2003: How does Berkshire compensate managers?

AUDIENCE MEMBER: Hello, my name is Martin Wiegand from Bethesda, Maryland. And first I’d like to thank you, and all the folks working here at the microphones and staffing the booths, for hosting this wonderful shareholders’ weekend. We enjoy your efforts. (Applause)

WARREN BUFFETT: Thanks, Martin.

AUDIENCE MEMBER: My question is about a company getting its employee compensation aligned with shareholder interest.

Charlie Munger, in one of his “Outstanding Investor Digest” interviews, cites the case of FedEx getting it right.

In the newspapers, we’ve all just read about American Airlines, Bethlehem Steel, and a lot of other companies getting it wrong. I find precious little written about compensation systems.

Would you share with us how you get it right at Berkshire companies?

Also, your old golf coach and racetrack friend, Bob Dwyer, asked me if you would like to share with us your pick in the Kentucky Derby. (Laughter)

WARREN BUFFETT: Is Bob back there with you, Martin?

AUDIENCE MEMBER: No, in the middle.

WARREN BUFFETT: Oh. Bob and I did spend a lot of time at the racetrack in high school. He was not only the basketball coach at Woodrow Wilson High, but he was also the golf coach.

And whenever I wanted to go the races he would write an excuse to my other teachers saying that we had to go out for the golf team. (Laughter)

And then we would head off to Charles Town, or Havre de Grace, or Pimlico or someplace.

And he cleaned up his act subsequently. (Laughter)

It’s good to have Bob with us. He was known for his famous three-iron shots. He was known as “Trolley Wire” Dwyer in those days.

18. “Crazy” to use stock options as compensation

WARREN BUFFETT: Charlie, do you want to talk about comp a little?

CHARLIE MUNGER: Well, as the shareholders know, our system is different from that of most big corporations. We think it’s less capricious.

The stock option system will give extraordinarily liberal awards sort of by accident to some people. And it’ll deny other people any reward at all at some different time, in spite of great contributions made by the people who are getting nothing.

So except where we inherit it, we just don’t use it. But we must be in a minority — far less than 1 percent, right?

WARREN BUFFETT: It’s where we like to be, right.

It’s interesting, we inherited some stock options at Berkshire, primarily in the General Re transaction. And, not through any failing of anybody or — there’s no aspersions to be cast at all, but those options turned out to be quite valuable.

They would not have been valuable if General Re had been left alone as a standalone company. They were — they profited from the fact that other parts of Berkshire did well, and the money went to the people that had these options who delivered nothing to the performance of Berkshire for a while.

Now, that’s — that is not an indictment of anybody, in the least, at Gen Re. It’s an indictment of an options system which represents a lottery ticket, and also a royalty on the passage of time.

Because as you know, an option holder has benefits from retained earnings and benefits not at all from dividends. And that puts his interest, maybe, quite contrary to that of the shareholders.

So we believe in paying for performance, but we believe in tying performance to what is actually under the reasonable control of the person that’s being measured.

And we — to give a lottery ticket on the overall results of Berkshire Hathaway to someone who is running a business that’s 1 percent of the whole is really crazy.

And I would say that you have seen probably more misdirected compensation throughout the corporate system — corporate America — in the last five years, you know, than in the hundred years before that. It’s been extraordinary.

There was wealth creation in the ’90s, just like in the ‘80s, in the ‘70s, in the ‘60s, in the ’50s. But there was a wealth transfer like had never been experienced before.

And, you know, you can’t blame people for wanting to cash in on it. You know, if anybody wants to walk up and hand me a half a dozen lottery tickets for the Nebraska lottery, you know, I’ll accept them. But it will have nothing to do with how I do in terms of running Berkshire.

Actually, Charlie and I think a properly designed options system, which includes cost of capital and some other factors, and ties it to the performance of the people involved, we think that can make sense, when we’ve used various incentive programs that are similar to that.

But the idea of just passing them out and telling people that for 10 years they get a free ride and then repricing — you know, if your stock goes down, their stock doesn’t go down, their option price goes down. You know, that is not our idea of a great compensation system.

CHARLIE MUNGER: Yeah, if we are right with our general approach, it has considerably important implications.

Because the natural implication is that more than 99 percent of corporate compensation systems are more than a little crazy in America.

And I want to emphasize that Berkshire is not illiberal. I mean, we’ve got various incentive systems out where people make tens of millions and may make hundreds of millions.

And so, we’re not against rewards for people who make vast contributions.

But a system that’s basically capricious, and which doesn’t tailor the results per person and per activity very well, we just think it’s crazy.

WARREN BUFFETT: We love to see people that are associated with Berkshire making money, as long as they’re making money for you at the same time. It’s very simple.

And — but we don’t want them to get a free ride off your money. (Applause)

Compensation’s an interesting subject and I’m going to write about it next year, some. But, you know, it’s not a market system. You can read all you want. I mean, you know, the PR people will tell you, you know, that “Joe Smith’s compensation was determined by a market system and he’s just like a baseball player,” anything of the sort.

But he’s not just like a baseball player. You know, the baseball player negotiates with somebody who’s spending his money to hire the baseball player, and making a calculation whether he’s better off laying out the money out of his own pocket — the owner of the team — to get that player.

But when you get a comp committee at a large American corporation, you have somebody with an enormous interest in the amount of comp on one side of the table.

And you’ve got somebody on the other side of the table, who was not picked because they were the Doberman of the board, believe me — and who is dealing with what — many times is what my friend, Tom Murphy, used to call “play money.”

I mean, you know, it’s almost meaningless to the person on one side of the table whether somebody gets 100,000 shares of restricted stock or a million shares of restricted stock, and it’s not meaningless to the guy on the other side of the table.

Almost every other negotiation in American business, you have some parity of concern. But you do not have a parity of concern, you know, in terms of the — in terms of comp at the top levels.

You have a parity of concern when you get down to labor unions. I mean, the management wants to keep down the prices and the union wants to get more money. And that’s a real negotiation.

And you have, you know, you have lots of other real negotiations in American business, but the compensation in many companies — not all, obviously — but in many, many companies has not been a real negotiation at all.

And the management has hired comp consultants to come in, and I have never seen a comp consultant come in and say, “We ought to reduce this guy’s salary.”

I’ve also never seen a comp consultant come in and say, “Why don’t you get rid of this bozo?” You know, I mean — (laughter) — they can’t all be wonderful.

But — you know, can you imagine a comp consultant doing that and ever getting another assignment? It wouldn’t happen.

So it’s a bad system, and it needs improvement. And it may be getting a little improvement. And as I wrote in the annual report this year, what happens with comp is the acid test of corporate reform.

Because frankly, the CEOs of America, they don’t care whether their boards are diverse, or not diverse, or anything of the sort. They care about how much money they make, in a great many cases.

And you, the owners, and big owners in particular, you know, have to provide some countervailing force, or you’ll have what you’ve had in the last 20 years, which is an enormous disparity in the rates of compensation of people at the top compared to people at the bottom.

And also a disconnect between the comp of people running businesses and the results of the owners who gave them the money. So arise, (inaudible) shareholder. (Applause)