by Brian DeChesare Comments (20)

The Era of Big Bonuses: Over? How the 2008 US Election Results Will Affect Investment Banking Pay

On January 23, 1996, President Clinton made a famous declaration in his State of the Union address:

“The era of big government is over.”

The promise, of course, turned out to be untrue: although Clinton moved to the center on welfare reform, among other issues, he later proposed hundreds of billions in additional federal spending.

With the results of the 2008 US election, many in the finance community have been asking a similar question lately:

Is the era of big bonuses over?

Before hitting the “panic” button, we need to break this question down so we can analyze it rather than running around with our heads cut off.

There are 3 major factors that could affect bonuses in coming years: the market, federal regulation, and tax law.

The Market

The market has, by far, the biggest impact on bonuses and business in general.  Investment banking salaries fell these past 2 years because of the market; they’ll fall again next year due to the market.

When bonuses dropped to almost nothing in 2001-2003, it had nothing to do with tax rates or regulations and everything to do with the lack of deal activity and the recession.  A 5% tax increase won’t kill bonuses, but a 25% drop in M&A activity will murder bonuses without mercy.

You could argue that increased taxes and regulations will hurt the market and therefore indirectly hit bonuses.  But it’s difficult to quantify this effect, and it’s even harder to know how much longer such changes would prolong the recession.

Regardless of who had won the election, there would be no silver bullet solution to a market downturn: the only cure is time.  And taxes can’t go too much lower than the levels they’re at now – so massive tax cuts are not a viable strategy.

Federal Regulation

Once the US federal government controls all the banks in the country, they’ll limit bank executives to a measly $400,000 per year, right?

Surprisingly, both candidates had promised increased regulation in some form.

Artificially capping pay at banks is one extreme of the federal regulation equation, but it’s not unthinkable. After all, if Lehman really went bankrupt, where did they get that $2.5 billion bonus payment from?

Since Obama has not yet announced his plan for federal regulation of banks, we can’t say specifically how regulation would have differed under either administration.

However, from statements both candidates made and from the public backlash to the financial crisis, we can surmise that regulation would have increased regardless of who had won the election.

Tax Law

When it comes to finance, there are 3 relevant tax policies to look at: the corporate tax rate, the personal income tax rate and the capital gains tax rate.

I recommend reviewing this comparison of both candidates’ tax plans.  Yes, I realize it is from a conservative institution and therefore the conclusions are not “fair and balanced,” so just pay attention to the objective parts where they discuss the features of each plan in detail.

Corporate Tax Rates

In the US most companies pay a 35% or 40% corporate tax rate. McCain wanted to reduce it to 25%, while Obama claimed that the effective tax rate was far lower and that a reduction would therefore be unnecessary.

It doesn’t matter who was correct because there’s no way a corporate tax cut would have become law with the financial crisis and the accompanying public outcry for more oversight, not less.

In all likelihood, Obama will keep corporate tax rates the same and banks will continue paying the standard tax rate on their earnings.

Personal Income Tax Rates

So now we get to the famous “Over $250,000 per year” issue – and I do think that this one will become law. As a result, anyone in finance above the entry-level will soon be making 5% less after-taxes.

Of course, this won’t affect most readers since Analysts never make more than $250K per year.

Some Investment Banking Associates and Private Equity/Hedge Fund Associates at the largest firms will be affected, though pay in general will be down over the next few years – so the poor market might make some of them exempt from the tax increase.

Update: As you might have seen in the comments below, one reader points out that Obama’s proposed removal of the payroll cap in FICA (Social Security & Medicare) tax will affect anyone making over $97,500.

Effectively, anyone making over $97,500 will have to pay 6.2% tax on anything over that, which will impact pay more substantially than the increase in income taxes (for most people).

So the situation is worse than what I initially thought, though even this will still be outweighed by the poor market and potential capital gains tax increases.

Capital Gains Tax Rates

Near the end of his campaign, Obama settled on a 5% capital gains tax increase, which would raise the rate from 15% to 20%.

This will marginally affect bankers and anyone else on the sell-side, but it will have far more of an impact on anyone in the private equity or hedge fund world.

But the more frightening prospect is that carried interest (the returns PE firms get from their investments) might be treated as ordinary income – at close to a 40% tax rate – rather than the 15% or 20% rate.

This one may not be at the top of Obama’s agenda right now, but if it does become law, it will be the single most significant tax change.

However, even if it does happen it won’t affect too many people at the Associate level in Private Equity – they rarely get to invest their own money alongside the Partners anyway.

So Who Will Be Affected?

We’ve already seen that hardly anyone at the entry-level will be affected by possible changes to the tax law.

If, however, buy-side firms start getting taxed at much higher rates that could negatively affect hiring practices and bonuses and therefore indirectly impact everyone.

Anyone more senior will be hit by the tax increases, though not dramatically in most cases (ok, I suppose 5% of $5 million is somewhat dramatic).

Increased regulation, of course, will impact almost anyone in finance – but again, most of it will be felt at the top rather than the bottom.

And the market will have the biggest effect of all – and it’s the one factor beyond the control of anyone in Washington.  Sure, higher taxes may lengthen the recession, but even if taxes were cut dramatically it would still take years to recover from the mess we’re in.

And Outside the US?

Although I’ve lived and worked abroad before, I’m certainly not an expert on the political and economic systems of other countries.

But if I had to guess, I would say many of them are likely to follow in the footsteps of the US, at least in terms of increased regulation and government intervention.

We’ve already seen developing economies (see: China) and more mature countries alike (see: the UK) introduce regulation and intervene in their respective economies in recent weeks.

And that means lower bonuses at international firms, though the market downturn will still have more of an impact than regulation or tax increases.

So, What About Those Bonuses?

Now that you’ve learned all sorts of tax trivia, let’s return to our original question:

Is the era of big bonuses over?

Yes, it is.

But not because it was a Democratic victory specifically.

Regardless of who had won, we would have seen more regulation and restrictions on what banks can do. True, with Obama you’ll now be losing more in taxes – but I don’t think you’d be saving much more had McCain won.

Extreme tax cuts would not have made it through a Democratic Congress, and no one would have miraculously cured the market’s woes.

Every market is cyclical, and in a few years bonuses will return to higher levels as the economy recovers.

But will they ever reach $90,000 for 1st-Year Analysts as they did in 2007?

No, I don’t think so.  Not anytime soon, anyway.

Will people still make millions of dollars per year in finance?

Yes, but their ranks will be reduced.

Will everyone still chase after finance jobs with the hope of making millions?

Sure, but fewer people will do so now and even fewer will actually get there.

Good luck.

M&I - Brian

About the Author

Brian DeChesare

is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys memorizing obscure Excel functions, editing resumes, obsessing over TV shows, traveling like a drug dealer, and defeating Sauron.

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  1. Ray Murphy

    What is going to happen the IB, HF, PE, etc. salaries and positions now? Will someone entering as an quant or analyst etc. still be able to make $1M+ after 10 or so years? Will there be good opportunity to get these jobs? BusinessWeek, NYT, etc. are all full of stories of students who wanted to be investment bankers – now switching to engineering, science, mathematics, consulting, etc. In other words, they seem to have dropped their desire to become investment bankers.
    Perhaps more favorable conditions will be restored upon an economic expansion? That shouldn’t be more than 4-6 years from now – possibly 8 depending how bad this recession is.

    1. How should I know? I’m just a regular guy, I don’t have a crystal ball.

      BTW, you should never read mainstream news publications as they are clueless when it comes to finance. NYT in particular has a really bad liberal bias.

      Let me say this, though: the 2 best ways to make money are to be an investor, or to own your own business.

      No economic conditions will change that rule – so traders and other investors should still do ok…

      1. Ray Murphy

        Indeed, NYT, Huffington, Washington Post, etc. are totally incompetent when it comes to finance.
        However, I typically get my news from Financial Times, WSJ, Fortune, Forbes, and BusinessWeek. Do you feel these are more “clued-in?”

        When you say “investor” – do you mean it in a general sense? Such as, investment banker?

        BTW: What think you of this FORTUNE article. Does it not sound like “DOOM.”

        1. No, it sounds like:

          “Mid-level guys are screwed.”

          “Bankers are now going abroad and to boutiques to find work.”

          Which is what I’ve been saying all along.

          No, investor means to put your own capital to work in such a way that your time is not tied to your money – that is the key element. So bankers do not qualify because they do not use their own capital.

  2. I was wondering have you ever heard of the SEO minority internship and if you have do you think its a good program

    1. Yes, it’s a good program and I definitely recommend it. Many friends have used it to get in.

  3. Josh Haynes

    So, I’m considering business school (fall 2009) because I’m interested in finance. I studied as an engineer at the university and have spent the past 3 years doing consulting work.

    I want to switch, and I want education and then transition. I’m going to do this regardless because I find the industry very interesting.

    However, what are your thoughts on new associates a few years down the road? Perhaps now is a good time to train for a couple of years for the industry and get it while a) still sucks or b) starting to rise?


    1. It’s really hard to time the market, whether it’s the stock market or the job market… presumably, things will be better in a few years but no one really knows one way or the other. Also be aware that competition is going to be tougher in the near future since everyone is going back to school rather than working.

  4. I think rational has everything except one little thing, the social security cap for 2008 is $104K and he is planning to remove this cap. So that is one thing that will add and he also proposes to impose a new payroll tax that will be similar to social security, paid at 2-4% of your comp, half of it will be borne by the employer and half by the employee. So taking an average, people may see another 3% of their paychecks go to a tax.

  5. Libertarian

    The comment by “rational” is absolutely spot-on. Obama’s overall tax plan is both deceptive and economically unsound (not that McCain’s was substantially better). If our media’s golden boy is really the solution to our problem and not a further cause of even darker times ahead, he would cut taxes (at all levels), significantly cut the national budget, and deregulate (basic econ 101 for getting out of any recession). Consumer spending accounts for over two-thirds of GDP, and regulation (as most people conveniently forget or were never bright enough to comprehend in the first place) is, in large part, what caused this mess. The CRA (Community Reinvestment Act), passed in 1977, basically forced regulated institutions (basically most mortgage lenders), to provide loans to individuals who couldn’t pay them back (the American Dream at its finest). Well, SURPRISE, these people are significant credit risks, and more likely to default (lowering home prices and MBS significantly, which spreads to other credit markets). Great job Congress and Jimmy Carter! Also, many losses the banks faced were paper losses, referring to “mark-to-market” losses (accounting regulation largely increased by SOX). So, in summation, regulation may have very well led to the current credit crunch through costly accounting standards (unnecessarily raising cost of capital) and forced lax lending standards. And Obama calls for more regulation, what a great eight years we have ahead of us! Look forward to higher taxes (the fact that Social Security is not private, by itself, is a testament to Capital Hill’s incompetency), a deeper recession (maybe even a depression), and the continued demise of the banking sector.

    1. Who said anything about 8 years? :)

  6. So just out of curiosity, I was reading somewhere that the “top dogs” at GS make about $100MM/year, the “big dogs” make around $25MM, and the terriers and shih tzus make about $600,000. Who exactly are these top and big dogs? Apparently not M&A MDs according to your analysis…

    1. Not even the CEO of Goldman makes that much (especially not this year).

      The only people making that kind of money are hedge fund or PE founders who can afford to take huge cash distributions from investments each year.

      Group head MDs and people very high up in the organization might make $10-20MM; “normal” MDs are probably doing $3-5MM (not when the economy is bad). Anyone below them is probably around $1MM or less.


  7. What do you think bonuses will be like in late 2010 or early 2011?

    1. Hopefully higher than 2009… maybe moving back up to $40-$50K range for analysts.

  8. So on a raw dollar basis, how much do you expect overall bonuses and earnings to change for everyone from analyst to MD?

    1. I would expect 2009 bonuses to be roughly 2001-2002 levels for almost everyone. Back then, top bucket was $30K and bottom was $10K-$15K, if you didn’t get laid off that is.

      Everyone else will see their bonuses cut in half as well and I would expect most MDs will be lucky to see even $1MM pre-tax this year.

  9. Your analysis forgot one aspect…the removal of the income cap on the payroll FICA tax of 6.2%. This is currently capped at $97,500. As a result, your analysis above is VERY misleading. As it relates to the income tax, yes, everyone will be making 5% less on every dollar above $250,000. But here is where Obama’s plan really hits: your will now have to pay an additional 6.2% on every dollar earned in excess of $97,500. So, If you earned $300,000 in 2008 and then earned the same amount in 2009, your taxes paid would actually be $15,055 more for your 2009 income, not the $2,500 that some would have you believe. This $15,055 represents the combination of the $2,500 resulting from the 5% increase to the top bracket (income over $250,000) PLUS the 6.2% that you will be required to pay on every dollar of income over $97,500. That’s right…do the math. For someone making $300,000 per year, your taxes will be a total of 5% higher on EVERY dollar earned, not just every dollar above $250,000.

    1. Thanks for the addition. $15K vs. $2K certainly is a big difference, but still not much compared to how dramatically taxes changed under, say, Reagan when he sharply cut rates.

      The basic point remains that the downturn in the market will play a far bigger role in lower bonuses than anything tax-related.

  10. […] Is the era of big bonuses over? Mergers & Inquisitions takes a look. […]

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