Berkshire Hathaway 2003 Annual Meeting Audience Question # 45

Berkshire’s compensation policy

Warren Buffett:

Number 6.

Audience Member:

Good afternoon. My name is Ravi Gilani. I come from New Delhi, India.

I have questions regarding management policies. Since you follow quite different management policies, I would like to know the impact of them on the management CEO’s motivation.

Mr. Munger has mentioned that where capital is unimportant in a business, you tend to give the CEO a part of the earnings. You have also mentioned that you do not greet good work by raising the bar. Clearly, static earnings over a period of time may become successively less valuable.

My question is in, now, four parts. Bearing the above in mind, could you give us an example of compensation policy in Berkshire subsidiaries which illustrate your thinking on the subject of executive compensation?

Number two, though you do change… charge… subsidiaries for using capital, and believe in linking rewards to bottom line performance, Mr. Munger does not respect economic valued added as a concept. Could we have your thinking on EVA as a tool to monitor and reward corporate performance?

Number three, do you restrict yourself to setting compensation policy for the CEO, or do you involve yourself in larger part of the organization?

And finally, you do not have any retirement age for the CEO. Does it impact the morale, motivation, of the people below the CEO?

Warren Buffett:

Charlie?

He knew that was coming.

Charlie Munger:

Well, one, you’re right. Where a business requires practically no capital, we tend to reward the management based on the earnings. The minute the business starts requiring capital we tend to put a capital factor into this compensation system.

We don’t have any one standard system. They’re all different, based on accidents of history and circumstances.

But where capital’s an important factor, of course, we take it into account.

As far as the effects on morale, as far as I’ve ever been able to see, the morale’s pretty good in the Berkshire subsidiaries. And the Berkshire managers practically never leave. And my guess is we have about as low a turnover rate as any place around. Is that right, Warren?

Warren Buffett:

Oh, I’m sure of that. And besides, the “no retirement policy” is wonderful for my morale.

And Charlie’s.

The… you also asked about EVA. We would not dream of using something like that, although I think actually a few of our subsidiaries may use it in some way.

So, the subsidiaries set their policies for the pay of the people below the CEO, and the… all… they have all kinds of systems, because we have all kinds of businesses.

And, frankly, we’ve never had big problems with compensation because, I think, our arrangements are rational.

When capital is an important part of the business, we stick a charge for capital in. If it’s an unimportant part of the business, we don’t stick it in. We don’t believe in making things more complex than needed.

So, we don’t try for little… all kinds of little refinements… which a compensation consultant would come in and tell you was needed, because that’s how he would justify a large bill. And he would also come in and tinker with it a little the following year, and the following year, and so on.

We have very simple systems on comp. But some of our businesses are terrific businesses, and so we have very high standards of performance before people get performance bonuses.

Some of our businesses are very tough businesses, and the threshold is much lower, but the managerial talent needed to reach that threshold is just as much as in the… with the higher threshold in other businesses.

It’s not a… compensation is not rocket science. I mean, people will want you to think it is, and you read these proxy statements and it blows your mind, what they get into. I mean, the proxy statements are thicker than the annual reports because they’re talking about the compensation of people.

And it is not that complicated. We’ve had… in 38 years, we have never had a CEO leave us to go to another business, except a few we’ve… where we’ve made the decision ourselves, but very few.

And it is… you know, I see all of the time and effort put in because, frankly, it pays off for the CEO to do it. And then they create a whole department that spends all their time attending conferences about, you know, compensation methods, and they have consultants in, and it becomes an industry.

And it isn’t going to break itself up. I mean you… when you get those… when you get a huge bureaucracy involved in making all kinds of pay determinations and everything, it’s never going to go away unless you do something about it. But that’s true of any bureaucracy we run into.

We don’t have much bureaucracy at Berkshire done.

I think that there’s no question that our “no retirement policy” means that somebody who’s just itching to be the CEO of a business, and they see that the CEO is 65, and then 70, and then 75, above them at some of our companies, is probably not going to stick around.

I mean we don’t develop, naturally, lots of number twos because we can’t promise them that number one is going to go out the door. But as long as number one doesn’t go out the door, from our standpoint, that’s just fine.

And we occasionally have to replace managements, but it’s very occasional. I mean if… on an expectancy basis, you know, even with all the subsidiaries we have, you know, we may face one management succession problem, perhaps, every 18 months or something of the sort. And we’ve got all kinds of other businesses. So it’s not a big deal at Berkshire.

Charlie Munger:

Yeah. And on EVA, there are ideas implicit in that that we use. For instance, hurdle rates by… based on opportunity costs. Perfectly reasonable concept.

But to us, that system, with all its labels and lingo, has a lot of baggage that we don’t need. We just use the implicit, simple stuff that’s buried in EVA.

Warren Buffett:

Yeah. We could spend a million bucks a year on consultants to get an answer we can get in five minutes, frankly. I mean it is… it just isn’t that complicated.

But can you imagine a consultant coming around and saying, “I’ve got a one-paragraph compensation arrangement for you?”

Are they going to be able to send you a large bill for, you know, their consultancy? Of course not. So, they’ve got to make things complicated, and we don’t believe in that. We want things that are very easy to understand, and we’ve just never had a problem with it.

And we get good results out of our managers.

The main reason we get good results out of our managers is that, you know, they like hitting .400. They like hitting .400 and being fairly paid, but they… the fact that they batted .400 is the biggest thing to them, in life.

And it’s, you know, it’s sort of the way we feel. If we get a good batting average in our business performance, the pay is incidental.

Now, it shouldn’t be incidental to our managers. It’s got to be fair or they’re going to… nobody wants to work in an environment where they feel they’re being treated unfairly, but…

That is not a complicated procedure. And we do make them very specific to the enterprise that’s under their control. We do not pay the people of See’s Candy based on how The Buffalo News does or vice versa.

And I can show you a lot of crazy compensation systems in corporate America where that really is the ultimate effect of what’s happening.

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