The Great Financial Crisis (GFC) demonstrated the consequences of adverse incentives. Although the principle that the risk to the agent’s incentive payout should be as similar as possible to the risk experienced by the principal is easy to state, it is very difficult to achieve in practice. An incentive structure for a U.S. foundation that must make a return on its endowment to offset its required 5% annual payout is proposed.
The incentive structure is a combination of call spreads linked to the performance of the foundation’s invested assets and put spreads linked to the performance of the foundation’s invested assets whose payout is the carry-forward of investment staff’s unearned incentive compensation.
With this structure, the risk of the staff’s incentive compensation is similar to the investment risk of the foundation’s invested assets. One of its benefits is that it further encourages investment staff to protect capital when necessary.