SAN FRANCISCO (MarketWatch) -- American International Group said Friday that it's spending $1.1 billion in bonuses to retain key staff members to help the troubled insurer wind down businesses and keep other parts of the company competitive.

AIG said it has already incurred $824 million of expenses from a retention plan that was set up in 2008 and runs through 2011. Another $249 million will be spent during the second half of 2009, the insurer estimated in a regulatory filing.

In 2010, the plan will likely cost $18 million, while in 2011 it will cost $1 million, AIG added. That brings the total cost of the plan to $1.092 billion, AIG estimated.

The ultimate amount paid could be less, mainly because of forfeitures, AIG AIG, +0.55% noted in the filing.

AIG almost collapsed last year under the weight of billions of dollars in derivatives-based guarantees it sold on mortgage-related securities. The government saved the company with multiple bail outs worth more than $100 billion.

A national furor erupted earlier this year when it emerged that AIG had paid roughly $160 million to retain employees at the derivatives unit that wrote the guarantees. See story on AIG death threats.

Some recipients of the bonuses agreed to pay the money back, but the episode has sparked a debate about compensation across corporate America. See MarketWatch Special Report on CEO Pay.

'Penny wise pound foolish'

AIG is in a tricky situation, because its derivatives unit still has more than $1 trillion of exposures that need to be unwound while keeping losses under control. The company needs derivatives experts to stick around to manage this process, but if it pays them too much to stay it may be heavily criticized for spending too much government money on eye-popping bonuses.

"This company is not going to heal itself and be wound down without people," Cathy Seifert, an insurance analyst at Standard & Poor's Equity Research, said. AIG's derivatives business "needs to be wound down very carefully. You want qualified people doing that."

If AIG doesn't pay experts enough to keep them, the company could lose more money on its derivatives positions than it saves on compensation, she explained

"There's something to be said for not being penny wise and pound foolish," Seifert added. "I'm sorry if that's not a politically acceptable thing to say."

Pay czar

The White House in June appointed Kenneth Feinberg to oversee compensation at some of the large financial institutions, including AIG and Citigroup C, +1.42% , that received a lot of government support.

Feinberg has the power to reject pay packages for the top 100 employees of these institutions. However, he only has authority over future compensation arrangements, so AIG's 2008 retention plan may be outside of his jurisdiction.

"AIG, along with the other six institutions receiving exceptional assistance, will need to convince Mr. Feinberg that they have struck the right balance to discourage excessive risk taking and reward performance for their top executives," an official from the Treasury Department said Friday.

"We are not going to provide a running commentary on that process, but it's clear that Mr. Feinberg has broad authority to make sure that compensation at those firms strikes an appropriate balance," the official added. "We all have a shared interest in ensuring that those companies can return to profitability as soon as possible so that taxpayers can recoup their investment."

Unwinding

AIG said Friday that the notional value of its derivatives portfolio was $1.3 trillion at the end of June. That was down 13% from the end of the first quarter. The insurer said it reduced the number of positions in the portfolio by 20% to roughly 22,500.

AIG Financial Products, as the derivatives unit is known, lost $132 million during the second quarter. That was less than the $6.2 billion the unit lost in the same period last year.