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If pleas for restraint could halt the remorseless escalation of top pay, they would have done so long ago. But beseeching bankers or chief executives to moderate the bonus culture seems like asking a cat to moderate small-bird-eating or a drug addict to go easy on the heroin. Consider the report by Incomes Data Services, an independent research organisation, that FTSE 100 directors’ pay increased by an average of 55 per cent last year. Austerity? What austerity?
It is impossible to halt the increase in top pay without knowing what drives it. And the causes are buried so deep in the system that it is too easy for everyone involved (directors, remuneration committees and consultants, shareholders, the recipients themselves) to hold up their hands and say, with superficial justification: “Sorry, folks, nothing to do with me – that’s just the way it is.”
Tracing it back, pay starts with governance and the assumptions behind it. One assumption is that the market sets pay rates and is self-correcting, so companies that overpay executives will, eventually, lose out to those that get it right. In turn, an important part of setting pay correctly is alignment. Conventional theory holds that without measures to align the interests of managers with those of shareholders, managers will concentrate on looking after themselves rather than stockholders. To persuade them to do their proper jobs, they need incentives.
And incentives they have had. Over the past three decades, stock options, bonuses and increasingly far-fetched inducements have proliferated to the extent that in the US the pay ratio from chief executive to average worker has ballooned from 30-40 to 300-400 times. (Curiously, while managers are assumed to need as much as possible to motivate them, for everyone else the opposite apparently applies.) Much of that increase has come in the past 10 years – in this period, the UK ratio, while less extreme than in the US, has nearly doubled from 47 to 88 times for FTSE 100 companies, according to Incomes Data Services.
Neither common sense nor comparison of shareholder returns supports the idea that chief executives are twice as productive as a decade ago, let alone 10 times better than in the 1970s, when those returns were in fact higher. So how have rewards become untethered from performance, allowing them to float free from the pull of market gravity?
The answer is that the “market” for chief executives’ pay does not work. Shared interests between shareholders and chief executives aligned primarily with their bank accounts (as Roger Martin, dean of Toronto’s Rotman School of Management, put it recently) have turned into something both cosier and more pernicious. Collusion is one description; “unholy alliance” is the term preferred by Ha-Joon Chang, the Cambridge economist, in his stimulating book 23 Things They Don’t Tell You About Capitalism.
Briefly, the author says, managers have bought shareholder acquiescence in soaring remuneration levels by dramatically increasing the share of profits going to shareholders. Sometimes the means are spectacular deals, often instigated by the investment banks, whose profits (and pay) in their turn are held aloft by the same deal flow.
In theory, shareholders should not buy this deal, because short-term privileges are bought at the expense of the company’s long-term investment prospects. But they do because, counter to assumptions that require them to be the most committed stakeholders, they are, in fact, the least. The average City fund manager is judged on quarterly performance and turns over 80 per cent of his or her portfolio a year. In an era of high-speed trading when “investors” own shares for a nanosecond, or when hedge funds borrow shares to vote for a short-term killing, the argument that a shareholder’s position in the company is more illiquid than that of other stakeholders – the assumption that underpins our governance structure – is impossible to sustain. Apart from a few patient investors such as Warren Buffett, their behaviour shows that many shareholders simply do not care about the long term.
This explains why appealing to shareholder activism to combat excessive executive pay is pointless. To put it baldly, shareholders are on the take too – and their influence on companies is not always positive. According to recent academic research for the American Accounting Association, one of the most important factors in explaining the performance of financial companies during the crash was the amount of stock owned by institutional investors. The higher the proportion, the worse companies fared. The explanation: these companies took more risks, and none of the shareholder-based governance checks and balances – independent directors, splitting the roles of chairman and chief executive, or even having a risk committee – reined them in.
Discussing hedge fund managers, Prof Martin noted recently that the people making the most money contributed least to society. Yet soaring pay – and, as Chang points out, the ability to pass on the consequences of faulty decisions to others, as in the banking crisis – are not an inevitable outcome of “natural” processes. They are the reverse: a symptom of market failure and broken governance. Determined intervention to correct these is the only way to align chief executive reward mechanisms with our interests, not just theirs.
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