(Reuters) - Top executives at Goldman Sachs (>> Goldman Sachs Group, Inc.) have been considering deep cuts to staffing levels and pay for at least two years, but feared too many layoffs would leave the firm unprepared for an eventual pickup in business, people familiar with the bank said.
They instead chipped away at staff levels and focused on non-personnel expenses that are less painful to cut.
But investors pressured the bank to cut costs further, the sources said, and on Wednesday, Goldman gave in.
The largest standalone investment bank said in the fourth quarter it cut the percentage of revenues it pays to employees in half to 21 percent. That brings the ratio for the entire year to its second-lowest level since the bank went public in 1999.
With less money going to employees, more was available for shareholders. The bank's annualized return on equity - which measures how well the bank uses shareholder money to generate profit - jumped to 16.5 percent in the fourth quarter from 5.8 percent a year earlier.
"Arguably for the first time, Wall Street's shareholders are getting the lion's share of the profitability," said Brad Hintz, a former Morgan Stanley treasurer who is now an analyst at Bernstein Research.
The bank's quarterly profit tripled, helped by gains from investments and bond trading as well, and investors sent its shares up 4 percent to $141.09, their highest level since 2006.
Analysts said other banks are likely to feel pressure to keep their compensation expenses in check after Goldman's results. But for Morgan Stanley (>> Morgan Stanley), the second-biggest stand-alone U.S. investment bank, paying out a lower percentage of its revenue to employees could be tough because analysts believe its revenue fell last year.
Goldman missed the worst pitfalls of the financial crisis but has suffered public relations embarrassments from trades it executed during the crisis and from executives' comments afterward. The bank, along with the rest of the industry, is struggling to figure out how to navigate the post-crisis world, in which clients trade less and regulations and capital rules crimp profits in many businesses.
Whether Goldman maintains its discipline on pay will be a test for Harvey Schwartz, who succeeds David Viniar as CFO at the end of this month.
On a conference call with investors, Schwartz declined to provide a target for compensation levels, but emphasized that shareholder returns would be one crucial factor in deciding how much revenue goes to employee pay.
"We don't look to overpay anybody," Schwartz said.
YEARS OF COST-CUTTING
Goldman first publicly signaled its intent to get serious about cost-cutting in July 2011, when Viniar outlined a plan to reduce costs by $1.2 billion a year, partly by laying off employees. Since then, Goldman expanded that cost-cutting plan by $500 million and has winnowed staff almost every quarter.
Staff reductions have targeted big earners, including dozens of partners, who have left since the start of 2011. Sources inside the bank expect that exodus to continue this year as Goldman makes way for younger employees to move up the ladder.
Analysts say that strategy is common.
"The polite way to characterize it is a ?generational change' - where you promote the young guys and you don't pay them," said Hintz.
In 2008, as the bank's revenue dropped, average pay per employee fell as well. While the average Goldman worker brought home nearly $622,000 in pay in 2006, that figure dropped to $367,057 per person in 2011, with the biggest decline happening between 2007 and 2008. But the percentage of revenue that the bank paid to employees did not stop falling until now.
The fourth-quarter drop meant that for all of 2012, Goldman paid employees 37.9 percent of the bank's revenue, down from 42 percent in the previous year.
"Management appears to be doing a superb job at keeping all expenses down and, in particular, retaining quality people without giving all the revenue away in the form of compensation," said Joe Terril, president of St. Louis-based investment firm Terril & Co, who invests in bank stocks.
WALL STREET WOES
Many banks are facing the same long-term revenue pressure as Goldman, and analysts expect layoffs across Wall Street. Morgan Stanley plans 1,600 job cuts in 2013, while Goldman cut 900 jobs in 2012, equal to about 3 percent of its workforce.
But laying off staff may not be enough, and employee pay may have to fall too. Hintz, the Bernstein Research analyst, estimates that across Wall Street average pay in trading businesses could fall 20 percent.
"There's only one way to get returns up on Wall Street, and that's to cut the compensation of the employees," Hintz said.
Investors have been pressuring banks to pay less of their revenue to employees. In 2011, investors pressed Morgan Stanley executives to pay somewhere closer to 30 percent of the bank's revenue to employees, instead of around 50 percent, according to one person at those meetings.
(Reporting by Lauren Tara LaCapra; Editing by Dan Wilchins, Paritosh Bansal and Ryan Woo)
By Lauren Tara LaCapra