you to keep the building and property in good shape, because if you sell the house for less than you bought it you will be the one to take the first loss.
Sunday, March 15, 2009
Saving
For almost all topics of personal finance, I think that general advice given to a group of people is unwise. Every person has different financial needs, abilities, risk tolerances, etc. Successful finance requires individual thought, analysis, understanding of the system, and some work. Nothing worth having is free, right?
One exception to this rule, though, is my advice about saving. Everyone should save, all the time. Not only when you get a raise, not only when your grandmother gives you gift, not only when you get a tax refund, ALL THE TIME.
Saving is the best kind of insurance you can have. You give up a little bit every month to build a safety net when something goes wrong. Not only do you have that buffer from financial hardship, but if you are lucky enough to get through ten years of your life without having to use your savings, you have a nest egg that can help buy your first home or get transferred toward your retirement savings.
For those of us who do have something go wrong, savings allow us to weather the storm without relying on potentially hazardous (and more expensive) financial tools like credit cards, second mortgages, and loans from family or friends.
So how do you save easily? First, go get your last pay stub. Right now, go get it. Look for the number that represents your pay before taxes and other deductions. Multiply that number by 0.1 or 10%. You should save at least that much of every paycheck.
You should consider this as important as paying your rent or mortgage. Make the life changes necessary to make this work. If you can afford to save more than 10%, then do it. Your future self will thank you for it. I know it will be painful, but you'll get used to it. Imagine if you had just gotten paid 10% less for the last 5 years. I bet you would have made it work.
So why weren't you doing this already? Americans used to, and other cultures still do. I think the credit revolution of the 20th century allowed us to slack on this one, and we found that temptation too alluring. I'm not dissing credit, it is a very useful tool, but access to credit is not the same as having savings.
The saving habit starts early in life. When your parents gave you that first 50 cent allowance, you should have asked for it in nickles so you could put one of them in a steel-hardened piggy bank. Think about this with your kids, students, and self.
One exception to this rule, though, is my advice about saving. Everyone should save, all the time. Not only when you get a raise, not only when your grandmother gives you gift, not only when you get a tax refund, ALL THE TIME.
Saving is the best kind of insurance you can have. You give up a little bit every month to build a safety net when something goes wrong. Not only do you have that buffer from financial hardship, but if you are lucky enough to get through ten years of your life without having to use your savings, you have a nest egg that can help buy your first home or get transferred toward your retirement savings.
For those of us who do have something go wrong, savings allow us to weather the storm without relying on potentially hazardous (and more expensive) financial tools like credit cards, second mortgages, and loans from family or friends.
So how do you save easily? First, go get your last pay stub. Right now, go get it. Look for the number that represents your pay before taxes and other deductions. Multiply that number by 0.1 or 10%. You should save at least that much of every paycheck.
You should consider this as important as paying your rent or mortgage. Make the life changes necessary to make this work. If you can afford to save more than 10%, then do it. Your future self will thank you for it. I know it will be painful, but you'll get used to it. Imagine if you had just gotten paid 10% less for the last 5 years. I bet you would have made it work.
So why weren't you doing this already? Americans used to, and other cultures still do. I think the credit revolution of the 20th century allowed us to slack on this one, and we found that temptation too alluring. I'm not dissing credit, it is a very useful tool, but access to credit is not the same as having savings.
The saving habit starts early in life. When your parents gave you that first 50 cent allowance, you should have asked for it in nickles so you could put one of them in a steel-hardened piggy bank. Think about this with your kids, students, and self.
Tuesday, March 10, 2009
Basics Terms in Retirement Investment Planning
If you have spent any time thinking about investing or building a retirement savings, you've probably heard a lot of different terms related to the subjects. I notice that people often confuse the investment options with tax options involved with retirement investment.
This is a huge topic, and I'm not going to be able to describe it all in one posting. Instead, today I will explain the difference between an investment vehicle and a tax shelter (in relation to retirement planning). I plan to explain more details later; let me know if you want me to cover certain things sooner than others.
An investment vehicle or asset is an item you pay for with the hopes of getting more money later. Examples include stocks, bonds, CDs, options, futures, mutual funds, etc. If you don't know what those are, we'll talk about that later. In fact, I think we'll get into what stocks are soon.
A tax shelter is an account that is given specific tax breaks by the government. Retirment examples include IRA, Roth IRA, 401k, and 403b. Any number of investments can be inside one of these tax shelters.
The big take away here is that a tax shelter is NOT an investment. Just putting money into your IRA isn't enough. You also have to invest it in something, like a mutual fund or a CD.
This is a huge topic, and I'm not going to be able to describe it all in one posting. Instead, today I will explain the difference between an investment vehicle and a tax shelter (in relation to retirement planning). I plan to explain more details later; let me know if you want me to cover certain things sooner than others.
An investment vehicle or asset is an item you pay for with the hopes of getting more money later. Examples include stocks, bonds, CDs, options, futures, mutual funds, etc. If you don't know what those are, we'll talk about that later. In fact, I think we'll get into what stocks are soon.
A tax shelter is an account that is given specific tax breaks by the government. Retirment examples include IRA, Roth IRA, 401k, and 403b. Any number of investments can be inside one of these tax shelters.
The big take away here is that a tax shelter is NOT an investment. Just putting money into your IRA isn't enough. You also have to invest it in something, like a mutual fund or a CD.
Wednesday, March 4, 2009
The Two Flavors of Finance
There are two general areas of Finance: Asset Management and Corporate Finance.
Asset Management is named well. It involves the allocation and investment (management) of stocks, bonds, dollars, euros, gold, commodities, real estate, etc. (assets). People who work at brokerages, mutual funds, hedge funds, stock exchanges, endowments, etc. are doing Asset Management work. This is what I want to do with my career.
Corporate Finance is all about finding money for your company. This happens at all companies, not just financial firms. I'll explain with an example: SOL Inc. wants to build a new solar panel factory, but they don't have the cash to pay for it right now. Their Corporate Finance folks will figure out the best way to get the money to build the factory. They might get a loan from a bank, sell bonds, sell stock, etc. Each of these options has different pros and cons, which will be different for each firm, which is why different firms have their own finance professionals on staff. This staff is often led by the CFO (Chief Financial Officer).
Asset Management is named well. It involves the allocation and investment (management) of stocks, bonds, dollars, euros, gold, commodities, real estate, etc. (assets). People who work at brokerages, mutual funds, hedge funds, stock exchanges, endowments, etc. are doing Asset Management work. This is what I want to do with my career.
Corporate Finance is all about finding money for your company. This happens at all companies, not just financial firms. I'll explain with an example: SOL Inc. wants to build a new solar panel factory, but they don't have the cash to pay for it right now. Their Corporate Finance folks will figure out the best way to get the money to build the factory. They might get a loan from a bank, sell bonds, sell stock, etc. Each of these options has different pros and cons, which will be different for each firm, which is why different firms have their own finance professionals on staff. This staff is often led by the CFO (Chief Financial Officer).
Tuesday, March 3, 2009
Getting Started
I have set up this blog to discuss issues of finance and economics as they apply to all people. If the current crisis has taught us anything, ALL issues of finance apply to all people. So, there is a lot to discuss.
I often have friends asking me to explain finance stuff, and I am usually able to do so successfully with enough time. This blog allows folks to get some answers without being forced to listen to me blabber for 10+ minutes.
Although I think I know more than the average citizen when it comes to this stuff, I am not an authoritative source. Some may disagree with my thoughts and answers to questions. I welcome suggestions, corrections, and even spirited debate.
Most of all, I ask for questions. They will be the driving force of this blog.
Future posts could get long, so I'll keep this one short. Thanks for reading!
I often have friends asking me to explain finance stuff, and I am usually able to do so successfully with enough time. This blog allows folks to get some answers without being forced to listen to me blabber for 10+ minutes.
Although I think I know more than the average citizen when it comes to this stuff, I am not an authoritative source. Some may disagree with my thoughts and answers to questions. I welcome suggestions, corrections, and even spirited debate.
Most of all, I ask for questions. They will be the driving force of this blog.
Future posts could get long, so I'll keep this one short. Thanks for reading!
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