2002: Did compensation mis-incentives result in writing mis-priced insurance policies?

AUDIENCE MEMBER: My name is Martin Wiegand, from Bethesda, Maryland.

Thank you for hosting this wonderful and formative shareholder meeting. Thank you also for running Berkshire in a manner that is an example to corporate America and the world. You make us proud to be shareholders.

My question, you touched on just before the lunch break. Did the compensation plans at Berkshire and its competitors have anything to do with the mispriced insurance policies they issued?

And if so, has Berkshire or its competitors changed their compensation plans to correctly price those policies?

WARREN BUFFETT: Incidentally, I asked you this last year, I think, but are you my Martin’s son or grandson?

AUDIENCE MEMBER: Son.

WARREN BUFFETT: Son, OK. Good enough. It — Martin’s father and I went to high school together. Matter of fact, your Aunt Barbara and I went to high school together also.

And she went out on one date with me, and that was the end. (Laughter)

It was not because I didn’t ask her out again. (Laughter)

I picked her up in a hearse. I think that kind of put the — (Laughter)

I think compensation plans lead to a lot of silly things, but I would say that, at Berkshire’s insurance companies, I don’t think our problems resulted from compensation plans at all.

I think we had an — and we’re talking about General Re here basically, because that’s where we had the problem.

I think General Re had an enormously successful operation, which went on for a long time. And I think that there was some drift away, perhaps because competitors were drifting away in a big way, too, from certain disciplines, and we paid a price for that.

But I don’t think the comp plans entered in at — in any significant way, if at all, into the fact that we did drift away for a while.

I think it — I think you want to have rational comp plans. I think we’ve got a rational comp plan at General Re, but — and it’s quite similar to what we had before. And I just don’t think that was the problem.

It’s very difficult, it’s difficult in the investment world, when other people are doing things that look like they’re working very well, you know, and they get sillier and sillier. It’s — it could be difficult for many people to not succumb and do the same things.

And that happens in investments, but it also happens in insurance. And it was, you know, it’s a competitive world, and your people are out there every day, and they’re competing against Swiss Re, and Munich Re, and Employers Re, and all of these people.

And you’ve worked hard to get clients, and the client says, “I want to stay with you, but the competitor says if I go with him, I don’t have to do this or that, or I can get it a little cheaper,” or whatever. You know, it’s tough to walk away. And it may even be a mistake to walk away in certain cases.

So, I just think that there was a — what you might call a cultural drift. I don’t think it was a shift, but it was a drift. And I think it was produced, in part, by the environment in which the company was operating. And it took a jolt to get it back. And I think that it is back.

I think it’s probably stronger than ever in terms of what we have now, but I would not attribute it much to the compensation system.

But I have seen a great many compensation systems that are abominations and lead to all kinds of behavior that I would regard not as in the interest of shareholders. But I don’t think we’ve had much of that at Berkshire.

Charlie?

CHARLIE MUNGER: Yeah, I think if you talk generally about stock option plans in America, you see a lot of terrible behavior caused. And, no doubt, they do a lot of good at other places. But whether they do more good than harm overall, I wouldn’t know.

I think, in particular, if you have a corporation where a man has risen to be CEO, and he now has hundreds of millions of dollars in the stock of the company.

He’s been loyal to the company and the company’s been loyal to him for decades, and he has his directors vote him a great stock option annually to preserve his loyalty to the company, and his enthusiasm to the business when he’s already old, I think it’s demented.

WARREN BUFFETT: How about when they grant options as he leaves the company?

CHARLIE MUNGER: I — and I also think it’s immoral. I think that there comes a time when — (Applause)

I don’t think you would improve the behavior of the surgeons at the Mayo Clinic, or the partners of Cravath, Swaine & Moore, if you gave the top people stock options in their sixties.

I mean, by that time, you ought to have settled loyalties, and you ought to be thinking more about the right example for the company than whether you take another hundred million for yourself.

WARREN BUFFETT: Yeah, well, we had a case — (Applause)

We’ve inherited some option plans because the companies we merged with had them. And in some cases they got settled for cash at the time, in some cases they continued on, depending on the situation.

But more money has been made from options at Berkshire by accident, and that, you know, this is not — it just happened that way, but more money was made by people that had options on General Re stock during a period when General Re contributed to a decrease in value of Berkshire.

So we had all of the other managers essentially, in a great many cases, turning in fine results, and we had a bad result at General Re, and yet more money, by a significant margin, was made under options at General Re than had been made probably by all other entities combined.

But it was an accident, but that’s the point, it leads — it can lead to extremely capricious compensation results that have no bearing on the performance of the people that, in some cases get great benefits, and in other cases people did great jobs and were — their efforts were negated by results elsewhere.

So, it’s — it would be very capricious at Berkshire — you can argue that at Berkshire, for those that succeed me and Charlie, that anybody that is in the very top position at Berkshire has got the job of allocating resources for the whole place.

There could be a logically constructed option plan for that person, and it would make some sense because they are responsible for what takes place overall.

But a logically constructed plan would have a cost of capital built into it for every year. We don’t pay out any dividends, so why should we get money from you free?

We could put it in a savings account and it would grow in value without us doing anything. And a fixed-price option over 10 years would accrue dramatic value to whoever was running the place, if they had a large option, for putting the money in a savings account or in government bonds.

So, there has to be a cost of capital factor in to make options equitable, in my view, that there can be cases where they make sense. They should not be granted at below the intrinsic value of the company.

I mean, the market — a CEO who says, you know, my stock is ridiculously low when a merger — when somebody comes around and wants to buy the company, but then grants himself an option at a price that he’s just gotten through saying is ridiculously low, that bothers me.

So if somebody says, you know, I wouldn’t — we don’t want to sell this company for less than $30 this year because it’s going to be worth a lot more later on, you know, my notion is that the option should be at $30 even if the stock is 15.

You know, otherwise you have a — actually a premium built in of — for having a low stock price in relation to value. And I’ve never gotten too excited about that.

Charlie, you have any further thoughts on options?

CHARLIE MUNGER: Well, we’ve been — we’re so different from the rest of corporate America on this subject that, you know, we can sound like a couple of Johnny One Notes, but I don’t think we ever quite tire of the subject. (Laughter)

A lot is horribly wrong in corporate compensation in America. And the system of using stock options on the theory they really don’t cost anything has contributed to a lot of gross excess. And that excess is not good for the country.

You know, Aristotle said that systems work better when people look at the different outcomes and basically appraise them as fair. And when large percentages of people look at corporate compensation practices and think of them as unfair, it’s not good for the country. (Applause)

WARREN BUFFETT: It will be hard to change though, because basically, the corporate CEOs have their hands on the switch. I mean, they control the process.

You can have comp committees and all of that, but as a practical matter — I’ve been on 19 public boards, Charlie’s been on a lot of them.

And in the end, the CEOs tend to get pretty much what they want. And what they want tends to go up every year because they see other people getting more every year. And there’s a ratcheting effect, and the consultants fan the flames. And it’s very difficult to get changed.

And right now, you’ve got corporate CEOs descending upon Washington, doing everything from trying to persuade to threaten your elected representatives to not have options expensed. And it’s — I think it’s kind of shameful, actually.

Because it, you know, this group, who is getting fed very well under the system does not want to have those — what clearly is a compensation expense recorded because they know they won’t get as much. I mean, it’s that simple. And it’s not based on anything much more complicated. (Applause)