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How Aligned Interests Can Lead to Perverse Incentives

What does working as a lowly private detective have to do with how investors should pay their managers? Three words: alignment of interests.

I spent some years in my early 20s enamored of the idea of a career in law enforcement, working several jobs in private security and investigations. I was briefly a licensed private detective in Illinois, determined to catch the bad guys — or, failing that, at least help the system process some of the less-than-perfect ones.

Thankfully, life experiences quickly disabused me of this fanciful notion.

One night in particular stands out. I was serving a summons at around 10:00 in a tough neighborhood to a gentleman in the top-floor apartment of a tiny, three-story walk-up. As the door opened I was struck by two nearly instantaneous realizations. The first was that there were two enormous pit bulls, focused intently on me, standing directly behind the heavily muscled man. Second, in the cramped hallway there was nowhere for me to go other than over the railing and straight down.

Fortunately, this massive man and his colossal canine companions were friendly, but the knowledge that most of the people I met in that role were not left me uneasy. I calculated that the risk — in Illinois, private detectives, unlike licensed private investigators, were unarmed — could not be justified by the meager returns. It just wasn’t worth it.

You see, process servers were required to positively identify the defendant before serving the papers. Failing that, the documents could be left at the place of residence or work, if it could be affirmatively determined that the defendant still lived or worked there. If the process server could not ascertain this, the documents could not be served. And if they were not served, the process server could not collect the $6 fee.

I had spent many days driving from one location to another, stubbornly refusing to fail my employer or the defendant, but also realizing I was burning more in gas money than I was actually earning. After a few more frustrating, 12-hour days driving around DuPage County searching for a defendant, but all too often finding none, I finally turned to the most successful detective at the firm, hoping to learn his secrets.

What was his magic formula? How did he manage to locate and serve so many more cases than I did?

The dirty secret was he didn’t. He made one attempt per defendant, at most, and if the individual wasn’t at the location, he simply dumped the documents and reported it closed. He pocketed the $6 and moved on to the next.

No wonder he was cranking out 20-plus a day in only six hours, and I was grinding through double shifts to close out three or four cases, if I was lucky.

Adulthood’s first massive perverse incentive hit me smack in the face (as did a sudden awareness of why none of the “guests” on the TV show Cops ever seemed to have a clue regarding their outstanding legal issues). The system paid the least diligent individuals the best, and the most ethical and committed individuals the worst. While a painful lesson at the time, it was a valuable one nonetheless.

It boils down to this: Alignment of interest in your compensation structure matters. A lot.

Like most mammals, humans have a highly predictable tendency to do more of what they are rewarded for doing and less of what they are punished for doing. If you pay people to punch a clock, they’ll punch a clock. If you pay them to sit at a desk, that’s just what they will do. If you want them to perform a specific task, you should pay them based upon some objective measure of performance.

While this may not be universally accepted today, it’s been the norm for most of human civilization. In an agrarian society, for instance, farmers who worked 300 acres received twice the yield as those who worked 150 acres. Tradesmen who wove more rugs or cobbled more shoes than their peers likewise sold more and earned more. Their greater productivity was rightfully rewarded. Even in an industrial economy, given the standardized manufacturing that assembly-line methods ensure, a factory worker who chooses to pick up a few extra shifts each week will surpass his colleagues putting in a regular workweek in both production and compensation.

In the information economy, those producing intellectual capital should be compensated based upon performance metrics as well. It is critical that those metrics are well thought out, as poorly designed compensation structures can incentivize gaming, as was recently the case with unethical, illegal sales practices at Wells Fargo. Some argue that performance fees, such as the typical 20 percent of profits for hedge funds, also produce perverse incentives to take excessive risk. Others, however, disagree and have suggested models with even higher incentive fees.

A fixed fee can create problems as well. Take the typical consultant fee structure, a flat fee regardless of performance. As a recovering consultant, I know their dirty secret is the incentive to keep costs low and do just enough to retain clients.

In some areas these concerns may not matter, but in certain asset classes they can create enormous problems. If you haven’t thought long and hard about your fee arrangements and compensation structures, you run the risk of turning your intended alignment of interests into perverse incentives.

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