How Buffett and Munger set incentives

George Mack

How Buffett and Munger set incentives:

Everyone has heard: "Show me the incentives -- and I'll show you the outcome"

But what do good incentives actually look like?

Here's the incentive system Buffett and Munger used for GEICO:

1. Principal-Agent Problem

Principal = Shareholders of the business
Agent = Employees of the business.

The agents (employees) are acting on behalf of the principles (shareholders).

The principal-agent problem is the conflict of interests between these 2 groups.

Buffett & Munger looked to create an incentive model so that every agent in the business was rewarded for thinking like the principal.

2. Inversion

"You get what you reward for. If you have a dumb incentive, you get dumb outcomes" - Munger

Having a dumb incentive scheme is worse than having no incentive scheme.

The worst incentive schemes are ones that create a greater principal-agent problem.

The best example of this is FedEx, which paid people by the hour rather than by when the job was done -- and could never deliver anything on time.

Buffett & Munger outlined ways that would make the principal-agent problem worse -- and avoided that.

3. Simplicity

For 20,000+ employees at Geico (One of Buffett & Mungers companies) - there are 2 simple variables that incentives are based on:

A. New business (Number of policies)
B. Profit growth

This is the midwit meme in play.

It's so simple that everyone in the company can repeat it back to themselves.

4. Pairing metrics

If the only metric was new business, the principal-agent problem would lead to employees focusing on growth at all costs.

If the only metric was profitability - the principal-agent problem could result in them turning off all advertising, which would maximise profit but harm the business in the long run.

The balance of business growth and profitability aligns the employees goals with the shareholder's goals -- and prevents a perverse incentive problem.

5. Long term thinking

The incentive system at GEICO only kicks in after a year of being there.

And it increases as a % each year after.

The beauty of this system is that the most valuable employees are the ones with the most experience in the business -- but they are also more likely to hit motivation entropy with time and leave the business.

The incentive system is set up like a video game designed to reward long term thinking and combat fatigue.

6. Win-Win alignment

The very top people, CEO and shareholders, (Principals) are getting paid on the same variables as everyone else in the company (agents).

The knock on effect on culture is that everyone is swimming in the same direction.

------

If you have any other tactical nuggets on incentives, drop them below.

It feels like an incredibly under discussed topic.

Table of contents

How Buffett and Munger set incentives:

Everyone has heard: "Show me the incentives -- and I'll show you the outcome"

But what do good incentives actually look like?

Here's the incentive system Buffett and Munger used for GEICO:

1. Principal-Agent Problem

Principal = Shareholders of the business
Agent = Employees of the business.

The agents (employees) are acting on behalf of the principles (shareholders).

The principal-agent problem is the conflict of interests between these 2 groups.

Buffett & Munger looked to create an incentive model so that every agent in the business was rewarded for thinking like the principal.

2. Inversion

"You get what you reward for. If you have a dumb incentive, you get dumb outcomes" - Munger

Having a dumb incentive scheme is worse than having no incentive scheme.

The worst incentive schemes are ones that create a greater principal-agent problem.

The best example of this is FedEx, which paid people by the hour rather than by when the job was done -- and could never deliver anything on time.

Buffett & Munger outlined ways that would make the principal-agent problem worse -- and avoided that.

3. Simplicity

For 20,000+ employees at Geico (One of Buffett & Mungers companies) - there are 2 simple variables that incentives are based on:

A. New business (Number of policies)
B. Profit growth

This is the midwit meme in play.

It's so simple that everyone in the company can repeat it back to themselves.

4. Pairing metrics

If the only metric was new business, the principal-agent problem would lead to employees focusing on growth at all costs.

If the only metric was profitability - the principal-agent problem could result in them turning off all advertising, which would maximise profit but harm the business in the long run.

The balance of business growth and profitability aligns the employees goals with the shareholder's goals -- and prevents a perverse incentive problem.

5. Long term thinking

The incentive system at GEICO only kicks in after a year of being there.

And it increases as a % each year after.

The beauty of this system is that the most valuable employees are the ones with the most experience in the business -- but they are also more likely to hit motivation entropy with time and leave the business.

The incentive system is set up like a video game designed to reward long term thinking and combat fatigue.

6. Win-Win alignment

The very top people, CEO and shareholders, (Principals) are getting paid on the same variables as everyone else in the company (agents).

The knock on effect on culture is that everyone is swimming in the same direction.

------

If you have any other tactical nuggets on incentives, drop them below.

It feels like an incredibly under discussed topic.

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