2006: How would you design a compensation system for a cyclical business?

AUDIENCE MEMBER: Good morning. My name is Phil Rafton (PH), shareholder from Orinda, California.

My question for you: How would you design a compensation system in a very cyclical industry that can swing from boom to bust?

You want to tie compensation to results in some way, but this can lead to huge swings in pay. And, for example, today in booming industries, like energy and mining, profits are large as a result of the boom in the industry and not necessarily the results of management skill.

Conversely, when the industry is down, profits are low due to no fault of management.

So, again, my question: How do you design a compensation package to best reward management performance?

WARREN BUFFETT: Yeah. That’s a terrific question. Because if you’re running a copper company now with copper at 3.50 a pound, you can coin money even if you happen to be the village idiot, you know.

And, similarly, when copper was 80 or 90 cents a pound, which has been most of our adult lifetime, in that general — there were fairly sparse times in mining much of the time.

And we design compensation systems at Berkshire. We have dozens and dozens of companies. Some of them are capital-intensive. Some of them are cyclical. Some of them don’t require much capital.

Some of them are terrific businesses if no one runs them. Some of them are very difficult businesses, even if the best of management comes.

And we have a wide variety of compensation systems. You’re wise when you say, “How do you design one for that kind of a situation?” Because so often people come in with, sort of, standardized systems or whatever the highest system they see is, and then apply it to their own benefits.

Most people, if left to select their own compensation systems, will come up with the appropriate, from their standpoint, comparable arrangement.

If we owned a copper mining company in its entirety, we would measure it, probably, more by cost of production than we would by whether copper was selling for $2.00 a pound or a dollar a pound.

I mean, they — the management has control — depending on the kind of ore bodies and everything — but they certainly have control over operating conditions. They do not have control over market prices.

And we would have something, I think, that would not fluctuate a lot in a business like that, the bonus available, but it would probably tie to what we thought was under the control of the individual who’s managing the business. That’s what we try to measure.

We try to understand the industry in which they operate, and we try to understand the things that the manager can have an impact on, and how well they’re doing in that.

We measure, at GEICO, for example, we measure by two unit measures: one is growth — unit growth — and one is the profitability of seasoned business.

New business costs money. We want new business; so we don’t charge that against the manager or the 20,000 other employees who share in it.

We do not want to pay for anything that is not under their control. We do not want to pay for the wrong things.

And I would say, in a cyclical business, that you — you know, if oil is $70 a barrel, I don’t think any particular management deserves credit for it. In fact, they all sort of deny that they’ve got anything to do with it when they get called before Congress.

But I would not give them credit for the fact that oil is $70 a barrel or $40 a barrel. I would give them credit for low finding costs for — over time.

I mean, what you really want to do, if you have a producing oil company, is you want a management that, over a five- or ten-year period, discovers and develops oil at lower-than-average unit cost.

There‘s been a huge difference in performance in that among even the major companies, and I would pay the people that did that well. I would pay them very well, because they’re creating wealth for me.

And I would not pay the guy a lot of money that simply is cashing in on $70 oil and that really has got a terrible record in finding it at reasonable prices. Charlie?

CHARLIE MUNGER: Yeah. It’s easy to have a fair compensation system like we have at Berkshire.

And a lot of other publicly-traded corporations also have fair compensation systems, but about half of them have grossly unfair systems in which the top people get paid too much.

We know how to fix Berkshire, but our ability to influence the half of American industry where the compensation systems are unfair has so far been about zero.

WARREN BUFFETT: Yeah. One thing you may find interesting, we have — I don’t know — 68 operating companies. We probably have — I probably have responsibility for the compensation system of, perhaps, 40 managers or thereabouts, because some of them have businesses grouped under them.

I can’t think — again, I can’t think of anyone we have lost over a 40-year period because of differences in views on compensation.

I also — we’ve never had a compensation consultant come into Berkshire. They may have had them at the subsidiaries, but they’re smart enough not to tell me. (Laughter)

They — it’s never happened. I mean, we do not — and we do not have lots of meetings. We don’t spend a lot of time on it. It is not rocket science.

It’s made more complicated than it needs to be, more confusing than it needs to be, because having a system that is complicated and confusing serves the needs of some who want to get paid a whole lot more than their worth.

And the system won’t change because it’s working to the advantage of the people that have their hand on the switch, the people that pick the human relations consultants and pick the people who are on the comp committee.

I was put on one comp committee, and Charlie can tell you what happened. (Laughter) He was there.

CHARLIE MUNGER: Yeah. We were the biggest shareholder at Solomon. Two of us were on the board, and Warren was on the comp committee.

And in that frenzy of envy, which characterizes compensation in investment banking, Warren remonstrated, softly, I thought, towards a slightly more rational result, and he was outvoted.

WARREN BUFFETT: Charlie used the term “envy” rather than “greed,” which is interesting, because that’s been our experience, is that envy is probably a bigger motivation, in terms of people wanting to be in that top quartile, or whatever it may be, than greed.

It’s a very interesting phenomenon that you can hand somebody a $2 million bonus, and they’re fine until they find out that the person next to them got 2-million-1, and then they’re sick for the next year. (Laughter)

Charlie has pointed out — you know, of the seven deadly sins — that envy is kind of the silliest because you don’t feel better. You know, I mean, if you get envious of somebody, you feel worse the whole time.

Now, you know, gluttony — you know, I’ve had some of my best times while being gluttonous. (Laughter)

There’s a real upside to gluttony. (Laughter)

We won’t get into lust. (Laughter)

But I’ve heard that there are upsides to that, occasionally.

But envy, you know, all you do is sit around and make yourself sick and can’t get to sleep. But that’s — it’s part of the human psyche, and you see it big time and you get this irony.

The SEC wants even more transparency on pay, which I think, you know, basically is a good idea except for the fact that it becomes a shopping list for every other CEO when they see that somebody is getting their haircuts paid for by the company.

They decide that they, too, need their haircuts paid for by the company, and they suddenly become big tippers.